Pairs Trading Can Be Risky!

So, I thought I’d check up on a pairs trade that I was considering entering last March. Pairs trading involves taking advantage of a correlation between two markets or stocks. When the pairs diverge, you short the higher one and buy the lower one, hoping that they will come back together in the future, and you will capture the difference as profit.

I noted one such divergence between the oil market and the clean energy sector. They usually are highly correlated because higher oil prices makes investment in alternative energy technologies more attractive. Early last year, as oil went on its historic bull run, the correlation broke down. I saw an opportunity for a pairs trade emerge. The chart below shows the divergence:

(from Yahoo Finance)

I have to say I’m not exactly sure why I did not take on the position. Anyhow, I did not, and it was probably a good thing. The blue dot on the graph is when I would have put on the position. I would have been short USO, the graph on top, and long PBW, the graph on bottom. As of about July 1st, I would have been carrying about a 40% loss on USO, and about a 20% loss on PBW!!! Ouch! Even with a leverage of 2-to-1, I would have stopped out! With out leverage, I would have had to wait until December to realize a loss of about 60% on PBW and a gain of about 80% on USO, for a net of about 20%.

Looking deeper into the pair, the correlation coefficient is 0.49, which is quite a bit lower than the 0.70 that some people consider a minimum for a significant correlation. However, I like the logical argument behind the correlation and attribute the low coefficient to my small data set that only goes back to 2006.

The point of this article is that, sometimes, markets can irrationally diverge for longer than you can stay solvent. Even a hedged pairs trade can be very risky under leverage. But, if you’re careful and patient, you can make money in a logical way!

Correlation between VIX and Gold?

Some consider the VIX index as a measure of "market fear." Indeed, the index does depend on demand for S&P 500 puts, which is a good sign that portfolio managers are worried about a market drop. I have been thinking recently that gold is another measure of "market fear." When people become concerned about the economy and the solvency of the federal government (along with inflation), they buy gold.

So, we should be able to see a correlation between the VIX and gold, right?
Let's look into it. I'll plot the daily closing value of Gold on the vertical axis and the daily closing value of the VIX on the horizontal axis. My data set goes back to 1991 and contains over 4,000 data points.

What an interesting pattern we see here! I have to say, it does not look like what I was thinking it would look like. The only re-assuring aspects of the graph are the points in the top right (when gold is high, the VIX is high, signaling a correlation) and the points in the bottom left (gold is low, VIX is low, signaling a correlation). Most of the other points, however, do not signal a correlation.
One might argue that Gold is influenced by inflation, while the VIX is not. That would be a good argument. Here is the same graph with the gold price adjusted for inflation using the GDP deflator:

Not as much of a change as we would like. I still find this graph to be very interesting and hope others might be able to comment on it’s value…