In an earlier article here on Finhaven, I justified my rationale for why I believe that entering into a pairs trade that favors long the Russell 2000, short the NASDAQ 100 is a solid way to perhaps endeavor the current volatility in the global markets due to the coronavirus.
- The Russell 2K has less exposure outside of the United States, where the virus currently is taking a larger economic and social toll.
- The Russell 2K has a more balanced sector composition than the FANG-dominated NASDAQ, with health care as the largest sector to the small-cap index
- One can argue that valuations have are overdone in the NASDAQ relative to the Russell. While valuation is not a timing tool, it can prove helpful when the market is in a state of dislocation.
How to Trade It
Supposing you are inclined to move forward with the pairs trade, you are probably asking yourself questions about how to accomplish the task.
More advanced traders may incline themselves over to trading the futures. I am linking futures specs on both the Russell 2K and the NASDAQ 100 e-mini futures for your careful consideration. I would not recommend anyone just launch futures trades without previous experience, and any trader will tell you that you want to understand the contract specs before you start trading a product’s futures. The imperative to do contract research especially holds when trading options on the futures; we will discuss options (which themselves have contract information) in some depth later in this piece.
Futures can definitely be an efficient way to trade the pair (long /RTY, short /NQ), but we will go with what may be a more familiar set of ETFs for many retail traders. Long exposure to the Russell will be explored via the iShares Russell 2000 ETF, ticker IWM. We will assume short NASDAQ 100 exposure using the Invesco QQQs, ticker QQQ.
QQQ should not a problem to short, so long as your trading account allows for such activity. Trading volume in the product is huge (14.6MM shares at around $200/sh on Friday, Feb 28).
Choosing a Dollar-Weighted Trade Ratio
Now that we’ve settled on a product (or at least an underlying), the next question to answer is what ratio you’ll want to select for the trade. Some traders will decide to lean into the side of the pair for which they have more confidence. For instance, if you believe that the pair is more likely to bounce higher than lower, you might select to put more money in the long Russell 2K position in relation to the short NASDAQ 100. To keep our discussion streamlined, I will ignore such considerations here, at least until we get into the options segment.
The simplest approach would be to allocate the same number of dollars to each trade. So for example, $25K long IWM, $25K short QQQ. That’s pretty straightforward, sure, but the approach will often fail to consider the relative volatilities of the products, as well as their correlation. In other words, the simple equal-dollar-weight method does not take into account asset betas.
Without getting too deep in the weeds, an asset’s (“A”) beta relative to some benchmark (“BM”) is the ratio of their volatilities, multiplied by the correlation of the two assets. This is important, especially in cases like today, because folks often misuse betas as a way of thinking of how volatile one asset it relative to another (I’ll refer to the “ABM” for this ratio or the volatility of the asset divided by the volatility of the benchmark). That’s part of the story, but correlation plays an equally important role.
In the left pane above, the 10-day correlation between the IWM and the QQQ is shown going back to August 1, 2019. Observe that most of the data cluster around a two-week correlation of around .83 or so. IWM and QQQ tend to co-move a good deal, though not always in lockstep. As we shall see, the pair have exhibited rather low correlations over two-week stretches, which may give us pause on the pairs trade.
The blue histogram shows the ABM ratio of IWM relative to QQQ. Going back to early August, the IWM has on average featured 24% more volatility than the QQQs (as reported by the mean-ABM of 1.24x). Keep in mind, however, there the ratio has fluctuated significantly.
Because beta multiplies the ABM by correlation, which by definition has a max value of 1.00, the beta will consistently print lower than the ABM. Mean 10-day beta on the pair back to August 1 measures in at .97… so pretty close to parity.
The correlation is at .7, below its historical range, but on the rebound.
So scaling the pair might reasonably take a range somewhere between shorting $.75-$1.20 for each $1.00 of long Russell exposure. Again, that’s if you don’t want to overweight one of the two on the basis of your view on the overall markets trending higher or lower.
Options Exposure for Breathing Room
Volatility in these products is quite high, given the current circumstances. Still, relative vols are not that wildly out of line relative to much of the past year, as measured by VIX of NASDAQ (VXN) less VIX of Russell (RVX).
I want to make the case that giving yourself some breathing space can help you to play for the larger moves that matter and not sweat quite so much the smaller dips and rips (well, small for a 40-vol environment) that you shouldn’t be fixating on. I’ll focus on offsetting risk reversal structures.
Focusing on Friday close’s term structures as a pair (IWM on top pane, QQQ on bottom pane), there has been more dislocation in the term structure of volatility for the QQQs than for IWM. I will focus on the April (“J”) contracts for our analysis. If the market does bounce higher, we’d be long the IWM call and short the QQQ call. One might readily expect vols to melt off, which argues toward more bleed on the QQQ calls that we’re short.
Selecting the Pair
To go long the IWM risk reversal, I’ve chosen to buy the 34-delta call, and to finance the purchase by selling a meaty 34-delta put. That corresponded to strikes at the time of analysis of buying the $153 call and selling the $138 put for April. With the underlying trading around $145.50 at the time of analysis, the trade doesn’t hit in-the-money status until $153 to the upside or $138 to the downside.
The trade has a pretty modest Vega exposure for where we sit right now, with a net delta of about +68, which would jet up to 85 if IWM jets higher about 10%, and edges up to about 70 if IWM continues to spill violently.
While the IWM risk reversal spread had a positive delta (ie positive market exposure), the QQQ will feature negative exposure. I’ve traded 10 spreads (the same as the number for IWM for the sake of comparability). At the time of analysis, the April $215 call was 31-delta, and the April $190 put was 31-delta.
From a risk standpoint, that corresponds to comparable exposures to what we observed on Russell. Current delta is -63.5, which also cruises upward if the market rebounds, while gently nudging up on continued consternation. Once again, the Vega profile is pretty neutral here.
The options approach may be particularly valuable in an environment characterized by exceptionally high volatilities and rather unpredictable correlations. Of course, options are not required, but traders would need to make use of some pretty tight risk controls should the trade move in the wrong direction. The options approach creates some cushion, and potentially some other dimensions (vega, theta) to tailor one’s take on the situation.
My belief is that vols will bleed off pretty significantly if we get a couple strong recovery days. I’m not talking sub-20 vol: we’re way beyond that for the time being. But somewhere in the 25-35 range is pretty doable with just a little bit of positive action. Offsetting these risk reversals would likely make for some rather interesting set-ups over the next couple weeks, especially if the markets did recover some.
As I mentioned at the close of the prior Finhaven piece I wrote, you might feel as though you simply do not have the know-how or the inclination to put this pairs trade on. Hopefully you learned something in this piece in terms of ways to go about structuring such an opportunity, and you can always just make some asset reallocations away from large-cap (which is very much big-tech dominated at present) and toward small caps. It’s a defensible move, and does not require some of the mechanical abilities that we have covered in this piece. Never trade outside the boundaries of your understanding; that especially holds in times of severe market upheaval.