The Most Basic Pairs Trade

Many of you should be familiar with the concept of pairs trading. At its simplest, a pairs trade is when someone buys one stock and sells the other, with the shares usually sold short.  This is meant to be a relatively market neutral method for capturing changes in the relative values of related, but not identical assets.[i]  Although the most active practitioners of these strategies are now high-frequency traders utilizing complicated statistical methods, the relationship between QQQ and SPY offers individual investors an important framework for their own strategies.

While the NASDAQ 100 Index (NDX) is often referred to as “the tech-heavy NASDAQ,” at this point the S&P 500 Index (SPX) is also quite tech-heavy.  We have the outsized performance of the most highly capitalized tech stocks to thank for that.  The two indices, and hence the two ETFs that track them, share the same top 5 stocks.  It’s just that the weightings are different.  Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Tesla (TSLA) and the two classes of Alphabet (GOOG, GOOGL) represent almost 43% of NDX’s market cap, while those same stocks represent about 22.5% of SPX’s.  By definition, the two indices should not be able to diverge all that much from each other.

And that is indeed what we see.  I ran the correlation between the two key ETFs, QQQ and SPY, over several timeframes and methodologies.  In almost all cases, the R-squared was 0.90 or more.  I prefer to focus on the relationship of the daily percentage changes in each ETF, using SPY as the independent variable.  The choice of QQQ as the dependent variable may be arbitrary, though I believe that the broader index is the more independent one, but I am quite firm on my preference for daily percentage changes.  For several years I managed a highly profitable pairs trading portfolio, and we found that daily percentage changes were much more useful for a system that was trading constantly.  Less active traders can still correlate values rather than changes, however. 

What we find is hardly surprising.  As we noted, the correlations are quite high by definition.  The two indices share the top components, while almost all of NDX is contained within SPX.  The key difference is that SPX contains 400 more components that NDX doesn’t, and a good portion of those extra 400 offer exposure to sectors that NDX does not.  NDX offers no exposure to the financial or energy sectors, for example.  The narrower focus of NDX means that while it moves roughly in tandem with SPX, it tends to have a higher beta.  In layman’s terms, NDX typically moves more than SPX.  One way this is reflected is that VXN (CBOE NDX Volatility Index) usually trades at a premium to VIX (CBOE Volatility Index).

That should be the key takeaway for investors of all types.  If NDX and QQQ move quite similarly to SPX and SPY but only more so, this provides an important framework for structuring market exposure.  During periods of trending markets, aggressive traders would generally be better suited focusing on QQQ rather than SPY.  If they’re both moving in the same direction – up or down – traders who want to participate in the rally or decline would usually be better off utilizing buys or sells of QQQ rather than SPY.  Simply put, there is more bang for the buck.  On the other hand, investors who want to remain exposed to equities in a less-risky or more diversified manner are generally better off in SPX and SPY.  Among other things, if you favor financials and/or energy over tech, then SPX is the better choice (and vice versa).

More aggressive traders can of course try trading the pair themselves.  The simplest way is to short some shares in whichever ETF you think is relatively expensive and use those proceeds to buy an equal dollar amount of the other item.  Risk control is key, because although the two items have correlated well in the past, there is nothing that says they will remain similarly well-correlated.  I certainly learned this lesson the hard way.  Another thing to bear in mind is that even if you start off dollar neutral, you won’t remain that way.  If you are correct, your long will appreciate faster than your short, giving you a positive balance in your account.  If the opposite occurs, you get a negative balance.  That also means that you become somewhat exposed to the broader market until the trade is closed, though that exposure is far less than going long or short either on an outright basis.

Bottom line, if you have a strong market view, particularly on megacap tech stocks, you’re generally better off using products related to NDX to express your views.  If you’re correct, history shows[ii] that NDX will tend to move more than SPX.  On the other hand, if you want less volatility or more exposure to key sectors other than tech, then SPX-related products tend to offer a better choice.

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[i] The term “hedge fund” arose from this strategy.  In 1949, Alfred W. Jones created a fund that attempted to capture relative value changes while minimizing market risks by employing this hedged equity strategy.  A few years later, he changed his fund to a limited partnership with a 20% incentive structure and utilizing leverage.  Over time, the term “hedge fund” became linked to the organizational and compensation structure rather than a hedged relative value strategy.

[ii] Past performance is no guarantee of future success