Thursday, August 07, 2008

Divergences and Pairs Trading

Here we see three charts from yesterday's trade: the Standard and Poor's 500 Index (SPY; top chart); the Financial sector ETF (XLF; middle chart); and the Housing sector index ($HGX; bottom chart). Note that, as the S&P 500 Index moved to new highs in the afternoon, the financial and housing stocks failed to follow. This is what's known as a divergence--a discrepancy in path between an index and its component(s)--and it was something I noted in the day's Twitter comments. When you see multiple sectors fail to follow an index higher or lower, it means that a relatively small proportion of high cap stocks are accounting for a good amount of the move in the index. Very often, those narrow moves are not sustainable and are prone to reversal.

But let's dig a little deeper and ask what it *means* when we have divergences such as the above. Traders--particularly those outside institutional settings--tend to think directionally: they trade SPY, XLF, etc. outright for a move either up or down. That's great when the market is moving directionally; not so profitable when the market chops around.

An alternate trade is a relational one, known as a pairs trade, in which we buy one stock, sector, or index and sell another one against it. Instead of trading the market directionally, we're trading the relationship between two assets directionally: we're trading the relative strength of one stock/sector versus another.

The pairs trade, properly constructed, can be a powerful tool precisely because it is not dependent on market trending. In other words, the S&P 500 Index could move higher or lower, but if Financial stocks underperform the index, I'll still make money if I'm short XLF and long SPY. When markets trade in ranges, they are doing so precisely because large traders and investors are reallocating capital among sectors. This environment of sector rotation is perfect for pairs trading, if you can catch the reallocation shifts early.

So now back to divergences. When we see a new high in SPY and Financial and Housing stocks failing to confirm, what we're really seeing is a decline in the pairs relationship of XLF/SPY and $HGX/SPY. Think of that relationship as a single stock that moves each minute: as SPY is moving to high ground and XLF is not following, we are trending lower in XLF/SPY.

The divergence can be an important sign of directional shift in the broad index (which is why I Twittered the observation yesterday), but it can also signal an emerging pairs trend. If you can catch those pairs trends early, you can run a more diversified book--and you can expose yourself to greater opportunity in non-trending market conditions.