Saturday, October 20, 2007

Dow Industrials vs. Russell 2000: A Long-Short Illustration

Here's a chart of the Dow Jones Industrial Average (DIA) denominated in shares of the Russell 2000 Index (IWM). The charts we're accustomed to denominate shares in dollars. When we use a second market as the denominator, we create a new instrument that reflects the relative strength of the numerator with respect to the denominator.

In other words, what we're looking at is the price performance of a holder of a long-short position (long DIA, short IWM). Note that this looks like a pretty nice bottom pattern on a chart; DIA has been in an uptrend vs. IWM for over a year now.

When you trade a long-short portfolio, the relationships between markets become your trading instrument. When those markets are highly correlated, your portfolio is thus hedged against general market risk. A long-short portfolio is an excellent way to exploit market themes without having to time or crystal ball general market direction.

Moreover, your new instrument--the relationship between markets--has its own historical price patterns that you can identify and exploit, no less than an individual stock or index. More on this to come shortly.


2007 Performance By Style

2007 Performance By Style and Region