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.