Monday, October 27, 2014

If you're afraid of the volatility...

In my most recent post, I indicated that I expected US stock prices to move up further, but in a choppy fashion (see Correction, what correction?).  For more risk averse investors and traders who are afraid of the volatility, I can suggest another way to approach this market.

Under these circumstances, directional market volatility could be mitigated with a pairs trade. Buy the outperforming sectors and groups and short the underperforming sectors and groups. There are a few that could be looked at.

One possible long position is Healthcare. The Healthcare sector and its industries have been fairly consistent outperformers in the last year, even in the recent correction. The chart below shows the relative performance of this sector and its industries compared to the SPX in the past year, as well as the SPX in the bottom panel.

I do have one caveat. The relative performance of the Medical Devices group, as represented by the ETF IHI, seems overly volatile and should probably be avoided as a long candidate.

Another long candidate might be the NASDAQ. The NASDAQ 100 has been on a tear since May. By contrast, smaller stocks, as represented by the Russell 2000 small caps (IWM) or mid-caps (MDY) have continued to underperform during the same period.

These charts suggest the follow long and short positions as pairs trades:

  • Long: Healthcare or any healthcare industry except Medical Devices
  • Long: NASDAQ 100
  • Short: Small or mid caps (IWM or MDY)

Disclaimer: Pairs trading represent a relatively exotic position and require a higher level of sophistication that is not appropriate for everyone. Do your own due diligence and know your own risk tolerances before entering the trade.

Disclosure: I have no pairs positions on at this time, but I could enter in any of the aforementioned positions at any time in the near future. 


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