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.
To summarize:
Pairs trade initiated on XLF and SPY. Long XLF, short SPY. Closing out trade when prices converge.
Chart of pairs trade below:
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