Consider This Arbitrage Strategy As The Market Moves Sideways Or Into Correction

Includes: PBP, SH, SPY
by: Gary Cheng

The U.S. equities market has had a strong run in the last seven months and gained over 25% since last November. However, investors have become skittish in recent days amid speculation that benign economic growth, steady new jobs creation, and a reviving housing market might prompt the Fed to start tapering or unwinding its QE3 program. Since the Fed's QE3 stimulus program was largely credited for this recent bull run, it's feared that the tightening will withdraw excess liquidity that has been supporting risky asset prices. As the market began to price in this increasingly probable event, the S&P 500 Index has fallen 5% off its peak as of Wednesday.

Until the Fed makes a more definitive move or stance, I believe the specter of a looming monetary tightening will remain a focal point of the equities market in the summer months ahead. That feeling of uneasiness will likely be reflected in rising market volatility as measured by the CBOE Volatility Index (VIX). In fact, some bearish sentiment has returned to the market and the VIX has already risen 50% from a low of 12.3 to 18.6. Compared to levels seen in recent years, market volatility is still very low but looks poised to break out to much higher level if the market indeed moves into a prolonged correction in the next few months.

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For investors expecting a flat or declining equities market coupled with rising market volatility, one particularly useful strategy involves an long/short arbitrage between the S&P 500 Index SPDR (NYSEARCA:SPY) and the Powershares S&P 500 BuyWrite Portfolio ETF (NYSEARCA:PBP).

Studies of the S&P 500 BuyWrite strategy and historical performance of PBP have shown that a S&P 500 buy-write strategy consistently outperformed S&P 500 in flat or declining markets, but under-perform the S&P 500 during most rising equity markets.

Although the S&P 500 BuyWrite Portfolio ETF may outperform the S&P 500 during a declining market, the ETF could still post negative returns due to the value of S&P 500 Index portfolio declining more than the downside protection provided by the premium of the written call options. However, pairing long PBP with a short position in SPY changes the risk-return profile and makes it a potentially profitable opportunity.

The payoff of the long/short pair trade is equivalent to selling the S&P 500 Index at-the-money-call options and receiving the call option premium which is generally 1.8% per month according to CBOE, without actually engaging in option trading. As market volatility increases, the payoff could go as high as 3% - 8% which increases the attractiveness of this arbitrage strategy.

I backtested this arbitrage strategy for the four most recent market corrections with at least 5% or more declines and found that the pair trades' resulting returns ranged from 2% - 7% with an average positive return of 4% over an average holding period of 2 months. Considering that the average decline of these four correction was about 11%, a positive return of 4% represents fairly significant alpha.

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A secondary consideration from looking at the hypothetical monthly performance of this arbitrage strategy below is a fairly strong reversion-to-mean tendency. The strategy return alternates between positive and negative two to three months each time. Since the S&P 500 has had a strong 7-month run going back to last November and the strategy's negative return spread is widening by a big margin, I would expect the reversion-to-mean pattern to again emerge in the next few months to result in the strategy again posting positive returns.

For investors who are not allowed to short the SPY in their accounts, another variation of this arbitrage strategy is to long PBP and long the ProShare Short S&P 500 Index ETF (NYSEARCA:SH). The results from further backtesting in the same four market corrections revealed similar average positive return of 4%.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.