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Relative Value Trading
In lower-correlation environments, there is differentiation
in performance across and within asset classes exists.
Given the breadth of the ETF and ETF options market,
investors can take a view on the spread between two
assets—at the sector, country or cross-asset level.
For example, using sector ETFs, investors can trade a
single stock against a basket of its peers (same sector), thus
allowing one to isolate the fundamentals of a particular
company in a relative value trade. Or investors can trade
the outperformance between two equity sectors. Likewise,
with country-specific ETFs, investors can play an outperformance
between regions. Even further, ETFs allow for
views across assets to play the relative value between any
Figure 15
Hypothetical Expiry P&L
Of Short Iron Condor Strategy On GLD
10%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
-20% -15% -10% -5% 0% 5% 10% 15% 20%
Source: BofA Merrill Lynch Global Research
Figure 16
Backtesting Results For Systematic 4-Week Iron Condors On Global Equity Indexes (From Jan. 1, 2002-Sept. 7, 2012)
S&P 500 Iron Condor
ESTX50 Iron Condor
NKY Iron Condor
Bloomberg Ticker
MLBWSPAR Index
MLFPEEAR Index
MLEINKAR Index
Annualized return since ‘02 3.8% 5.8% 6.0%
Volatility since ‘02 8.3% 8.5% 8.0%
Information ratio since ‘02 0.46 0.68 0.75
Source: BofA Merrill Lynch Global Research
Note: Backtesting is hypothetical in nature and reflects application of the trade strategy prior to its introduction.
Figure 17
120
115
110
105
100
95
90
85
80
75
70
Jun.
’08
GLD Iron Condor Strategy
Vs. HFRI Fund-Weighted Composite
Oct. Feb. Jun. Oct. Feb. Jun. Oct. Feb. Jun. Oct. Feb.
’08 ’09 ’09 ’09 ’10 ’10 ’10 ’11 ’11 ’11 ’12
■ GLD Iron Condor
Source: BofA Merrill Lynch Global Research
Note: Data covers June 2008 - Sept. 2012.
A 1-month 88/96 106/114 short iron condor
strategy on GLD since June 2008 provides
a risk-controlled way to capture the
richness in GLD options.
■ HFRI Fund Weighted Composite
pair of equity, commodity, fixed-income or currency assets.
A simple way to implement a long/short relative value
trade is by going long and short the respective assets.
However, the losses of an outright long/short trade can
be uncapped if the assets move in the opposite direction
Jun.
’12
of what was anticipated. Alternatively, a long-call-option/
short-call-spread-option pair also implements a long/short
relative value view, but with capped downside.
Example 7: Long Cyclical Sectors, Short Defensive
In Reflationary Environments
Historically, cyclical stocks strongly outperform defensive
stocks in reflationary environments. To express this in the
U.S., an investor could go long NYSE Arca: XLY (discretionary
sector ETF) and short NYSE Arca: XLI (industrials sector ETF).
However, this trade has uncapped losses in the amount that
XLI potentially outperforms XLY. To help mitigate the risk of
the relative value trade, an investor alternatively could purchase
call options on XLY and sell a call spread on XLI.
This long-call-option/short-call-spread-option pair
trade has limited loss, as the long-call option’s maximum
downside is the upfront premium, while the short call
spread’s losses are capped to the distance between the
two call-option strikes. If indeed XLY outperforms XLI, the
long-call option would be better than the short-call spread,
allowing an investor to capitalize on the relative outperformance
but with limited downside risk.
Endnotes
1 The S&P 500 Index options market is the largest in the world in terms of notional volume.
2 For a definition of the S&P Global Industry Classification Standard (GICS), please see: http://www.standardandpoors.com/indices/gics/en/us
3 Select Sector SPDRs are ETFs that divide the S&P 500 into nine sectors. Together, the nine Select Sector SPDRs represent the S&P 500 as a whole.
4 Each month this strategy sells a put that is 4 percent out-of-the-money and a call that is 6 percent out of-the-money and then buys back a put that is 12 percent out-of-themoney
and a call 14 percent out-of-the-money. All options are held to expiry and the trade is reinitiated each month.
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November / December 2012