I’m a fan of pair’s trades. I like the notion of minimizing market risk by taking a short position alongside one that is long. I often will look at the relationship between two markets to get a better idea of where the trader’s risk appetite might be.
An example of this would be the ratio between say the NASDAQ and 10-year bonds. When bonds are outperforming the stock index then we can make the assumption that things are in a ‘risk off’ type environment. I also will view these types of relationship as mean-reversion setups. Although it’s important to note that this article is not meant as a recommendation or an offer to buy or sell any securities.
ETF CORRELATION
The iShares MSCI EAEFE Index ETF ($EFA) typically has a positive correlation with the iShares China 25 Index ETF ($FXI). The 20-day correlation currently sits just over .70 and has only dipped negative three times momentarily in the last year. While the correlation between these two foreign ETFs is positive they still can be looked at through a lens of mean-reversion. The way this can be done is by looking at the Relative Strength Index (RSI) of the ratio created by $EFA and $FXI.
When the RSI indicator breaks into a historically oversold territory of over 70, we have been able to watch the China ETF begin to outperform the EAFE ETF (when the green line is falling $FXI is outperforming $EFA). A more conservative approach to trading momentum mean-reversion using the RSI is looking for divergences of the indictor and the price ratio. When the ratio between $EFA and $FXI makes new highs while the Relative Strength Index is above 70 and making a lower high, we can begin to see a warning sign of a possible trend change.
WILL MOMENTUM DIVERGE?
Currently we have an overbought RSI indicator which throws up the yellow flag for the pair of international ETFs. Going forward I’ll be watching to see if momentum begins to diverge and leads the relative performance to favor China against EAFE or if EAFE is able to buck previous trends and maintain control while working its oversold momentum.
Disclaimer: The information contained in this article should not be construed as investment advice, research, or an offer to buy or sell securities. Everything written here is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned.
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