New week, new pair trade under the belt

Betting on small cap underperformance

It's Thursday and it's time to share the ins and outs of another trade that we have researched and initiated on our trading floor.

As we discussed in our latest trade review, pairs have been some of our favorite setups. We have communicated extensively the reasons behind our affection towards these trades, and today, I want to dive into one pair in particular that presented a good opportunity last week:

SPY long vs IWM short

Let's start with a little background. Last week, we briefly mentioned this trade as a potential candidate and something to keep on your watchlist. Since then, I've decided to enter the trade and I want to share with you why.

Take a look at last week's review here:

An Ode to pair trading with ETFs

First, let's talk about the fundamental reasons why I think it makes sense even for the medium term.

Big-caps tend to outperform small-cap stocks in certain market conditions that seem to be growing currently: 

1. Inevitably we are approaching a time of an economic slowdown and during periods of economic uncertainty big caps are typically seen as more stable and less risky

2. Higher for longer or additional hikes talk will further negatively impact smaller companies that rely on debt financing, while larger companies may have more access to capital and better credit ratings, making them more attractive

3. The uncertainty around the next steps of the Fed and the current condition of the economy will certainly lead to higher volatility and greater up-and-down swings. In high volatility times, the perceived stability of large-cap stocks is appreciated as a safe haven, while IWM may be more vulnerable to investor sentiment

Now, let's turn to the technicals and discuss SPY

The day we entered the trade (March 1st), SPY had just tested the 200 daily SMA from above and I saw it as a great place for temporary support or at least a spot for a technical bounce. The index has broken below the 50% retracement from the previous high and was approaching the 0.618 fib level - enough of a move if this was going to be just a healthy pullback and not another leg lower in the markets.

The mega-caps, which are the biggest moving force behind SPY, were either oversold or also finding themselves at good technical levels, which gave me even more conviction going long. 

Recently no economic data was able to affect the markets big way even if similar info would mean a headwind for equities in normal circumstances. It makes me believe that the present fundamentals are already discounted and we currently find ourselves in a more technical environment until other really big news hit us again. It was just another reason for me to consider taking the SPY trade at these levels.

However, going long solely on SPY would expose me to market directional risks, which I didn't want to take on due to the increased choppiness of the markets last couple of weeks 

So, I started looking for a smarter play.

Is there an index that keeps a high correlation to SPY but at the same time was getting ahead of itself since the beginning of the year? 

The obvious answer was the small caps index (IWM) that was flying high since Jan. I switched to the charts to check if the ratio is close to any technical level that could represent a good area for support and a favorable entry point in terms of risk:reward. Voilà!

This led me to the second leg of the pair trade: going short IWM. By pairing a long position in SPY with a short position in IWM, I was able to mitigate some of the directional risks while still taking advantage of the potential for a bounce in SPY and the likely catch-up of big vs small caps.

A few times per year I get lucky with my entries and I should confess that this was definitely one of them. Of course, I was looking for the ratio to bounce off the support line and I wanted to get my entry as close to the lows as possible, but I would have never imagined that it would be so picture-perfect this time. Anyhow, when you aim for good entries and wait patiently, sometimes the trading gods will be nice to you.

Now, let's take a closer look at the individual chart of IWM. 

Taking the most recent high at around 200 and projecting fib retracement levels from it, we see that IWM made a much more modest pullback compared to the S&P and didn't even touch the 50% retracement. 

This is mainly due to the biggest index allocations in industrial and financial stocks that have been performing comparatively stronger and holding up well. A breather from them would mean consolidation or underperformance in IWM. Something that I was looking forward to. 

What are the main advantages of this trade:

• no directional risk and reduced overall portfolio risk

• great technical levels

• super liquid assets

• tight stop due to the good entry

• favorable risk:reward

• fundamental reasoning explained above

How did the trade progress?

Finding a good setup is straightforward but often managing the trade turns out to be even more important.

1. I took 1/3 of the profits on Friday's high (3rd March) which allowed me to finance the rest of the position and keep it more comfortable through the weekend and volatile days

2. On Monday morning (6th March) IWM was lagging behind the general market and it gave us another great opportunity to book profits. We covered the second 1/3 of the position

3. I did not expect the move to happen so fast but the underperformance of IWM pushed the ratio even higher in the later hours of Monday and our final target was reached as well. We covered the entire position on 6th March.

My plan was to hold the position longer but luckily it turned out to be a quick winner. As with any trade, there are always risks involved and things can change quickly. Although I could probably squeeze more from the trade, there was no reason to push my luck for a few more bps.

Thanks for reading and let the trading gods be on your side!