Relative Value Trading Techniques

26 February 2015 Adam Grimes, CIO, Waverly Advisors

Overview What does it mean to trade relative value? Why might relative value be useful? Tools and techniques to measure relative

performance. What to do with this information:

– Analytical context – Trading concepts

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Relative Value The concept of comparing the performance of one

asset or group of assets to another. Typical examples:

– Pair trades in stocks – Spread trades in commodities – Currencies

General concept is that we want to be long something and short something else, so that the P&L depends on the spread between the assets rather than the direction of either.

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Winning and Losing In the simple case of buying asset A:

– Make money if A goes up. – Lose money if A goes down.

Spread trade: buy A, sell (short) B: – Make money if A goes up and B goes down. – Make money if A goes up and B is flat. – Make money if A is flat and B goes down. These are obvious, but…

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Other Ways to Win or Lose Make money if both go up, but A goes up more than

B. Make money if both go down, but A goes down less

than B. Basic concept is:

– the “thing you are long” must go up more than the “thing you are short” goes up or

– The “thing you are short” must go down more than the “thing you are long” goes down.

– Any other combination, and you will lose money on the trade.

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Why Look at Relative Value? Trading relative relationships can reduce risk

– Can also increase risk, so you have to know what you’re doing.

We already think about markets in relative terms. – Currencies are an obvious example – “Stock A will do better than its competitors.” – “Europe should lag the US because of…”

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Why Relative Value? There are fewer market dynamics that can erase relative

value plays. – Directional tendencies can easily be eroded by buying and

selling pressure. – In the case of volatility, there are essentially no market

dynamics that can do this. – With relative value, can be done, but is much more difficult,

depending on the assets involved.

Many relative relationships are “real”. – Quantitative patterns often lack justification, but we can usually

point to real links between assets that explain the relationships. – This may allow different types of analysis.

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Measuring Relative Performance Percent change charts Spread charts

– Difference – Ratio – Analytics/indicators

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Percent Change Charts 1. Convert prices to returns (percent changes,

anchored to a starting point). 2. Pick a starting date (the same for both assets). 3. Plot percent changes since that starting date with

both assets on the same chart. 4. Optional: can plot another line that is the difference

between the two assets’ percent changes.

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Percent Change Chart

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Percent Change Issues Starting point matters.

– Can have completely different charts and impression of relative performance, depending on starting date.

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Starting Date Matters

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Percent Change Issues Starting point matters.

– Can have completely different charts and impression of relative performance, depending on starting date.

Choosing a starting point – Pick an arbitrary date (but it matters…) – Anchor to a structurally important pivot This is good for stocks, but more difficult for other

assets. Always ask “does this solution make sense?” (Common

sense rule)

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Relative Strength In its simplest form, comparing the performance of

an asset or group of assets over a certain timeframe. In most charting packages, Rate of Change (RoC) is a

percent return over a given time window. – Usually uses a fixed lookback period.

Can calculate a performance measure for many assets, rank, and compare.

But starting point matters.

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Multiple Period Comparison

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Things to Think About Are you comparing apples to apples?

– Currency considerations.

Are you accounting for dividends, splits, and other corporate actions?

If you are using futures, do you understand the rolls? – Two methods: Differenced: Cannot use for returns or percentages. Ratio-adjusted: Can use for percentage measurements.

A return is a measurement over a specific time window. – It is sensitive to what happens on both ends of the time

window.

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Possible Distortions

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One Possible Solution Rather than use a simple measurement of return,

average several periods’ returns. – A good discussion can be found in O’Neil (William O’Neil:

How to Make Money in Stocks, 4th ed. 2009), but many other authors use similar tools.

Many options: – Use as few as two or many more periods. – Weighted or unweighted. – Can implicitly weight by period selection: E.g., 1 week, 2 week, 1 month, 1 year is front weighted E.g., 1 month, 1 year, 1.5 year, 2 year is back weighted

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Waverly Advisors’ Relative Strength We use a front-weighted multi-period relative

strength measure. Periods and calculation are proprietary, but there is

no secret sauce. – The measurement was crafted to be coherent with and to

support our trading style, not because it is better than any other.

We use this as an idea generation tool and as a filter for other trades.

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Multi RS

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Ranked RS The actual RS value may not be especially meaningful.

– This shouldn’t be surprising: relative strength!

Can simply compare a list of RS values to each other to get a RS ranking.

