While it has certainly been the trade du jour, it is perhaps one degree separated from the more intuitive Energy vs. Consumer Discretionary trade -- at least for this writer. But how to successfully trade these sectors against one another in an erratic market characterized by rapid rotation?
This article poses one possible short-term quantitative answer to the question using traditional long-short pairings of exchange traded funds, including: the Energy Select Sector SPDR (XLE) versus the Financial Select Sector SPDR (XLF), and the Consumer Discretionary SPDR (XLY), respectively.
Method & Rules
The premise will be to trade mean reversions after statistically extreme sector divergences. After scanning for such divergences, we will then employ pairings of the above ETFs whereby one stock will be held long and the other held short with equal dollar weightings.
The method and rules for this simplified trade follow:
- Divide the Daily Closing Prices of ETF-A by ETF-B;
- Calculate the Log of the Resulting Price Ratio.
- Calculate the 15-Day Moving Average of the Derivative Log Pair;
- Subtract the Average from the Current Result and Divide by the Pair's Trailing Standard Deviation ("SD") of the Same Length;
- Long the Derivative (Long A and Short B) when the Number of SD's Exceeds -2.2.
- Short the Derivative (Short A and Long B) when the Number of SD's Exceeds +2.2.
- Exit the First Close after: 1) the Pair has Mean Reverted past Zero; and, 2) the Derivative Ratio Moves Against the Trade for First Time. Obviously, there are many potential variations for Entries and Exits.
Results A ~ Energy vs. Financials (XLE/ XLF)
Results B ~ Energy vs. Consumer Discretionary (XLE/ XLY)
Trading pairs can be notoriously tricky and it is not uncommon for both sides to move against the trader -- just look at all the reported hedge fund losses last month. Careful money management is needed, and the development of non-dollar weightings and intra-day rules may hold you in better stead than the simplified on-close method presented above.
If nothing else, I hope this article points you in the right direction for further study. These days, it certainly beats holding onto a theme based on discretion alone. In addition, you may find that tracking the relative success of various sector pairings provides advance notice of "what is working" beyond the trade du jour.
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Addendum: Apparently I haven't been the only one with pairs on the mind. A morning visit to Dr. Brett Steenbarger's TraderFeed blog presents an excellent companion piece to this article. Here is the link to "Divergences and Pairs Trading." Dr. Steenbarger frequently writes about inter-market relationships in addition to his core articles on improving trader performance. Highly recommended. Also, a spelling correction -- of course it's "Du Jour" (of the day), not "Du Jure" (by law!).
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