When we think something is overbought, and a correlated asset is oversold, we may construct something called a pairs trade.
A pairs trade hopes to take advantage of price divergence in two correlated assets.
For a pairs trade, we would ideally like to see a correlation between 0.6 and 0.8 between the two assets.Study:
Scanned the market for all ETFs
- Correlation to SPY between 0.6 and 0.8
Goal: Create opportunities sell call in overbought asset (SPY) and sell put in oversold asset
We find that the asset that fits both the correlation and the oversold criteria is XME. With a correlation of 0.6 and its 1% year-to-date performance compared to the SPY 14% performance, we can sell calls in SPY and puts in XME to benefit not only from theta decay like a normal strangle, but also price convergence.
When we adjust the notional value (beta weighted deltas) of XME to SPY, we find that we need to sell 8 puts in XME to every 1 call in SPY.