Pairs Trading – BUY Dow SELL SP500

Many traders are currently reducing or avoiding US exposures, ahead of the US Federal Reserve’s Open Market Committee (FOMC) meeting this Thursday. This may be why an unusual “relative value” trade is available. A gap has opened between the US SPX 500 and

the US 30 (tracking the Dow), and the strong correlation between the two suggests traders consider buying the US 30 and selling the US SPX 500.

Correlation is a measure of how one price moves in relation to another. Prices that move in lock-step have a correlation of 1 (the maximum). The one year, daily correlation of the two US indices is 0.975. The two year, daily correlation is 0.98 (Source: Bloomberg).

This is about as strongly correlated as prices in the real world get.

Yet in recent trading, a gap has opened. Here’s the daily chart of the two from the CMC Tracker platform:

US SPX 500 vs US 30 – Daily

The black line is the US 30, the pink the SPX. The gap is unusual. Although the two indices are very different (the Dow is a 30 stock “price” index, the SP500 is a 500 stock “value” index) the correlation shows they usually move very closely.

This has me very interested. I’ve written before about the lower overall market risk of pairs or relative value trading ( http://blog.cmcmarkets.com.au/2012/04/12/pairs-trading-an-explanation/ ).

In buying one US index and selling another, much of the overall market risk, and specifically the event risk around the FOMC announcement, is removed. This is important because I’m only looking for a 2 % gap close, and will need to put on a much larger trade (than I would trade outright) to profit sufficiently.

This looks ideal for a value neutral trade to me. Some thing like:

BUY 100 US 30  and simultaneously SELL 930 US SPX 500

The approximate US dollar value of this trade is $1,279,000, meaning if the two indices close the 2% gap, I’m looking at a profit of around U$25,580.

About michaelmccarthycmc

Chief Market Strategist - CMC Markets and Stockbroking Regular on ABC, BBC, Bloomberg, Channel TEN, CNBC, SBS and SKY
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8 Responses to Pairs Trading – BUY Dow SELL SP500

  1. Jason says:

    It is these pairs trades you look for that really interest me. I would definitely trade more of these if you made them available. Nice one.

    • michaelmccarthycmc says:

      Thanks Jason – I’m always on the look out

      • Jason says:

        Can you put a video tutorial together to show how you apply the overlay of 2 charts in tracker?

      • michaelmccarthycmc says:

        Good idea Jason. It’s fairly straightforward – you simply open one chart (say the US 30) and then drag and drop another index (US SPX 500) from the library or watchlist into the first chart

  2. dv34 says:

    Lol, adding to my pain… =)

  3. Raj DAS says:

    Whats the maximum risk in this trade?

    • michaelmccarthycmc says:

      Raj its a fair question, but difficult to quantify. As the correlation shows, this gap is already unusual, but it could grow. The beauty of these two instruments is that they trade through the three major time zones, so traders can actively monitor the risk. One method some traders employ is to set stop loss orders 2 % away on both orders, with matching price alerts. If a stop loss is triggered, the opposing order is closed immediately, regardless of the profit or loss situation. In the theoretical scenario that both stop loss orders are triggered (ie the gap has widened to 6%, which I consider highly unlikely) the maximum loss would be 4%

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