Long-Short ETF

Trading Strategy

Spread Trade- Long: GEX

(NYSE) and Short: NLR
(AMEX), XES (AMEX)

Rohan Patil

MSF 547: Hedge Funds

Stuart School of Business

Keywords: Discretionary spread trades, event based strategies, trade analysis

 Abstract

The trading strategy discussed hereafter attempts to exploit the impact of the current environmental,
political and technical trends on the spread between Market Vectors-Global Alternative Energy ETF
(NYSE: GEX), the SPDR Oil & Gas Equipment & Services ETF (AMEX: XES) and the Market Vectors-Nuclear
Energy ETF (AMEX: NLR).

We shall start our analysis with the fundamentals of this strategy wherein various geopolitical aspects
will be discussed. This is followed by the technical analysis of the market prices. The penultimate section
of this paper discusses the exit strategy and risk management aspect of the trade. In order to hedge the
trade two hedging instruments have been selected which will be discussed. This is followed by the
money management aspect of the trade.

I am grateful to John Showel, Geneva Trading LLC and Prof. Russell Wojcik, IIT for their guidance.
1. Fundamental Analysis:

(a) Economic, political and environmental aspect:

The issue of Global warming has been at the forefront of political and economic debates for more than a
decade. Additionally, we have experienced a huge increase in the price of crude oil in the last couple of
years. These two factors have compelled the economy to look for alternative solutions to fulfill the
energy requirements.

In the recent past, certain energy projects in U.S. involving the use of conventional sources (i.e. coal)
have been blocked citing environmental reasons. [1] Also, a large proportion of corn produced in U.S. is
now being used to make ethanol. Several such examples can be cited to indicate a paradigm shift in the
energy policies inclining towards alternative energies.

This issue is being widely discussed in the political arena especially the presidential campaigns in 2008.
After all other candidates had grown out of the competition we are left with two candidates with an
entirely different approach towards the “energy independence”.

Democratic candidate, Sen. Obama, has championed alternative sources of energy whereas the GOP
candidate, Sen. McCain, has been emphasizing on drilling more oil and on the use nuclear energy. Based
on the current events and opinions, it is clear that the Sen. Obama has a better probability of becoming
the next president.***1

This peculiar environmental, political and economic situation leads me to be bullish on the Alternative
Energy ETF and at the same time to be bearish on the Nuclear and Oil & Natural Gas exploration ETFs.

1
***A detailed description about their energy policies can be found here:
http://en.wikipedia.org/wiki/Comparison_of_United_States_presidential_candidates,_2008
(b) Selection of ETFs:

1. Market Vectors-Global Alternative Energy ETF (NYSE: GEX) [2]

 Replicates the performance of the Ardour Global Index (Extra Liquid) (AGIXL)
 Globally traded stocks of 30 alternative energy resources, distributed generation, energy
efficiency, enabling technology and environmental technology companies
2. SPDR Oil & Gas Equipment & Services ETF (AMEX: XES) [3]
 Seeks investment results that correspond to S&P Oil & Gas Equipment & Services Industry Index
 Invested in 25 companies in the business of drilling oil-wells & making supplementary products
3. Market Vectors—Nuclear Energy ETF (AMEX: NLR) [4]

I believe these two ETFs track the alternative energy, the oil equipment & services and nuclear energy
with sufficient accuracy. [5]

The trade involves three ETFs, alternative energy, nuclear energy and oil & gas equipment & services
respectively. These will be referred to using their ticker symbols hereafter.
2. Trading Analysis:

Long position involves GEX and the short position involves NLR and XES. Now we have to decide how
many shares of NLR and XES should be sold for every share of GEX bought. Constraints of beta neutrality
and dollar neutrality are put on to find out the exact position on the short side.

i. Beta Neutrality:

CAPM beta is used to measure the market risk. Thus, we need to match the betas of the long and short
side to be market neutral.*

CAPM Beta
XES 1.005
NLR 1.036
GEX 1.275

* Here the risk free rate was 3.45 %( annual; Source: Bloomberg)

ii. Dollar Neutrality:

The average price of these instruments over last one month is used to make the trade dollar neutral.
Note that we are using this constraint to estimate the ratio of the short side and not to be precisely
“cash neutral”.

Avg Price
XES 33.989
NLR 23.220
GEX 41.212
*Average price was calculated from 9/5/08 to 10/06/08

Equations to find the ratio are as follows:

1.036* x + 1.005* y = 1.275

23.22* x + 33.989* y = 41.212

Solving these two equations, we get;

x = 0.161, y = 1.103
Thus, for every share of GEX bought we shall sell 0.161 shares of NLR and 1.103 shares of XES.

