Relative Value Trading
In lower-correlation environments, there is differentiation in performance across and within asset classes exists. Given the breadth of the ETF and ETF options market, investors can take a view on the spread between two assets—at the sector, country or cross-asset level.
For example, using sector ETFs, investors can trade a single stock against a basket of its peers (same sector), thus allowing one to isolate the fundamentals of a particular company in a relative value trade. Or investors can trade the outperformance between two equity sectors. Likewise, with country-specific ETFs, investors can play an outperformance between regions. Even further, ETFs allow for views across assets to play the relative value between any pair of equity, commodity, fixed-income or currency assets.
A simple way to implement a long/short relative value trade is by going long and short the respective assets. However, the losses of an outright long/short trade can be uncapped if the assets move in the opposite direction of what was anticipated. Alternatively, a long-call-option/short-call-spread-option pair also implements a long/short relative value view, but with capped downside.
Example 7: Long Cyclical Sectors, Short Defensive In Reflationary Environments
Historically, cyclical stocks strongly outperform defensive stocks in reflationary environments. To express this in the U.S., an investor could go long NYSE Arca: XLY (discretionary sector ETF) and short NYSE Arca: XLI (industrials sector ETF). However, this trade has uncapped losses in the amount that XLI potentially outperforms XLY. To help mitigate the risk of the relative value trade, an investor alternatively could purchase call options on XLY and sell a call spread on XLI.
This long-call-option/short-call-spread-option pair trade has limited loss, as the long-call option’s maximum downside is the upfront premium, while the short call spread’s losses are capped to the distance between the two call-option strikes. If indeed XLY outperforms XLI, the long-call option would be better than the short-call spread, allowing an investor to capitalize on the relative outperformance but with limited downside risk.
Endnotes
1The S&P 500 Index options market is the largest in the world in terms of notional volume.
2For a definition of the S&P Global Industry Classification Standard (GICS), please see: http://www.standardandpoors.com/indices/gics/en/us
3Select Sector SPDRs are ETFs that divide the S&P 500 into nine sectors. Together, the nine Select Sector SPDRs represent the S&P 500 as a whole.
4Each month this strategy sells a put that is 4 percent out-of-the-money and a call that is 6 percent out of-the-money and then buys back a put that is 12 percent out-of-the-money and a call 14 percent out-of-the-money. All options are held to expiry and the trade is reinitiated each month.
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