Pairs trading is a strategy to reduce directional exposure and profit from the difference in price between two correlated underlyings. Since many stock indices move together, they serve as great candidates for pairs trades. Recently we’ve seen significant differences among the indexes, is there greater opportunity here?The Study:
- DIA, IWM, QQQ, SPY
- 2005 to Present
- Observed 1 Month of Movement in Each ETF (Daily) and Compared Movement Across Indexes to Find Standard Deviation of Monthly Moves in the Pairs
Compared to the recent spreads between SPY, QQQ, DIA, and IWM, we are seeing larger than normal differences. Notable differences exist between the DIA and QQQ and IWM and QQQ. Trading these spreads when the divergences are greater than 5% has historically resulted in strong performance. When compared to trading in all environments, waiting for divergences greater than 5% resulted in a higher win rate, greater average P/L and shorter holding period.