Relative Performance Trade - Essay Example

Develop a well-reasoned hypothesis regarding the relative performance of two assets within the asset Equities Interest rates Energy Agriculture Equities (stocks); involves the investment in shares of public traded companies either for short term trading or long term holding. Equities have outperformed other investments. Assets within the equities asset class include investment company stock and bank stocks. Investment companies stocks usually perform well in the long run. Bank stocks perform well both in the short term and in the long run. In this case, Investment company stock is likely to outperform bank stocks in the long run mainly due to the fact that they are diversified and usually invest aggressively to maximize on long term returns. Banks although they also perform well, they are limited to only one sector. Interest Rates; this involves the trading in options for future performance of interest rates and coupon rates like for treasury bonds. This are either exchange traded or over the counter instruments. An investor taking a long option in interest call options believes that the interest rates will rise. Energy; this options include trading on speculation of future energy prices like gas and oil. This vary depending on issues like oil exploration findings, oil spills. Future options in energy sector Agriculture; this options trade on speculated future prices for agricultural commodities like coffee, sugar and cocoa. ww.CBOE.com www.CMEGroup.com http://finance.yahoo.com/futures http://finance.yahoo.com/options You may also use the Bloomberg Terminals available on Paces 1 Pace Plaza, White Plains, and Pleasantville campuses. Relative performance trade Option traders use calls and puts to hedge risks and exploit volatility. A call option gives a writer a right to sell a stock at a given price in the future. A put option gives a writer the right to purchase a share at given price in future. Whereas futures require no upfront costs (other than commissions), options require upfront payment of premium. Market neutral pairs provide a hedge against market risk. Exposure to market is exchanged with relationship between short and long position. Therefore trade pairs reduce returns loss due to variability of the market. The first step in each of the assets; Equities, interest rates, Energy and agriculture is to select 2 securities that are related. The first step is to select closely related securities. This may be done by using a correlation coefficient. Traders try to look for securities with a high level of correlation so that they can profit when prices behave outside the statistical mode. Thereafter we can determine a price ratio between the 2 selected securities. The disadvantages of trade pairs is that the trader faces twice the fees and commissions, this is in entering the trade and in exiting the trade. The potential for profit can be identified when the profit ration hits its first or second deviation. The trader waits for weakness in the correlation and then go long on the underperformer while going short on the over performer. Profit is realized if long position goes up more than the short or short position goes down more than the long. Trader will sell the over performing security and purchase more of the underperforming security. This means from the proposed strategy, the trader will over the assigned 12 week period monitor the stocks and gradually sell the over performing stock while simultaneously purchase more of the underperforming stock. In this example if maybe in week 6 Walmart share is at $ 80, and those for Target are at $80, the trader will sell the Walmart over performing shares and purchase more of Target underperforming shares. www.onechicago.com www.Optionmonster.com In interest rates market, the trader may use closely related bonds In the energy market, Exxon and Chevron may be selected as the 2 are closely related. They recorded quarterly and yearly profits that triggered the response of the congress in a bid to control the unregulated markets that supply energy. The Foundation of Taxpayer and consumer Rights claims that the energy providing company. Exxon was making over 70,000 per minute by adulterating the crude oil prices. This eventually made the price of oil to reach unjustifiable levels. From such profits, other oil companies have been forced to implement the electronic energy trading so it can be regulated. As the housing collapse started the economic meltdown the energy prices were doomed to rice. Despite the fact that the demand of gasoline reduced drastically, the prices of their shares during the third quarter and fourth quarter were not drastically affected. The oil and fuel have a tremendous effect on all parts of the economy. This is evident from the $300 plus of the fuel surcharges that are sued in the long air lines. The Enron legacy is been seen as an out of control price that has seen the hedg funds and the various oil companies to add more money in a bid to regulate the market. The speculators are usually able to create hysteria for all the oil producing companies and reflect a different picture in the actual market conditions. All the major oil companies are able to make incredible profits that are facilitated by the multibillion dollar tax subsidies that are very evident in this industry. There are few publicly available databases that have historical profit that the oil companies make. Most of them are hidden so that they will not be taxed. There is little or any data that is available that can show how the influence market factors. Things such as the price of the oil, the pump price of gasoline will greatly influence the price of oil products in the online market. Merging of different oil segment can also have great influence. In the equities security market, an example of related stocks is Wal-Mart and Target, if for example Walmart shares are trading at $ 50 per share and Target at $ 100 per share, we can have long of shares of Walmart trading at $ 50 for $500,000 and short of Target trading at $ 500,000. The aim is to trade one share long and the other short if the pair price ratio diverges X number of standard deviation – X is optimized by standard deviation. If the pair reverts to its mean trend, a profit is made on one or both of the positions. In this example the price ratio is 100/50 = 2. The hypothesis is that the 2 stocks will face the same dynamics and almost exhibit similar price rises and fall. However when there is a deviation, it is minimized. Work cited www.onechicago.com www.Optionmonster.com Read More