Brazil Beats Germany

The World Cup is over and Germany won the much coveted trophy. This World Cup will be remembered for its beautiful attacking-style games as well as one of the most crushing defeats in football history: the Host lost 1-7 to Germany in the semi final.

However, the Brazilians do not have to wait for another 4 years in order to have a chance to revenge against Germany. Their stock market has already beaten the German’s one. The chart below shows the ratio of the Brazil ETF (EWZ) v.s. Germany ETF (EWG) and we can see that the ratio is in an uptrend.

Statistically, the Brazilian market has underperformed over the last 3 years. It lost -29%, while the German market gained 45%. However, EWZ started bouncing at the beginning of this year from an oversold condition.

The bounce is also supported by fundamental factors: Brazil is an exporter of commodities and the uptrend in base metals lends support to its market recovery. Additionally, the upcoming Summer Olympics in Rio in 2016 will give a boost to the local economy.

Germany, on the other hand, is suffering from problems in Europe:   deflation threat, a weak euro, negative interest rates, geopolitical tension in Ukraine and Russia, and a possible bank failure in Portugal, just to name a few. This is a good opportunity for pair traders who want to take advantage of the divergence.

Brazil, Emerging Markets and the World Cup

There are now less than 2 weeks until the start of the 2014 FIFA World Cup of Soccer, which is the biggest sport event in the world. The event is being organized in Brazil. From an economic point of view, Brazil is one of the BRIC countries; it has underperformed the overall emerging market during the last 4-5 years.  The chart below shows the relative strength of Brazil ETF (EWZ) with respect to the emerging market ETF (EEM).

The ratio has been in a down trend for more than 4 years. We can observe, however, a rebound taking place in early 2014. Some analysts said that this rebound is supported in part by the preparation of the 2014 World Cup of Soccer and the 2016 summer Olympics.

Interestingly, Brazil is the favorite for winning the World Cup this year. It has the highest chance of winning the World Cup, followed by Argentina, Germany and Spain.

The implied probability of winning calculated from the various bookmakers odds is in the range of 20%-25%. A World Cup win can boost consumer confidence and hence the local economy in general. (We saw a similar situation before in 1998 when France won its first ever World Cup at home).

To play a potential recovery in Brazil, one can go long EWZ and hedge the downside with EMM.  If you worry about the negative impact of the host nation’s not winning the World Cup, you can hedge by laying against Brazil on a sport exchange.

Good luck and enjoy the Game!

Quantitative Poker Player

If there were an equivalent of a quantitative trader in the poker world, then Chris Ferguson would be a perfect example. Chris earned a PhD in computer science in the late nineties and went on to become a professional poker player and gambling and lottery industry consultant.  He has won five World Series of Poker events, including the 2000 WSOP Main Event, and the 2008 NBC National Heads-Up Poker Championship. His playing style is highly mathematical as he uses a strong knowledge of game theory and has developed computer simulations to improve his understanding of the game.  Last but not least, Chris also tried his hands at day trading.

I watched a video of him being interviewed by Michael Covel, who is known as one of the original Turtles. Although the video is short, it successfully brings across the following important points:

  • Play with the best players and learn from them.
  • Spend more time away from the tables doing analysis, thus developing an analytical thought process.
  • Do not focus on last hands’ results. Winning or losing does not matter in the short run. Focus on the process and long-term results.
  • Put faith in mathematics. Try to make decisions less emotional as possible and mathematical as much as possible.
  • Study the game hard. Analyze the game from mathematical stand points.
  • Practice and practice and practice.

Although Chris discussed these points in order to educate aspiring professional poker players, they are definitely important lessons for quantitative traders as well.

Longshot Bias in Tennis Market

The longshot bias is an observed phenomenon in sports betting where on average bettors tend to overvalue (undervalue) “long shots” and undervalue (overvalue) the favorites. It has been studied extensively in betting markets such as horse racing, American football, ice hockey and soccer. The most plausible explanation is provided by behavior finance which studies the betting patterns of several types of bettors: informed, uninformed, amateur, professional using advanced models such as utility function theory. The tennis market, however, attracted much less attention, and very little research was conducted in this area.

Unlike other sports, the tennis market presents some particularities, mostly:

  • The cost of becoming an “informed” bettor is relatively low. Hence there is no uninformed, “fun” bettor who just enjoys an outing at the courts as they often do in horse racing,
  • Insider information is less valuable because almost everything (e.g. players’ injuries) is visible and disseminated quickly to the public,
  • Unlike team sports, tennis does not have a large number of fan clubs with permanent and fervent allegiance. Therefore the prices (odds) are less likely to be distorted by supporters’ sentiment,
  • The transaction cost is low.

Among noteworthy articles, the one published by D. Forest and I. McHale, entitled “Longshot bias, insight from the betting on men’s professional tennis”, presented interesting results regarding the longshot bias in the tennis market.  Using publicly available data, the authors tabulated returns of strategies that bet on favorites and underdogs from January 2001 to April 2004. They demonstrated that:

  • Betting on underdogs yielded statistically significant losses,
  • Betting on favorites was break-even in 2001 and made positive returns in 2002-04.

From their results, it was concluded that men’s tennis market is weak form inefficient, and a positive longshot bias exists. Therefore good values are found by betting on strong favorites. Bettors should use this result in developing their strategies.

Sports Arbitrage

Although sport and financial markets are seemingly two different worlds, arbitrage trading and sports betting have a lot in common. Trading strategies and risk-management techniques used in financial markets can be applied to sports betting and vice versa. As in financial markets, pricing inefficiencies do exist in the sport bookmaking markets which result in opportunities for arbitrageurs.

Sports arbitrage can be loosely categorized into two main types:

  • Inter-bookmaker arbitrage which exploits bookmakers’ different opinions on sport events’ outcomes or plain pricing errors.
  • Intra-bookmaker arbitrage which exploits the relative mispricing, based on the actual and implied odds, of a sport event.

Of the two types of sports arbitrage, the latter is being used by us. It is in a sense very similar to the options volatility trading strategy where one seeks an edge by taking advantage of the discrepancy between historical and implied volatilities of an underlying asset. To see how sports arbitrage work, let’s go through a real-life example.

Soccer is unarguably one of the most popular sports in the world. At the club level, UEFA Champions League is the most prestigious competition for a European soccer club. The final this year will be held on May 25 at the Wembley stadium. As of this writing there are four clubs remain in the competition, two from Germany and two from Spain. The draw for the semi-finals was held last Friday and the following match up will occur:

Bayern Munich – Barcelona        

Borussia Dortmund – Real Madrid

The first leg of the Bayern Munich- Barcelona match will be played on April 23 in Bayern’s homeland. As of this writing, the implied probability of a Bayern Munich win is 40%. It is calculated from the posted odds of 2.5 on Ladbrokes, a well-known bookmaker.

Note, however, that this price is not static; it can vary from now until the end of the match, thus creating short-term trading opportunities.  The actual probability of winning for Bayern Munich, calculated based on its past and recent performance, is 45.9% (2.18 in decimal form).  Consequently, there is an opportunity for arbitrage. If we place a bet on Ladbrokes now, we’ll have an edge of 5.9 %.

As can be seen from the example above, the goal of sports arbitrage is to find as many as possible this kind of mispricing opportunity and repeat the betting process over and over again. This way we play a positive expectation game and will make money in the long run.