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Published: June 7, 2010
How many times has this happened to you
lately? You carefully research and buy a stock. The company
announces unexpectedly good financial results. But the stock's
price plummets, caught up in one of the market's now-frequent
downdrafts.
You curse high-frequency traders. Your sleep suffers as the
market roils. You even begin to wonder if it's worth all the
time and effort put into researching the investment.
But now is absolutely the wrong time to
give up your fundamental investment strategy.
There is a way to put solid research skills to work -- and beat
the market's volatility. But instead of executing one
well-researched idea, consider executing the idea in pairs.
Pair trading is a tried and true method for beating the market.
In fact, studies confirm it produces an average of +11% excess
returns annually -- delivering twice the average gains of the
S&P 500.
But the real beauty of this strategy is its ability to produce
positive gains in down markets from poorly performing sectors.
How Pair Trading Produces Gains in Ugly Markets
Say you believed in December 2009 that the home improvement
retailer Home Depot (NYSE: HD) was poised to do well,
even though housing and broader economic indicators were still
inconclusive. Say you also believed that Home Depot would do
better than its main competitor Lowe's (NYSE: LOW) based
on its historical performance and business plan.
If you bought Home Depot on December 15th, you would've had a
small loss of -0.1% by February 12th. That's still better than
the broader market, since the S&P 500 lost -2.9% during that
same period. And you were much better off than if you had bought
Lowe's, which lost -7.7%.
But if you executed a pair trade -- taking a long position in
Home Depot and taking a short position in Lowe's -- you would
have a +7.6% gain in just two month's time.
Use Pair Trades For Company-Specific News
On April 20th, the Deep Water Horizon oil
rig exploded while tapping a well for BP (NYSE: BP).
Initially the oil spill looked minor. But as the days passed,
BP's problems became more pronounced. If you placed a pair trade
-- long ExxonMobil (NYSE: XOM) and short BP -- on April
30th, you would have booked a nice +15.5% gain by now.
Birds of a Feather Flock Together --
Eventually
Another popular pair trading scenario
involves finding a temporary divergence between similar-behaving
stocks. For instance the performance of Coca-Cola (NYSE: KO)
and Pepsi (NYSE: PEP) tend to track each other. But as
you can see in the chart below, there are times when one starts
to outperform the other.
Some pair trading investors view this as a temporary anomaly,
and assume the two stocks will converge again in the long run. A
pair trader will short the temporary outperformer and take a
long position in the underdog until they fall back into
lockstep.
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Take Market Risk Out of Your Investment
Equation
Action to Take -----> As
long as you find two similar investments, pair trading allows
investors to practically eliminate market and sector risk it's a
simple strategy, easy to execute -- and perfect for today's
market conditions.
One pair trade on my watch list is Toyota (NYSE: TM) and
Volkswagen (OTC: VLKAY). A weaker euro will make
Volkswagen's cars cheaper in world markets and I think the
German auto manufacturer has an opportunity to pick up more
market share in the foreseeable future. Toyota's technical
woes are temporarily out of the headlines, but a stronger yen
will make Toyota's cars more expensive in world markets -- just
when it is trying to buy back customer loyalty. If I were to
execute this trade, I would go long VLKAY and short TM.
-- Amy Calistri
Editor
High-Yield Investing
High-Yield International |
