Profitable ETF Trading Techniques – A Pair Trade Strategy Refinement

Ken Long asked:

A pair trade strategy refinement to consider to take advantage of long term market psychology which is known to persist despite evidence that the market is changing.

I was thinking of a pair trade earlier today that would capture something like the mood of the mass market psychology in practice. It would pit the wisdom and maturity of the world’s greatest value investor against the promise of opportunity of the most volatile marketers. Specifically, this pair trade would feature Warren Buffett vs emerging markets. The symbols involved would be: BRK/B for Warren Buffett’s Berkshire Hathaway Class b shares and symbol EEM representing the emerging markets exchange traded fund (ETF). Clearly, this is a pure volatility or market psychology play.

The concept: EEM should outperform Buffett whenever market mob psychology is insanely overvaluing growth at the expense of real earnings. Buffett should outperform when we begin to see whiffs of fear entering the markets and we experience a flight to quality.

In good times then we would want to be long EEM and short BRK/B in order to capture the difference in relative strength. We’d be long enthusiasm and short wisdom, which is a pretty good definition of market mob psychology in extreme bull markets.

In bad times we would reverse the strategy and be long Buffett and short emerging markets. I am going to run some research tests on this going back a decade, but my intuition suggests that this will be a fruitful idea. We have to be sensitive to when market conditions change in any pair trade, but in this case a simple moving average crossover should be sufficient to protect against disaster.

As always, do your own due diligence and consult a financial professional before taking actions, as the stock market is inherently risky.

Rosemary

Profitable ETF Trading Techniques – Pair Trading in Down Markets to Preserve Capital

Ken Long asked:

In a nutshell, here is what pair trading is all about.

You pick 2 trading instruments that you believe will continue to perform on a relative basis in the way they have been. This means you think the stronger one will continue to be stronger, and the weaker one will still be weaker.

A pair trade is a way to neutralize market volatility. As an example, right now the US market is losing money every day. Emerging markets are also losing money everyday. The crucial difference is that emerging markets are losing money faster than US markets.

Since this relationship may very well continue for the near future, here is what you can do (hypothetically, for purposes of discussion and education only):

Go long the US market by buying shares of the S&P 500 exchange traded fund (symbol: SPY). Go short an equal dollar amount of the emerging markets exchange traded fund (symbol: EEM). T Then on days when the US is down 3% but emerging markets are down 5%, you will net the difference in the 2 performances, which in this example is a positive 2%

As you can see this method will neutralize market volatility and allow you to make money based on the difference in relative performance.

Exchange traded funds are an ideal way to play this kind of short to intermediate term trade because they are composites of underlying companies, and you are able to minimize the risk of individual companies.

By analyzing a relatively small number of exchange traded funds, you will be able to find some persistent macro-economic trends in the market that give you an opportunity to make money even when all markets seem to be going down.

As with all investments, these have been hypothetical examples and you should do your own due diligence, and consult with a financial professional.

Kathleen