The stock market provides an endless stream of possibilities for investors to invest their hard-earned money. With so many choices, identifying the right opportunities can be a tedious exercise. Sharenet Analytics is excited to announce the launch of the latest addition to our existing suite of research and trading tools, the Regression Trend Analyser (RTA), to help you spot more trading opportunities on the JSE.
The next bit might get a bit technical for the non-geeks out there, but will shed more light on the mechanics of the Sharenet Analytics RTA, so bear with me. The Sharenet Analytics RTA uses linear regression techniques and the theory of mean reversion to identify trading opportunities in more than 150 shares listed on the JSE. Linear regression is used to identify the general trend or direction that the share price tends to follow. When the share price deviates too far from this linear trend, the theory of mean reversion suggests that the share price should correct towards its linear trend over time. These techniques can be used to identify buying opportunities when a share price has drifted too far below its trend line, or selling opportunities when the share price has drifted too far above its trend line.
The Sharenet Analytics RTA also looks at the relative movement of two shares that should tend to follow each other closely due to fundamental and/or economic factors. Shares in the same industry, like two local banks or retailers, is a good example. By analysing the relative co-movement of these shares using the same linear regression and mean reversion techniques, a number of trading opportunities can be identified by the Sharenet Analytics RTA.
Right, with all the theory behind us, let us explain how you as the trader can use the Sharenet Analytics RTA to enhance your trading:
Say you hold a local bank in your equity portfolio and let’s suppose you are comfortable with your current level of exposure to the banking industry. Wouldn’t you like to know that you are holding shares of the local bank that will yield the best returns for your portfolio? The Sharenet Analytics RTA can help to set your mind at ease. Let’s suppose you are currently invested in Standard Bank (SBK). Since all local banks tend to be influenced broadly by the same fundamental and/or economic factors, their share prices tend to follow each other closely. In the same way that linear regression is used to identify the trend of a specific shares’ price movement, it can also be used to identify the trend of the relative share price of two shares (i.e. SBK share price divided by another bank’s share price). Now, if Standard Bank has been outperforming another local bank, let’s say Nedbank (NED), wouldn’t it be a good time to rather hold Nedbank than Standard Bank. Well, maybe. If Standard Bank tends to generally outperform Nedbank, there will be no reason to switch. The Sharenet Analytics RTA uses linear regression techniques on the relative share price of the two shares to identify these general trends. It also identifies divergences from this general trend – if Standard Bank has been outperforming Nedbank more than usual, this might present a trading opportunity. Mean reversion theory suggests that Standard Bank should underperform Nedbank in order to get back to its general level of outperformance. It might be worthwhile selling your Standard Bank shares and buying Nedbank shares for your portfolio. By doing this, you still maintain the same exposure to the local banking sector, but you can now be fairly comfortable you are holding the share (Nedbank) that should offer better returns relative to the share that you used to hold (Standard Bank). You’ll need to keep a close eye on this, as their might come a time to switch back to Standard Bank once the share prices has corrected towards the general relative trend. Using the Sharenet Analytics RTA, you can also compare different sectors of the market and establish that maybe the banking sector isn’t even the best industry to be invested in right now, and you should consider tilting your portfolio towards resources.
Long/short pairs trading:
Pairs trading is a slightly more advanced strategy than portfolio switches. This strategy makes use of derivative instruments like contracts for difference (CFDs) or futures contracts, to implement a market-neutral strategy with zero net equity exposure and requires a derivative account like a Sharenet CFD trading account. Lots of big words in there, so allow me to explain. Using derivatives, an investor is able to short sell a share, simply meaning that you will realise a gain when the share price goes down and vice versa. Short selling a share is opposite to owning a share or being long a share. If you are long the same amount in one share as you are short in another, you have a net equity exposure of zero. Using the same example as above, you can implement a market neutral strategy to exploit the divergence in the relative price movement of Standard Bank and Nedbank. A market neutral strategy means that you can realise a profit regardless of the overall direction of the market. In this example, we would expect Nedbank to perform better than Standard Bank since Standard Bank has deviated from its general performance relative to Nedbank. By going long/owning the share you expect to outperform (NED), and short selling the share you expect to underperform (SBK), your trade will realise a profit as the relative price movement of the two shares corrects towards its general trend. The great thing about pairs trading is that you can realise a profit regardless of whether the share prices for the two shares involved goes up or down. The only thing that needs to happen is that Nedbank has to perform better, i.e. up more than or down less than, Standard Bank. Check out this Views article for a detailed working example of this pairs trade.
As you can see, applying these simple techniques can help an investor identify numerous trading opportunities and ultimately enhance the returns on their portfolios. A wiser man than me once said: “Opportunities are usually disguised as hard work, so most people don’t recognize them.” Fortunately, we’ve done most of the hard yards for you!
You can get access to the Sharenet Analytics RTA by signing up for a Securities/CFD account with Sharenet, or by subscribing to the Sharenet Analytics research tools package. Contact firstname.lastname@example.org or visit the RTA product page for more info.
As always, it is advised to double-check the validity of any trading opportunity identified by technical analysis with a healthy dose of fundamentals. If a company has just released a dreadful trading update and their share price falls, it might look like a bargain, but it is trading at those levels for good reason. Check out our SENS page for all the latest company updates.