Monday, November 23, 2009

A Primer on Relative Performance


Though I tend to favor delta neutral positions such as iron condors, I still have a smattering of somewhat directional positions within my portfolio. What do I mean by 'somewhat directional'? Well, rather than placing an aggressive position such as long calls or puts, which can be both quite lucrative when right, but quick to punish when wrong, I usually opt to sell out-of-the-money credit spreads. Obviously when I sell a call or put spread I'm making a directional bet, but much less so than if I were to buy calls or puts outright. One of the tools I use to aid in choosing which underlying I want to use for these types of trades is relative strength.

Though the relative performance of two securities can be measured over any time frame, I tend to favor longer term. The rationale being that day to day we often see minor aberrations in price that are nothing more than noise. No sense making a mountain out of a mole hill. It's when relative strength continues over weeks to months that I begin to take notice. From a relative performance standpoint, what can we surmise about the following 2 securities?

ABC has increased 5% over the last two weeks.
XYZ has increased 2% over the last two weeks.

We could say any of the following: ABC is outperforming XYZ. ABC is exhibiting relative strength. XYZ is underperforming ABC. XYZ is exhibiting relative weakness.

If you subscribe to the notion that strength begets strength and weakness begets weakness, then naturally you would look for bullish trades on ABC or bearish trades on XYZ. In other words, when bullish we seek relative strength and shun relative weakness. When bearish we seek relative weakness and shun relative strength. Next time we'll explore a few different methods used to perform this type of analysis.

3 comments:

ngbstl said...

I enjoy credit spreads b/c my view is they are one of few ways you can profit from 2 outta the only 3 possible behaviors of underlying (up, down, sideways); so it can either go away from you or just slosh around where it is, and you profit in both those instances. My criteria for finding ideal candidates this far has been limited to seeking some sort of technical line of defense between short strike & current price. But I'd love to learn more 'sophisticated' criteria for finding such candidates...maybe a future post? thx!

Tyler Craig said...

Ngbstl-

Good points on the credit spreads. I'll give you my thoughts in a blog post (probably Wed.). Thanks for stopping by.

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