How do I maximise returns using share price divergence
I am happy with the pairs trade concepts but everyone seems to talk about stocks that have close /familiar relationships. Is there some advantage in associating a long positive momentum position with a short negative one even when they may come from different sectors of the same market?
As an example I have recently associated a long in Tesco (supermarket outperformer) with a short in Alliance Leicester (mortgage bank laggard) which are both from the FTSE100. The result is phenomenally good and much more than I expect from the classical position.
For those who don’t have an understanding of the conventional pairs trade, it involves the simultaneous buying long and selling short of two related stocks, taking advantage of any divergence in the share prices. The basic principle behind this strategy is to establish the natural price relationship between the two related stocks and use any price irregularities to create a trading opportunity.
Unlike the traditional pairs trading scenario, which is generally seen as a more conservative strategy, the concurrent trading of stocks from different sectors is generally a more aggressive strategy designed to maximise returns from share price divergence - however with reduced protection from market fluctuations.
An example of this strategy comes with the recent credit concerns in the US. This prompted many traders locally to short some of the major banking stocks, whilst strong demand for Australia’s resources made for a prime opportunity to buy some stocks within our materials sector. Typically I would suggest we would see this type of activity in times of economic adversity where traders and investors may decide to reduce holdings of a discretionary type and enter stocks of necessity (safety stocks).
Naturally, you will see times a particular sector will out-perform another, however, identifying a direct correlation or trend between stocks within different sectors is a little more complicated and in most cases unlikely.
It is also important to consider the effects on your risk to reward ratio as this strategy is essentially increasing your exposure to a market rather than a strategy designed to mitigate risk.
The below chart demonstrates the divergence with Alliance and Leicester (LSE: AL/) and Tesco Plc (LSE: TSCO) mentioned in your question.
Chris Gore, IG Markets
Disclaimer: The views expressed in this article are those of Christopher Gore, a representative of IG Markets and is not intended as general advice. This does not constitute a recommendation nor does it take into account your investment objectives, financial situation nor particular needs.
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