Relative Value Trading
Derivatives-based Portfolio Solutions
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.
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.
Trading Relative Value
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