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Complete Guide to Relative Value Strategy

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Relative-value arbitrage is an investment strategy that seeks to take advantage of price differentials between related financial instruments, such as stocks and bonds, by simultaneously buying and selling the different securities—thereby allowing investors to potentially profit from the “relative value” of the two securities.

What is Relative Value Strategy?

Relative value (or relational value) can loosely be defined as the relation of the price of a particular financial asset or commodity to its intrinsic value. An instrument’s relative value may be thought of as the ratio of the price to the underlying value or the inverse of the price-to-value ratio. Relatively cheap assets are considered to have a high relative value. A central theme with relative value is the concept of fair value which is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between two market participants.

This is very similar to the Wyckoff method which helps us to calculate the value of an individual instrument, based on two sets of charts: the chart for the instrument itself, and the charts for SIMULTANEOUS price movement of the instrument and the underlying (or correlated) commodity, market, or stock market.

Our definition of a relative value opportunity is: Any situation where a financial instrument trades at a level that is relative to its similar counter-part. For example, an individual stock may trade at a price that is 100% higher than its price relative to its own industry index. The same principle is true for bonds and currencies.

Where profitability is concerned, relative value plays offer a similar potential to trend/trend-following strategies, as well as a much lower capital requirement. Another big advantage of relative value plays is that they can be carried out in “real-time”. The disadvantage is that the potential profit is smaller and harder to calculate. Additionally, losses are harder to determine, since the whole exercise is about balance.

The beauty of relative value plays is the wide range of possible options. For example, one may sell a put option on Apple, while simultaneously selling an at-the-money call option on a certain fund that doesn’t have anything to do with Apple, and none of the risk from the outcome of Apple is transferred to the person selling the put option. This is true even if the trade is meaningfully profitable because of adverse price movement of Apple, as long as the instrument being sold has a certain amount of implied volatility, as explained in this article.

We love relative value plays because they offer a great way to profit from being in the right place at the right time, without having to know anything about the fundamentals for the underlying instrument. This makes them a great deal less intimidating for many people, and places them in a entirely different category of trade from those that require analysis of the instrument in question.

Perhaps the most important thing to understand about relative value trading is that if the underlying instrument which is being bought and sold moves too much the trade will lose money regardless of the movements of the two instruments which are being hedged. This is a key consideration for people who like to use trading systems when trading relative value.

(Trading systems have “stop losses”. Relative values don’t have stop losses built in, but instead they have what we call “Margin requirements” which amount to the same thing. This is another reason why trading relative values is “riskier” than trading systems.)

Relative Validity

Relative value trading only sometimes leads to increased profitability, or produces positive trading results. As a rule, the underlying instrument being traded has to move to at least the mid-point of the range of the trade in order for the trade to be profitable. Since anything can happen at any time, it is also a good idea to plan on a “worst-case” scenario for any trade, and so it is a good idea to “risk manage” by setting a loss stop in place.

We have found that trading in and out of positions in a relative value trade is generally a losing proposition, and so we suggest implementing a strategy using the term “swing trading” where one stays in a single position for a greater period of time, even if that position only goes slightly in our favor. In this way, we are able to utilize the strengths of both trending strategy and relative value strategy, and experience the stronger profitability that is more typical of trend following.

Oftentimes, several degrees of separation are needed to capture an accurate picture of the value of a security. For example, a security’s price, compared to that of its own industry, relative to its sector, to the overall market, etc. This is a more sophisticated method of creating a relative value play, and it is for this reason that there is a greater degree of complexity involved in the analysis. In some situations, we find it advantageous to “shuffle” a technique that would otherwise be used in trend following, and use it as a component of a relative value trade.

A common misconception among practitioners of relative values is that the trade will lose money if the underlying instrument (the one sold) moves up, or that the trade will lose money if the underlying instrument moves down. In reality, the only way a relative value trade maintains a profit is if the underlying instrument remains unchanged or moves in the opposite direction of the trade, or inversely correlated instrument.

The most basic relative value trade is the diagonal spread. The underlying instrument is bought and sold simultaneously in order to generate profits from changes in volatility. For example, one may buy an out-of-the-money call while simultaneously selling an out-of-the-money put, or buy an out-of-the-money put while simultaneously selling an out-of-the money call. This method of trading is best suited to those who are able to wait patiently for a profit.

Relative Value Trading Example

This was a less-than-ideal trading example, and there were a few things that we were doing wrong that I want to point out.

Step 1: We buy the December 2015 Call @ 1.26

Step 2: We sell the December 2015 Put @ 1.10

Step 3: We cash out @ 1.15

Problems with this trade:

– The Underlying Stock was in an up-trend which meant that we were betting against the trend, and hoping that the Trend would reverse right around the time that the expiration date for the trade came around. This did not happen, and we lost money on a trade that we thought was in our favor.

– We did not profit from our short position, and so we did not set a loss stop.

Step 4: We wait for the stock to move up to 1.26

Step 5: We sell @ 1.27

Step 6: We cash out @ 1.28

– We initially thought that the trade would profit, because the stock had moved up a full point on us. The back-testing, however, showed that this trade would have lost money.

– We used the short-position in an attempt to hedge-out the first trade, but ended up using it in the same trade. This makes things so complex that it’s impossible to understand what is going on. This practice is utterly pointless, and is not recommended.

– This trade was still doing well, and so we took it off as planned, while effectively selling the same underlying instrument short a second time.

Step 7: We buy the December 2015 Call @ 1.14

Step 8: We sell the December 2015 Put @ 0.95

Step 9: We cash out @ 1.00

Problems with this trade:

– The underlying instrument stopped falling, but it did not move back up in a way that would make this trade profitable.

Step 10: We take the trade off and we lose 0.05 on the trade

– This is not actually a problem, because we are in fact out of the trade.

The actual exit price of the underlying instrument was 1.05, and because of the leverage on our contract, which amounts to trading 1000 shares of Apple stock without actually holding any of the stock, we are still able to collect a profit, and we are able to hide from the volatility variability. And because we are hiding from the volatility variability, we are also able to take our profits at whatever price we initially decided on.

In this case, the profit is, $1.51 – $1.05 = $0.46 per share of stock.

Step 11: We close out the position and collect a profit.

The Bottom Line

This is a simple example that does not demonstrate the full power of relative value trading. It shows, however, that discipline is everything, and that it is possible to make money even when the stock trades in a way that you don’t like. Long-term relative value traders will probably see a narrower profit margin on their trades because the profit will be compressed over a greater period of time. We recommend reading through this entire instruction set at least once before attempting to use this technique. You should also read through the position management section because it will help you avoid the problem of over-trading.

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