When in Doubt, Spread it Out

Spread is the operating word in the above title. Mr. Market rallied to new highs and closed strong in today's session. Both professionals and retailers seem to be nervous as the broad market moves up to new highs. How long can this buy the dip routine last? Quote a while and longer than anyone expects are both good answers. Here's a daily chart of the SPY:What a climb..it's really pretty amazing. Now back to the name of the post...what's this about the spread? Something I've been playing with for a while is spread analysis and spread trading. I haven't gotten to the point where I'm putting money on the line with a spread/pairs trading strategy, but I'm not far from it.

One pair that I think is interesting to follow is the spread between the SPY and the VIX. The way spread/pairs trading (or statistical arbitrage if you work at a bank and want to sound fancy) works is that you use statistics to measure the spread between two instruments..in this case its the SPY and VIX. When the spread gets too wide, as determined by the statistics, you buy one instrument and short the other. Then you cash out once the spread narrows or widens. This type of trading can get you into trouble if you only use the statistics (see Long Term Capital Management) and not sound money management rules combined with a little common sense.

Here's a chart of the Density Curve for the SPY/VIX pair using the past year's data:The Density Curve is a series of numbers between 0 and 1. The closer it is to 0, the narrower the spread which would indicate that it's time to buy SPY and sell the VIX. Check out the chart around March of last year and you can see that the Density Curve was nearly at 0...buy time. On the flip side, a reading close to 1 would mean that it's time to sell SPY and buy the VIX as the spreads are too far apart, according the last year's worth of data. Although the pair is not quite at the top pegged at 1 yet (yesterday's reading was .935), the pair is much closer to the top than the bottom. This tells me that any move higher will likely slow down quickly because we are in over bought territory.

So what do I do with this? I continue to monitor readings everyday and wait for it to get very very close to one, like .995 and then I put on an initial short position in SPY and buy a little of the VIX. Then, when my trend following system starts giving me sell signals, I short more SPY and buy more VIX and then manage the trade according to my trend trading system. Note that I only put on a small position (like 1/4 a position) before I get a sell signal from my other system. The Density Curve and it's associated statistics act more like a heads up that change is probably coming.

I find this kind of stuff very interesting and thought some of you might as well. I'm currently working on a spreadsheet that tracks all of the stocks that I follow (30 stocks in 10 sectors) and correlated Sector ETFs with the broad market to expand my Spread Analysis and I hope to implement it all into one big trading system. We'll see, I'm still working on it and it's very time consuming. I'll post an update in another week or so as to the SPY/VIX readings.

Hope you all had a great trading week.

TLT