Dow Industrials vs. Russell 2000: A Long-Short Illustration

Includes: DIA, IWM
by: Brett Steenbarger

Here's a chart of the Dow Jones Industrial Average (NYSEARCA:DIA) denominated in shares of the Russell 2000 Index (NYSEARCA:IWM).

The charts we're accustomed to denominate shares in dollars. When we use a second market as the denominator, we create a new instrument that reflects the relative strength of the numerator with respect to the denominator.

In other words, what we're looking at is the price performance of a holder of a long-short position (long DIA, short IWM). Note that this looks like a pretty nice bottom pattern on a chart; DIA has been in an uptrend vs. IWM for over a year now.

When you trade a long-short portfolio, the relationships between markets become your trading instrument. When those markets are highly correlated, your portfolio is thus hedged against general market risk. A long-short portfolio is an excellent way to exploit market themes without having to time or crystal ball general market direction.

Moreover, your new instrument--the relationship between markets--has its own historical price patterns that you can identify and exploit, no less than an individual stock or index. More on this to come shortly.

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