A high percentage of an airline’s operating budget is fuel costs, approximately 35% at today’s prices. There appears to be a possibility of a Pairs Trade. The first step to take to determine of there is a Pairs Trade is to look for correlations. Correlations, of course, are measured between -1 and +1. A strong positive correlation means the two things being measured move together. A strong negative correlation means they move in opposite directions. A correlation close to zero means there is little connection between the movements of the two.
A table of the 3-month correlations between American Airlines (AAL), Delta Airlines (DAL), Southwest Airlines (LUV) and United Airlines (UAL) to Crude Oil and the S&P 500 was displayed. The table showed very little correlation between Airlines and Crude and a much higher correlation between Airlines and the S&P. Correlations are not static. They can change. This was demonstrated by a graph comparing the correlations of the Bonds and the S&P 500. The graph showed that the two have recently diverged away from their historical correlation.
Correlations may be low between asset classes but they are often high within them, which is why some look to sectors for Pairs ideas. We looked within the airlines sector for a trade idea and found much higher correlations. A table comparing the correlation of the Airline stocks to each other was displayed. Some of the correlations were quite high. This led to a trade idea that was laid out in a table. The trade idea was a Cross-Product Strangle, as UAL has recently been stronger than LUV, stretching their correlation. It was long LUV by shorting a Put and short UAL by shorting a Call. The table included the current price, strategy, Delta, Notional Value and credit received. The trade was executed in this segment by Tom.
For more information on Correlation see:
Market Measures from November 17, 2015 “Correlations and the Market”
Options Jive from February 29, 2016: “Correlation | Is Your Portfolio In Trouble?"
Best Practices from May 2, 2016: “Four Facts About Correlation”
Watch this segment of Options Jive with Tom Sosnoff and Tony Battista for the key takeaways of why and how we use correlations to find trading opportunities.
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