It is also possible to compare stocks relative to a stock universe.

We do this with a non-parametric ranking: – Create the raw RS measure for each stock in the S&P 500 – Create the raw RS measure for the test stock. – Express the test stock’s RS as a percentile of the S&P 500. Can also be outside the range of the S&P 500

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In Our Research

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Spread Charts Shows the “spread” between two assets.

– “Assets” could be a basket, but this creates complications.

Two possibilities: – Ratio charts Ratio spread = Price of asset A / Price of asset B

– Difference charts Difference spread = Price of asset A – Price of asset B

Add some measure of central tendency (average) and extension (standard deviation bands). – Examples use 20 period and 2.5 standard deviations

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Spread Chart

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Some Issues to Consider Apples to apples?

– Example: stock to cash index = probably not best idea Do you understand your futures contracts?

– Some back adjustment methods can take prices < 0 in the history. This creates problems with ratio charts.

– Use difference spreads with “Panama canal” (difference) back-adjusted, and ratio spreads with ratio back adjustment. Critical point, often ignored.

Is A a component of B? – AAPL vs QQQ – XOM vs XLE

Dividends and futures pricing issues can create distortions.

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Futures to Cash

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SPY (dividends!) to Cash

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Where to Find Tradable Spreads Stocks

– Share classes – Similar companies – Index vs components – Stock vs market (think about what you are trying to do)

Futures – Intercommodity (different months) – Intracommodity (ex. Gold / Silver, Crack or Crush spreads)

Currencies – Can be a complicating factor in other trades

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General Concepts in Trading There are, broadly, three kinds of spreads

– Mean-reverting – Trending – Changing

Many spreads wander between these categories over their price history, but when and how they change regimes is important.

Do not assume that all spreads mean revert! When you “think that” the spread is going up, be

long A and short B, and vice versa for a declining spread.

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Trending Spread

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Mean-reverting Spread

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Trading Considerations Spread relationships have a bid/ask, just like assets. Make sure your spread chart shows a relationship

that is bigger than that bid/ask spread! – Seems basic, but charts scale so that small moves may look

the same.

Spread charts generally assume rebalancing each period, and may not track P&L over longer timeframes? – Is this an issue? Depends.

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Trading Considerations (2) Size can create risk in spreads that might not be present

in outrights. You must truly understand your spread trades.

– Cointegration, if appropriate – Pending corporate actions – Crop year issues with commodities – Etc.

Volatility of one asset can change suddenly and dramatically. – What can make this happen? What is predictable what is not?

Historical relationships can drift apart for many reasons. There is no free lunch! There is always risk.

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Summary Relative value tools show the relationship between

markets. There is information in relationships that might not

be apparent in the simple price path of one assets. Many possibilities for trading these, but it is

important to understand the risks. It is important to understand the nuances and details

of any tool you use.

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Waverly Advisors’ Research Specific systems, broad tendencies, and actionable

ideas in major liquid markets. – Futures – Currencies – Stocks (indexes and individual names)

Both trend-following and counter-trend components. Applicable to traders working on all timeframes.

– day traders—swing traders—investors

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Waverly Advisors, LLC: Research Products

Tactical Playbook – Available on Interactive Brokers – Written for the active trader on the daily/weekly timeframes – Exact trade recommendations

Hybrid systematic-discretionary methodology – In-depth technical “drill down” into a set of markets. – Bigger-picture overview of all liquid asset classes.

Tactical Portfolio Outlook – Available on Interactive Brokers – Written for the longer-term manager

Addresses both the allocator and the longer-term active trader. – Emphasis on executing with ETFs in a long-only and long-short environment – Focus on Equities, Equity Sectors, and other asset classes – Macro perspective on risk factors and major economic events.

Options Market Outlook – Contact Waverly Directly – Proprietary, quantitative analysis of options market – Incorporates both volatility and directional analysis – Macro risk factors and cross-asset perspective – Actionable trade ideas

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My Blog

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http://adamhgrimes.com/blog/

Contact:

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Waverly Advisors 5607 Pittsford-Palmyra Rd. 1034

Pittsford, NY 14534

(607) 684-5300

www.waverlyadvisors.com info@waverlyadvisors.com

Adam Grimes Managing Partner, Chief Investment Officer grimes@waverlyadvisors.com Chris Noye Managing Partner noye@waverlyadvisors.com

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