Financially Fastened

There is no denying the growing interconnectedness between the Chinese and American financial markets. Like other global financial centers, upswings and downswings in either the Shanghai Stock Exchange or the New York Stock Exchange have often been preceded by similar trends in the other. The surplus of recent global financial headlines and heightened index volatility appears to have strengthened this relationship. A simple investment simulation suggests that the Shanghai Stock Exchange can be moderately useful as an intraday trading strategy for the Dow Jones Index during the current periods of volatility.

Although this correlation has not always been present, the Chinese and American markets have gradually shifted toward each other. From 1993 to 2001, the Dow Jones Index China had only a 0.0332 correlation coefficient with the Dow Jones Industrial Average, suggesting no observable correlation. But a loosened economic policy has led to more intertwined financial markets between the U.S. and China. From 2000-2009, the correlation coefficient between the Shanghai Stock Exchange and the Dow Jones had risen to 0.731, indicating a strong  relationship.

The trading strategy I’ve tested is quite simple: use a moderate rise or drop (0.85% or more) in the Shanghai Stock Exchange (SSE) to invest in the same direction in the Dow Jones when the New York Stock Exchange opens, six and a half hours after the SSE closes. For example, if the SSE opens at $100 and closes at $100.86, then I would buy shares long on the Dow since the SSE gained greater than 0.85%. If the SSE closed at $99.14, I would short the Dow.

After running this model from 04/20/09 through 10/14/11, excluding the holidays of both exchanges from the model, the total return was 83.81%, with annualized returns of 27.57%. The hit rate for positive gains, in which a 0.85% increase in the SSE led to any positive gain for the Dow, was 64%, while the hit rate for negative gains was 54.55%. Total return from positive gains was 44.62% and total return from negative gains was 39.19%.

With a modest hit rate but a significant return, this trading strategy seems to capitalize on the volatility of both exchanges. Essentially, when the Dow goes in the same direction as the SSE, it’s able to rise or drop high enough to offset the losses incurred when it goes in the opposite direction as the SSE. Moreover, it seems that those losses incurred are also quite minimal. As a result, although this trading strategy does not have a very great predictability factor for total positive or total negative gains, it does suggest a sort of dual volatility.

This should come as no surprise. The rise of a deeply intertwined and globalized financial market has inevitably strengthened the relationship of the Chinese and American financial systems. At the same time, financial crises with implications for the world economy have increased volatility and shaken investor confidence. Although this is not a long-term trading strategy, it may have strong returns in the near future by taking advantage of the US-China correlation and world market volatility.