Hi everyone, welcome to a quick mid-week update.
I noticed that the financial sector of the S&P500 (XLF) was underperforming the S&P500 (SPY) by about 20%. This large divergence has recently occurred, so to take advantage of it, I went long XLF and short SPY. I plan to hold it until the two prices converge again, which I suspect will take between 3 months and 2 years.
I would normally put a stop loss on the trade, but did not use one here since it is extremely safe (market neutral) and the two assets are 86-89% correlated. I currently only have 10% stocks and 90% cash in my portfolio, so I don’t mind owning XLF at a lower price if for some reason they start to diverge more.
Edit: Since it is possible for these two ETFS to diverge further, I will likely cut my losses if I lose 1% of my account.
For sizing, I went quite large, using 25% of my portfolio to buy XLF, and matched the same dollar amount to short SPY. Unfortunately, there’s a small fee on the SPY short, which is 20 cents a day or .25% per year. If the trade works out, I will gain 20%, which is large compared to the .25% fee to short SPY. Hopefully this fee doesn’t increase.
Pairs trade initiated on XLF and SPY. Long XLF, short SPY. Closing out trade when prices converge.
Chart of pairs trade below: