Reader Strategy: SPY/DIA Pairs Trade
This strategy is another example of the importance of the right data, and not confusing the intricacies of indices with the intricacies of ETFs (or futures, or options, or anything else).
The strategy comes from friend of the MarketSci Blog Russ: buy the S&P 500 and short the DJIA 30 at the open if the S&P 500 opens lower than the DJIA 30 (in % terms, relative to the previous close). Short the S&P 500 and buy the DJIA 30 if it opens higher. Exit all positions at the close.
The graph above shows the strategy results applied to the respective indices from early 1998 to present.
Geek note: This test is frictionless (i.e. ignores transaction costs and slippage). I realize that because we’re trading at the open (and therefore not using leveraged mutual funds) this assumption is unreasonable. I’ll explain in just a moment.
In a frictionless world, this strategy would have been very effective, not necessarily in terms of profits (15.8% annualized return), but in terms of risk-adjusted profits (only 4.2% annualized std. dev.) Notice that this is a simple pairs trade where the trader is going long and short two different market indices and capturing just the performance difference between the two.
But as we’ve repeated ad infinitum on this blog, intraday index data (as opposed to ETF data for instance) has to be taken with a grain of salt…especially the opening price. I would say that any strategy that relies on intricate differences in intraday price (like this one) is meaningless when tested on the indices themselves.
For example, here is the same strategy applied to ETFs in red, compared to the original impossible-to-mimic index strategy in blue.
Still profitable, but only barely. Total returns were approx. 0.018% gain per day, meaning friction in excess of about $3.51 per $10,000 traded brought profit to zero.
Strategies (particularly the shorter-term variety) that are based on small changes in price need to be tested on the actual asset being traded. Anything else is just asking for trouble.
P.S. A big thank you to Russ for asking us to put this one to the test and giving us the idea for this post.
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