Price Graph:

Long GEX and Short NLR & XES

Long Short

$65

$60

$55

$50
Price

$45

$40

$35

$30

$25
3/3 3/17 3/31 4/14 4/28 5/12 5/26 6/9 6/23 7/7 7/21 8/4 8/18 9/1 9/15 9/29
Date

Spread Graph:

Spread

$4

$2

$0

-$2

-$4
Price

-$6

-$8

-$10

-$12

-$14
3/3 3/17 3/31 4/14 4/28 5/12 5/26 6/9 6/23 7/7 7/21 8/4 8/18 9/1 9/15 9/29
Date

The spread has increased significantly from a low of -$12.44 on July 2nd into the positive territory. In my
opinion, this trend will continue throughout the time horizon of this trade.
3. Risk management:

a. Exit Strategy:

A 5% stop-loss strategy should be followed for this trade given the high level of volatility in the markets.

b. Hedging the exposure to oil and political uncertainty:

The SPDR Oil & Gas Equipment & Services ETF (XES) has historically shown a high correlation with the oil
prices. The correlation calculated here is based on the data of last 6 months. In order to hedge this risk,
we will have to go long oil futures (CLA) for the month of December 2008.

The correlation with Oil is as follows:

CORREL NLR XES GEX

OIL 0.445 0.623 0.376

Based on our ratios and these correlations we should buy 0.38 contracts of oil futures for every 1000
spreads.

Apart from the exposure to oil, this trade is also exposed to the political uncertainty which can be
hedged by buying options on the candidate which adversely affects the trade. In our case we need to
buy binary options on Sen. McCain. These options are traded publicly and have enough liquidity. [6]

The current rate of this option is $31.1 for a payoff of $100 at the maturity and one contract is of 100
options.

Now, selecting the number of contracts to buy depends on our exit strategy. We shall exit this strategy
whenever 5% loss occurs. That means we need to buy enough contracts to offset this loss. Given the
returns on this option, we need to buy 0.025 option contracts for every 100 spreads we buy.
4. Money Management:

1. Spread: At the current market price (i.e. closing price on Oct.6th 2008) the price of one spread is
about $0.075473. Thus, in order to buy 1000 spreads we need $75.47.

2. Rebate and borrowing cost for the short leg: Also, we need to calculate the borrowing cost for
the ETF. The rate of borrowing, in all likelihood, is firm-specific. In the calculations presented
here I have assumed a rate of 30 bps annual.

For 1000 spreads, we need to short 1000*(0.161*17.09+1.103*23.9) i.e. $ 29113.19 worth of

ETFs.

Now, assuming that the rebate is fed funds rate minus the borrowing cost, total cash-inflow for
borrowing the ETFs for 72 days is 72* (0.0345-0.003)/360*29113.19 = $ 183.41.

3. Margin Payment: To buy the crude oil futures we need to pay up a margin of $12,488 per
contract. For 1000 spreads it is 0.38 * 12488 = $4,745.44.

4. Commissions: Additionally an 8 bps commission cost is going to be incurred which can be

calculated as $ 58300* 0.008*2 = $93.28.

Thus, to execute 1000 spreads we need about $4730, out of which only -$15 is the inflow when we
execute the order. Rest of it is the upfront margin payment to hedge with crude oil futures.
References:

1. STEPHEN POWER (2008) Kansan Stokes Energy Squabble with Coal Ruling Official Cites Warming In
Blocking Two Plants; 'Ground Zero' in Fight , Retrieved: October 5, 2008, from CHESAPEAKE CLIMATE
ACTION NETWORK, Website: http://www.chesapeakeclimate.org/news/news_detail.cfm?id=523

2. Market Vectors Global Alternative Energy ETF Trust, Retrieved: October 5, 2008, from New York Stock
Exchange, Website: http://www.nyse.com/about/listed/gex.html

3. SPDR Oil & Gas Equipment & Services ETF, Retrieved: October 5, 2008, from American Stock
Exchange, Website: http://www.amex.com

4. Market Vectors—Nuclear Energy ETF, Retrieved: October 5, 2008, from American Stock Exchange,
Website: http://www.amex.com

5. Roger Nusbaum, New Oil Subsector ETFs Prove Refined, and Retrieved: October 5, 2008, from the
Street, Website: http://www.thestreet.com/etf/etf/10295399.html

6. Visit for contract details: http:/www.intrade.com/

More information: http://predictions.wsj.com/

7. Fran¸cois-Serge Lhabitant, (2006) Handbook of Hedge Funds, Hoboken, NJ, Wiley Finance