Proxy Trading

What Is Proxy Trading?

Proxy trading is the act of using certain securities or instruments to express a particular view in an inexact way.

Examples of Proxy Trading

Below are some examples of proxy trading:

Energy stocks and oil

One example would be buying energy stocks to express a bullish view on oil prices. They are similar but not the same.

Inflation

If you believe there will be higher inflation (relative to what’s discounted in markets), then paying fixed inflation swaps is the purest trade you can put on to express that belief.

If you can’t, then you will have to look at proxies that are as close as possible to what you’re looking for.

For example, short nominal rate Treasury bonds and buy TIPS.

If you can’t do that, another proxy would be to buy commodities with the tightest long-term correlation to inflation.

Gold is not a good proxy for inflation, as it’s really a bet on real (inflation-adjusted) rates with respect to the reference currency (USD if $/oz), not inflation.

However, no matter what proxy you use, it’s important to remember that these are still proxies and should not be mistaken for the true underlying trade.

These proxies may provide exposure to inflation, but they also involve additional risk.

 

Correlations can and do breakdown

Furthermore, when trading any kind of proxy, there is a risk that the relationship between the proxy and the underlying could change over time, leading to unexpected losses.

For example, if you believe that oil will increase in price but you can’t buy oil then you might be inclined to buy energy stocks.

However, if inflation were to pick and that caused interest rates to rise, the rise in rates could offset some or all of the rise in earnings of energy companies, causing their prices to lag behind the price of oil.

It’s not so much about correlation, but the cause-and-effect drivers of the correlation.

For these reasons, it is important to be aware of the risks associated with proxy trading and only use them when you understand the limitations they may have.

It is also essential that any decisions made involving proxy trades are based on thorough research into the relationship between the proxy and the underlying.

This way, you can make sure that you are making an informed decision with all of the relevant information available.

 

FAQs – Proxy Trading

What is proxy trading?

Proxy trading is using certain securities or instruments to express a particular view in a way that’s imprecise.

One example would be buying oil to express a bullish view on inflation.

What are the risks associated with proxy trading?

The main risk associated with proxy trading is that the relationship between the proxy and the particular view doesn’t match up.

Correlations commonly break down.

For example, if inflation rises and interest rates go up as a result, this rise in rates could dent equity prices, which would be bad for someone trying to use energy stocks to express a view on oil prices.

It is therefore important to be aware of the risks associated with proxy trading and only use them when you understand the limitations they may have.

Is proxy trading good or bad?

Proxy trading is generally viewed as a mistake because the proxy may not be a good representation of what you’re trying to do.

 

 

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