NaughtyPines

GLD/SLV PAIRS TRADING: WAITING FOR GREATER DIVERGENCE

AMEX:GLD   SPDR GOLD SHARES
Another tool in the tool box: pairs trading. What is it? It is the trading of closely correlated underlyings at points of unusual divergence and operates on the assumption that the pairs will eventually revert to the historic correlation.

GLD             and SLV             are closely correlated pairs. On the chart below, you'll see that, for the vast majority of the time, GLD             and SLV             enjoy a correlation darn near close to 1.0, which basically means that their trajectories are virtually identical the vast majority of the time. However, at various points, that correlation diverges dramatically, particularly at the end of April and the beginning of September, after which their respective trajectories reverted to their historic correlations. These divergencies are profit opportunities.

How do you trade these divergencies? You can either trade them buying and selling the underlyings or use options to do so. If using underlyings, you would buy shares of SLV             and sell shares of GLD             such that the dollar value of the SLV             shares is roughly equal to the dollar value of the GLD             shorts at the point at which the Correlation Coefficient shows them to be most divergent (near 0.0) and exit both trades when they return to convergence (at or near 1.0). If using options, there are a variety of ways to trade the divergence, but as a premium seller, I would probably opt for selling short put spreads in SLV             with the short put strike at or around the 1 SD             (standard deviation) and selling short call spreads in GLD             at or around the 1SD at the point of greatest divergence, using the Buying Power Effect to balance the short put side ( SLV             ) with the short call side ( GLD             ). By trading the pair in this fashion, you will not only get the benefit of options time decay, but also the price movement from the return to convergence that selling pairs gives you.

Currently, I don't think a GLD/SLV pairs trade is necessarily "ripe" for an entry, but it's worth keeping an eye on ... .
NaughtyPines
a year ago
There are a wide number of closely correlated instruments to trade in this fashion, with the most obvious ones being the index ETF's SPY, IWM, DIA, and QQQ, all of which enjoy an extremely close correlation to one another (.95+). However, there are other obvious candidates that can be found with underlyings in a similar sector (two financials like JPM and GS) or an underlying that plays a major role in a given index ETF's movement (AAPL and QQQ).
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