Relative strategies, broadly speaking, are closer to arbitrage. If buying a stock and selling it after a price increase is a one-dimensional strategy, then relative strategies are more of a two-dimensional approach.
In theory, if you’ve balanced both sides of the trade properly, you can profit regardless of the overall market direction.
For example:
• Hedging: Suppose you short $100 of Asset A and go long $100 of Asset B. If the market crashes and both assets go to zero, your position nets out to zero—no profit, no loss. This is a classic hedging scenario.
• Relative Value Strategy: Let’s take the same example. If Assets A and B are strongly correlated and tend to move together, but you notice a temporary divergence in their price relationship, you can open a position betting that the price spread will revert to normal. If your judgment is correct, you gradually earn relative returns as the price gap narrows.
• Arbitrage: Another scenario might involve price discrepancies between two exchanges for the same asset (e.g., Asset A trades at different prices on Exchange X and Exchange Y). In this case, you could buy low on one exchange and sell high on the other. This is still a relative strategy but is more commonly referred to as arbitrage.
Real-Life Examples
When thinking of practical examples, my first thought was Bitcoin and Ethereum. While the two are theoretically correlated, the high volatility of cryptocurrencies means that both price swings and risks are much greater. Relative strategies are not impossible here but require exceptional speed, sensitivity to news, and high precision—making them unsuitable for beginners.
More commonly used examples include:
• Gold vs. Silver: These two commodities are often related in price movements but may occasionally diverge in their ratio.
• Equities vs. Bonds: A company’s stock price relative to its issued bonds can reveal arbitrage opportunities.
• Industry Leaders: Similar stocks within the same sector (e.g., Apple vs. Microsoft) often have correlations that traders can exploit when discrepancies arise.
How It Works
The process is straightforward: when the price difference between two correlated assets deviates from what you believe is their “long-term average relationship,” you act. Open a position by buying the undervalued asset and shorting the overvalued one simultaneously. Once the gap normalizes, you close your positions and lock in the profit.
Of course, you don’t always need to short-sell. Simply going long on the undervalued asset can also work. The core idea is to identify and act on abnormal price distances between related assets.
Relative strategies, broadly speaking, are closer to arbitrage. If buying a stock and selling it after a price increase is a one-dimensional strategy, then relative strategies are more of a two-dimensional approach.
In theory, if you’ve balanced both sides of the trade properly, you can profit regardless of the overall market direction.
For example:
• Hedging: Suppose you short $100 of Asset A and go long $100 of Asset B. If the market crashes and both assets go to zero, your position nets out to zero—no profit, no loss. This is a classic hedging scenario.
• Relative Value Strategy: Let’s take the same example. If Assets A and B are strongly correlated and tend to move together, but you notice a temporary divergence in their price relationship, you can open a position betting that the price spread will revert to normal. If your judgment is correct, you gradually earn relative returns as the price gap narrows.
• Arbitrage: Another scenario might involve price discrepancies between two exchanges for the same asset (e.g., Asset A trades at different prices on Exchange X and Exchange Y). In this case, you could buy low on one exchange and sell high on the other. This is still a relative strategy but is more commonly referred to as arbitrage.
Real-Life Examples
When thinking of practical examples, my first thought was Bitcoin and Ethereum. While the two are theoretically correlated, the high volatility of cryptocurrencies means that both price swings and risks are much greater. Relative strategies are not impossible here but require exceptional speed, sensitivity to news, and high precision—making them unsuitable for beginners.
More commonly used examples include:
• Gold vs. Silver: These two commodities are often related in price movements but may occasionally diverge in their ratio.
• Equities vs. Bonds: A company’s stock price relative to its issued bonds can reveal arbitrage opportunities.
• Industry Leaders: Similar stocks within the same sector (e.g., Apple vs. Microsoft) often have correlations that traders can exploit when discrepancies arise.
How It Works
The process is straightforward: when the price difference between two correlated assets deviates from what you believe is their “long-term average relationship,” you act. Open a position by buying the undervalued asset and shorting the overvalued one simultaneously. Once the gap normalizes, you close your positions and lock in the profit.
Of course, you don’t always need to short-sell. Simply going long on the undervalued asset can also work. The core idea is to identify and act on abnormal price distances between related assets.
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