As Rodney pointed out above, Germany and Spain are on opposite ends of the spectrum. Germany is the euro zone’s greatest strength. Spain is its greatest weakness. Yet the two, thanks to their shared currency, are inherently linked. Oh, and Spain owes Germany a ton of money that Germany may or may not ever see…
Today’s chart compares the relative performance of Germany and Spain. This is a “ratio chart,” where the line is constructed by taking the ratio of two trading instruments.
Here, the line represents:
EWG (Germany ETF)
EWP (Spain ETF)
When the chart trends up… it means Germany is outperforming Spain. When the chart trends down… Spain is doing relatively better.
As you can see the trend is up. Germany has outperformed Spain since the start of 2010. But this trend has started to reverse. You can see how the ratio line (in yellow) recently dropped below its moving average (in blue).
These relationships are mean-reverting. So Germany’s outperformance can only last so long before the trend reverses toward an average value. This creates trading opportunities known as “pairs trades.”
In a pairs trade, you sell short one instrument and go long the other. You pull the trigger on this type of trade when you think the trend has gone too far (one country has outperformed the other for too long) and you expect the relationship will return to normal…. revert to the mean.
To make this trade we do the following:
1) Buy $1,000 worth of EWP (Spain), and
2) Sell short $1,000 worth of EWG (Germany)
We saw an opportunity to make this trade back in March of 2009. Using the same trigger (yellow line crosses below blue line), we could have done quite well. We would have lost about $518 by selling short EWG. But our profit on EWP was $730.
The net result was a gain of $212 on an investment of $2,000 ($1,000 on each ETF). That’s a return of 10.6% and the trade was only open for seven months.
I think the market has overvalued Germany’s strength. This is why the outperformance of EWG has gone so far above average. Now, it’s becoming clearer that Germany CAN be dragged down by its weakest “allies.”
This pairs trade is a great opportunity to capture some profit as the rest of the world catches on to the mess Germany can’t escape.
If you haven’t done so already read the Survive & Prosper issue on “Why the PIIGS Need to Stay in the Euro Zone…”.