Relative Value Trading
Derivatives-based Portfolio Solutions


 

Relative value is the name given to a variety of trades that attempt to profit from the mean reversion of two related assets that have diverged. The relationship between the two securities chosen can be fundamental (different share types of same company or significant cross-holding) or statistical (two stocks in same sector). Relative value can be carried out via cash (or delta-1), options or outperformance options.


TRADES ARE USUALLY CHOSEN ON CORRELATED ASSETS
The payout of a relative value trade on two uncorrelated securities is completely random, and the investor on average gains no benefit. However, if two securities have a strong fundamental or statistical reason to be correlated, they can be thought of as trading in a similar direction with a random noise component. Assuming the correlation between the securities is sufficiently strong, the noise component should mean revert. Relative value trades attempt to profit from this mean reversion. There are five main types of relative value trades.
  • Dual listing. If a share trades on different exchanges (i.e. an ADR), the two prices should be equal. This is not always the case due to execution risk (different trading times) and perhaps due to indexation flow. Non-fungible shares or those with shorting restrictions are most likely to show the largest divergence in price. Of all relative value trades, dual-listing ones are likely to show the strongest correlation.
  • Share class. If there is more than one type of share, perhaps with voting or ownership restrictions, then the price of these shares can diverge from one another. For example, preference shares typically have a higher dividend to compensate for lack of voting rights, but suffer from less liquidity and (normally) exclusion from equity indices. During special situations, for example, during the Porsche/VW saga, the difference in price between the two shares can diverge dramatically.
  • Cross-holding. If one company (potentially a holding company) owns a significant amount of another company, the prices of the two companies will be linked. Sometimes putting on a cross-holding trade is difficult in practice due to the high borrow cost of the smaller company. This trade is also known as a stub trade when the investor wants pure exposure to the larger company, and hedges out the unwanted exposure to the equity holdings of the larger company. Potentially, these trades can occur when a larger company spins off a subsidiary but keeps a substantial stake post spin-off.
  • Event-driven. In the event of a takeover that is estimated to have a significant chance of succeeding, the share prices of the acquiring and target company should be correlated. The target will usually trade at a discount to the bid price, to account for the probability the deals falls through (although if the offer is expected to be improved, or beaten by another bidder, the target could trade above the offer price).
  • Long-short. If a long and short position is initiated in two securities that do not have one of the above four reasons to be correlated, it is a long-short trade. The correlation between the two securities of a long-short trade is likely to be lower than for other relative values trades. Because of this, often two stocks within a sector are chosen, as they should have a very high correlation and the noise component is likely to be bounded (assuming market share and profitability is unlikely to change substantially over the period of the relative value trade).

Long-short can focus returns on stock picking ability (which is c10% of equity return)

General market performance is typically responsible for approx. 70% of equity returns, while approx. 10% is due to sector selection and the remaining approx. 20% due to stock picking. If an investor wishes to focus returns on the proportion due to sector or stock picking, they can enter into a long position in that security and a short position in the appropriate market index (or vice versa). This will focus returns on the approx. 30% due to sector and stock selection. Typically, relatively large stocks are selected, as their systematic risk (which should cancel out in a relative value trade) is usually large compared to specific risk. Alternatively, if a single stock in the same sector (or sector index) is used instead of the market index, then returns should be focused on the approx. 20% due to stock picking within a sector.


SIZE OF POSITIONS SHOULD BE WEIGHTED BY BETA

If the size of the long-short legs are chosen to have equal notional (share price × number of shares × FX), then the trade will break even if both stock prices go to zero. However, the legs of the trade are normally weighted by beta to ensure the position is market neutral for more modest moves in the equity market. The volatility (historical or implied) of the stock divided by the average volatility of the market can be used as an estimate of the beta.

 

DELTA-1, OPTIONS AND OUTPERFORMANCE OPTIONS

Relative value trades can be implemented via cash/delta-1, vanilla options or outperformance options. They have very different trade-offs between liquidity and risk. No one method is superior to others, and the choice of which instrument to use depends on the types of liquidity and risk the investor is comfortable with.


OPTIONS: CONVEX PAYOFF AND CAN LIMIT DOWNSIDE ON LONG LEG

Options can be used in place of stock or delta-1 for either the long or short leg, or potentially both. Options offer convexity, allowing a position to profit from the expected move while protecting against the potentially unlimited downside. Often a relative value trade will be put on in the cash/delta-1 market, and the long leg rotated into a call once the long leg is profitable (in order to protect profits). While volatility is a factor in determining the attractiveness of using options, the need for safety or convexity is normally the primary driver for using options (as relative value traders do not delta hedge, the change in implied volatility is less of a factor in profitability than the delta/change in equity market). Investors who are concerned about the cost of options can cheapen the trade by using call spreads or put spreads in place of vanilla calls or puts.

Weighting options by volatility is similar to weighting by beta and roughly zero cost

The most appropriate weighting for two relative value legs is beta weighting the size of the delta hedge of the option (ie, same beta × number of options × delta × FX), rather than having identical notional (share price × number of options × FX). Beta weighting ensures the position is market neutral. Volatility weighting can be used as a substitute for beta weighting, as volatility divided by average volatility of the market is a reasonable estimate for beta. Volatility weighting ATM (or ATMf) options is roughly zero cost, as the premium of ATM options is approximately linear in volatility.

Choosing strike and maturity of option is not trivial

One disadvantage of using options in place of equity is the need to choose a maturity, although some investors see this as an advantage as it forces a view to be taken on the duration or exit point of the trade at inception. If the position has to be closed or rolled before expiry, there are potentially mark-to-market risks. Similarly, the strike of the option needs to be chosen, which can be ATM (at the money), ATMf (ATM forward), same percentage of spot/forward or same delta. Choosing the same delta of an OTM option means trading a strike further away from spot/forward for the more volatile asset (as delta increases as volatility increases). We note that trading the same delta option is not the same as volatility weighting the options traded as delta is not linear in volatility. Delta also does not take into account the beta of the underlyings.

 

OUTPERFORMANCE OPTIONS: LIMITED DOWNSIDE BUT LOW LIQUIDITY

Outperformance options are ideally suited to relative value trades, as the maximum loss is the premium paid and the upside is potentially unlimited. However, outperformance options suffer from being relatively illiquid. While pricing is normally cheaper than vanilla options (for normal levels of correlation), it might not be particularly appealing depending on the correlation between the two assets. As there are usually more buyers than sellers of outperformance options, some hedge funds use outperformance options to overwrite their relative value trades.

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