Paired Trade

[Groty]

In part in response to the Bill Miller commentary I posted, I put on the following trade last week that some of you may want to consider.

Background: The Russell 2000 is trading at ~21x and the megacaps are trading at ~16x.

Thesis: The 5x multiple difference between the two asset classes will eventually narrow.

Trade: I shorted 1000 shares of the IWM, an ETF designed to mimmick the performance of the Russell 2000, at $76.47. I simultaneously got long 800 shares of the XLG, an ETF that mimmicks the performance of the 50 largest market cap companies traded in the U.S., at $96.10. I'm net long about $410, or essentially dollar neutral. I profit if the valuations between the two asset classes converge without being net long or net short equities.

Every 1x change in the multiple for the IWM results in a gain/loss of about $3600. Every 1x change in the multiple for the XLG results in a gain/loss of about $4800.

The chart below illustrates the convergence is already starting to happen.

http://finance.yahoo.com/q/ta?t=1y&s...;q=l&c=xlg

[DesertCat]

First, let me apologize for double posting the Bill Miller commodites commentary, for some reason I didn't see yours. And I blush to admit I don't know how to delete my posts.

But I'm uncertain how this trade relates to his commentary (other than a bet on reversion to the mean). It's a very interesting trade in it's own right. I think your only risk is that as more and more people become aware of the super returns small stocks have had, money pours into small cap index funds and your "spread" widens. There is no reason the Russell can't go over 30x in a bubble.

But if you aren't leveraged and can wait, it's likely just a matter of time. And you'll probably see a "reversal" when they converge. If small caps start dropping, since they are viewed as inherently risky, people will run for safety, i.e. big caps, driving them up in value.

I'd appreciate hearing about this trade occasionally, to see how it does for you. Thanks.

[Groty]

Although most of BMs commentary dealt with the commodity cycle, the bigger picture point I took away from it is that asset classes in general go through 5-7 year psychological cycles. He devoted a paragraph or two to how strong small caps and emerging market equities have been the past several years (perhaps approaching the end of their cycle?)...and how U.S. large cap equities have lagged on a relative basis for several years (maybe they're about to start a new 5-7 year cycle?). But when he suggested U.S. large caps might start getting some luvin' now that the major central banks of the world are all now in a tightening mode, it made ALOT of sense.

As for my trade, ideally small cap multiples will contract and large cap mutliples will expand and I'll make money on both legs of the trade. But that isn't necessary for it to be profitable. I only have to be right that the relative valuations between the two eventually tighten.

I'm not leveraged, and I like the risk characteristics associated with this trade alot, so I'll try to wait it out.

[Groty]

A few days ago, I swapped out of the XLG and replaced it with 680 shares of DIA's. The XLG just didn't have the trading liquidity.

Anyway, after netting the loss on my long DIA position against the gain on my short IWM position, I was up about $4400 as of 10 minutes before today's close. I'm expecting a snap back rally tomorrow extending into next week, so I covered my short on the IWMs and bought another 400 shares of the DIA at 111.50.

I'm now long 1080 DIA at a weighed average price of 112.44.

My break-even on the total trade is now ~108.5 on the DIA. I've got a stop loss at 110 which will ensure I book at least a small profit on the total trade if I'm wrong about the snap back rally (which I also think will fizzle later next week). The chart on the IWM looks hideous, so I'm sure the trend followers think I'm insane, but how often do you see 4 or 5 consecutive down days without a bounce?

[Paluka]

[ QUOTE ]
A few days ago, I swapped out of the XLG and replaced it with 680 shares of DIA's. The XLG just didn't have the trading liquidity.

Anyway, after netting the loss on my long DIA position against the gain on my short IWM position, I was up about $4400 as of 10 minutes before today's close. I'm expecting a snap back rally tomorrow extending into next week, so I covered my short on the IWMs and bought another 400 shares of the DIA at 111.50.

I'm now long 1080 DIA at a weighed average price of 112.44.

My break-even on the total trade is now ~108.5 on the DIA. I've got a stop loss at 110 which will ensure I book at least a small profit on the total trade if I'm wrong about the snap back rally (which I also think will fizzle later next week). The chart on the IWM looks hideous, so I'm sure the trend followers think I'm insane, but how often do you see 4 or 5 consecutive down days without a bounce?

[/ QUOTE ]

so you did a paired trade, and then just decided to screw it and get long the market instead?

[hawk59]

OK, so you have what you think is a fundamental reason why you think the paired trade will work. I have no opinion on the trade but it sounds fine. But now you are just going long or short the market because you think you know what it will do in the next week.

[Groty]

Yeah, I'm taking a shot with house money that the market bounces. If it doesn't bounce, I get stopped out and still book a profit.

If it does bounce, I move my stop up in sync with every half point it moves higher (unless it's like a 3% bounce or something sick..then I'm out completely.)

I can't lose. The worst that can happen is the size of the ultimate win could be smaller than if I'd closed out both legs of the trade. We'll see.

[hawk59]

Last night, I won a bunch of money playing poker. After that, I just played every hand, hoping to get lucky. I told myself that I would leave if my winnings dwindled to $100. Best case I got lucky and won a bunch, worst case I left with a small gain. I couldn't lose!

[Groty]

I'm not playing every hand hoping to get lucky. I'm playing the probabilities. History shows the probability of six consecutive down days is tiny. Technical bounce, bargain hunters emerging, whatever you want to call it, the market usually does not go straight down day after day after day after day, etc.

Mr. Market might hit his one outter, but if he does, at least I'm not all in.

[SmileyEH]

[ QUOTE ]
I'm not playing every hand hoping to get lucky. I'm playing the probabilities. History shows the probability of six consecutive down days is tiny. Technical bounce, bargain hunters emerging, whatever you want to call it, the market usually does not go straight down day after day after day after day, etc.

Mr. Market might hit his one outter, but if he does, at least I'm not all in.

[/ QUOTE ]

So you're saying if you flip a coin 5 times and it comes up heads everytime, that it's more likely to be tails the 6th flip?

-SmileyEH