Finding Your Next Trade

The following is a 3rd party contribution:

There is a lot of uncertainty in the markets with central banks attempting to prop up riskier assets in the hopes that this methodology will trickle down and reestablish growth. Stocks are breaking out in some countries while consolidating in others.  It’s difficult to find a sustainable direction, and in many cases the breakout is coming up false. One way to avoid attempting to pick the markets direction is to find a market neutral trade.

Market Neutral Trading is a pair trading strategy in which an investor looks to produce returns based on the relative change of one stock to another.  Market Neutral Trading is thought of as a relative value strategy, as it does not depend on the outright direction of the broader markets and instead produces returns based on the ratio between two stocks.

Stock pair transaction are where you trade shares by simultaneously initiating long and short stock positions in an effort to benefit from the change in the ratio of the stock pair.  Stocks are not the only assets that can be used to generate returns using a pair methodology.  

online share trading

Market Neutral

Pair trades are attractive because one stock is considered relatively inexpensive or dear relatively to another stock that functions within the same industry.  Market neutral strategies avoid a high beta to the broader market indexes such as the S&P 500 index given the risk is a relative value risk that is uncorrelated to market direction.  This type of trading strategy allows investors to diversify their portfolios by allocating capital to an uncorrelated market relative to stocks, bonds and cash.

Market Neutral Trading strategies that focus on mean reversion, seek to benefit when highly correlated stocks experience a divergence in returns over the short term.  Investors can back test the relationship between two specific stocks within the same industry to determine if a specific standard deviation from a historical mean of their spread represents attractive levels to purchase one stocks and simultaneously sell short another stock.

The first step in finding pairs of stocks or indices that move in tandem.  This could include any set of stocks, including consumer discretionary, staples, utilities, technology, industrials or financials.  

An example of two stocks that fit a mean reversion pair methodology is Visa and MasterCard.  Both of these companies operate similar businesses and generally have highly correlated returns.  The ratio of these companies stock prices historically trade in a range, but when the ratio moves a specific standard deviation from a medium term moving average of the ratio, a pair trade can be initiated to take advantage of the divergence.

Summary

Market Neutral Trading is a robust alternative strategy that offers returns that are uncorrelated to broader markets and therefore generate a return payout profile that creates a diversified mechanism toward asset allocation.  Investors interested in Market Neutral Trading should research methods in which they can attain safe returns with robust risk management.