The action in Apple (NASDAQ:
) over the past few weeks has been charged with energy as the
stock has fallen off the tree for the momentum players. After
hitting $704 last September, shares are trading near $423 Monday.
That's roughly 40% from the highs.
One way to take advantage of Apple's demise is to trade the
) pair as a spread. This "pairs" strategy would mean a long side
entry in Apple and short side entry in Google as a dollar neutral
position. This technique has been around Wall Street for over 20
years and is a form of statistical arbitrage.
There's no real "market" hedge. It is really dollar neutral in
terms of the number of Apple shares long compared to Google
shares short. The trade takes advantage of an anomaly in the
spread between Apple and Google as the price differences between
these two highly correlated stocks diverge to the point that the
spread widens to levels not seen historically.
But when I say historically, it's not just time that is
important, but the length of time two "similar" stocks have been
under a high correlation. In other words, Apple and Google would
move in the same direction at least 86% of the time for a very
long time. Then it changes. We want to take advantage of this
change in correlation. We can measure this change as a chart of
the spread then overlay a simple linear plot.
Below is a weekly chart of AAPL. Notice the distance from the
50 period MA and price range. Roughly an 18% move from the 50
Below is the weekly chart of GOOG and the relationship of the
price to the 50 period MA.
Below is the weekly chart with both AAPL and GOOG's divergence
in correlation. We can see the time line I plotted on the chart
when AAPL and GOOG divorced and went their separate ways. The
stocks accelerated away from each other as GOOG trends higher and
AAPL trends lower to historically wide levels.
The Trade defined as a spread between the "pair".
Since we are setting up the trade based on the spread being
wider than historic levels (Selling short the winner and buying
the loser), we only care about the movement of the spread. In
this model, we are looking for the spread to narrow. If history
repeats itself, the prices will converge and the spread will
narrow and we make money. We do not care which end of the trade
creates the narrowing of the spread. We only care about the
spread. How does this happen? Well, there are several scenarios
and I'll go through a couple examples leaving out any dividends
or splits that would have a direct impact on our profit/loss.
Scenario 1) is Google falls at a faster pace that AAPL falls. 2)
AAPL rises at a faster pace than GOOG or 3) one stays in a tight
range as the other increases in volatility. These scenarios might
bring that spread tighter. We won't try to guess what will happen
or when, we just want a few scenarios too potentially work in the
favor of the spread to narrow based on historical prices between
the two stocks. Remember, this is a contrarian strategy and we
are betting the ratio moves back to the mean.
We would want to keep the same dollar amount. Using the weekly
close data of AAPL and GOOG, our set up shows a ratio of .53.
Using AAPL as a base long of 100 shares makes this really easy to
comprehend. For example, we might want to buy 100 of AAPL and
short the same dollar amount of GOOG. So to find this, we plot
the spread and see that 100 AAPL equals the same dollar amount of
a short position of 53 shares of GOOG.
Sheet of a very basic ratio plot to see how it looks over a
few week periods. Look at the last line item taht represents the
current spread data point we would use if we wanted to put this
trade on now.
Below is a chart of the spread: I plotted a simple linear
regression over the spread and we can see the spread is at the
lower band of the linear regression line. We want the spread to
eventually migrate back to the mean.
What's the risk?
There is risk in several areas. The spread gets narrow to a
point of margin pressures and time is a risk. Remember, this is
technically a contrarian strategy. There's potential bankruptcy.
If you trade pairs in other companies that might not be so
fundamentally sound. (Very doubtful this occurs in AAPL or GOOG).
Also, execution costs, margin costs and changes. Illiquidity or
carry costs associated with short selling will alter the
performance. All these factors can have an impact on your net
profit/loss that's not adjusted in the spread.
I can take this strategy a few steps further by altering the
ratio. The ratio can be altered through factors in a proprietary
model that many professionals have in their statistical arbitrage
models. For example, a weighting of volatility, dividends,
liquidity or volume. But this example is the as basic as you can
possible get and with the right risk and discipline, can work out
if you want to take advantage of a contrarian bet in AAPL or
GOOG. Be aware there are several other methods to plotting the
spreads and ratios between two pairs which can alter your trading
time frame dramatically. Take the time to do the research that
fits your risk.
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