A Perplexing Pair
Vol #83: May 27th, 2022
Newly minted trader trainees love talking about all the different ways to make money.
Unlike the grizzled veterans who have seen a dozen different ways to lose money, who keep their edge closely guarded, the pollyanna greenhorn is bursting with ideas. There are patterns to capture, easy arbs to lock in, and a sports car in the house on the hill is a few buy lows and sell highs away.
One of the popular trading techniques when I was coming up was pairs trading. As computers got faster and brokerage became electronic, the early 2000s were a fertile ground for profiting from the relationship between two (or more) different stocks. Statistical arbitrage was a revenue cornerstone for the halcyon days of hedge fund glory.
It makes sense why the shares of Morgan Stanley and Goldman Sachs will trade in tandem. They have broadly similar business lines and are impacted by the same macroeconomic factors like interest rates and investor sentiment. If $MS reports good earnings on Tuesday, chances are $GS will rise in sympathy even before their own quarterly report.
Big picture good or bad news will likely have the same impact on them in the short term. Over longer time lines, the nuances of management decisions like relative concentration in investment banking vs. sales and trading, or the ability to secure ongoing deal flow and maintain customer relationships will determine ultimate profitability and share price.
It was pretty funny to hear a fellow trainee suggest one day after a mock trading class that he had found a significant relationship between JetBlue and Morgan Stanley. Sure there is a relationship between US Equities, and perhaps there is some relative cost of capital they’re both subject to, but flying planes and eating orderflow are two very different games.
Even in a world where old school traders still boasted about only needing a ticker and a vol surface to trade a product, this was an easy trade to poke holes in. Our peer wasn’t wrong about the relationship - he had a masters in a quantitative field and the arithmetic was there - but there wasn’t any intuitive sense to it.
Earlier this week on Options Brew TV, I suggested a pair trade that was somewhere in between these two prior examples. Over the last several months, one of the biggest stories across the digital asset ecosystem is how highly correlated it has been to the traditional finance space. Now we’re seeing strong divergence between the two, and I asked - “is the ETH-SPX spread a buy right here?”
There have been good reasons for the correlations recently. The last two years have seen a boom in cross-over players. As crypto gets more institutionalized, it will feel the knock-on effects of what happens in traditional markets and vice versa. When a portfolio manager lightens their book in a risk off moment, it all comes down to tickers and capital, not necessarily what type of asset it is.
Suggesting an ETH/SPX pair trade is a little bit zany on one hand, because they seem so fundamentally different. However I specifically chose ETH because of all the crypto assets out there, it’s the one that has the characteristics most like an equity.
For starters, ETH has real revenue that is paid to the service providers who secure the blockchain. When a user wants to perform a transaction on the Ethereum network, they pay a gas fee in ETH that depends on both the complexity of that transaction and the overall network congestion. Ethererum the blockchain is a computer, where the vast network of users rent space.
Thousands of different applications (dApps, decentralized Apps) are being built on top of Ethereum. These can be relatively simple protocols that exchange one token for another, or they can be complex transactions with multiple layers, dependencies, and balance adjustments.
In January these fees grossed $1.5 billion in revenue for the chain. While those numbers have come off with the drop in prices as well as the reduced activity, Ethereum is consistently generating hundreds of millions of dollars in revenue every month for renting out its virtual computer and keeping track of all the different transactions. On a price to earnings basis, it’s well below the SPX, somewhere in the upper teens.
With the full caveat that anyone can make an Excel model dance if they squeeze it hard enough, plugging this revenue into a discounted cash flow model has some compelling suggestions for the value of ETH. While there are some healthy growth assumptions here, even the more conservative estimates put ETH at a value 2-3x higher than where it’s currently trading.
So what could go wrong here - buy ETH, sell SPX, and laugh all the way to the bank? Currently the spread is almost $2300 apart. That has widened dramatically just over the last 5 days as SPX has rallied 3% and ETH has shed almost 11%.
Looking at the above chart, we’re starting to get into an area where this divergence seems (feels? hopes?) likely to snap back. It was only last November that ETH traded over SPX by almost $100. ETH could easily double in the next 6 months, but I’m not sure SPX could.
This is where pairs trading starts to get very dicey. It’s almost impossible to tell when you’re looking at the biggest opportunity of a lifetime, or stepping in front of a steamroller of paradigm shift. With pure mean reversion it’s always the darkest just before dawn, with pairs trading sometimes the lights just go out.
If you’re just using underlying assets (e.g. buy ETH to sell SPX), then one strategy is to start nibbling when the relationship diverges from fair value. You’ll want to risk manage the position so that you can scale into more and more size as the spread gets fatter. But at some point there’s “no mas”.
Options make a trade like this interesting with both an embedded leverage and risk management framework. Rather than selling SPX, one could sell call spreads against it, to buy call spreads on ETH. There’s perhaps a collar you could put around each asset at varying degrees to express your bias.
I don’t think there are a lot of people making this specific bet. (Maybe that’s why it’s so “out of line”?) Most participants tend to be long only on both of these assets, and are looking at relative value independently. But it is an interesting reflection on risk management, and how until you connect with the bat, every fastball looks like a homerun.