The Best of Both Worlds
A pairs position is constructed from a long position in a stock you favor and an equivalent short position in a similar company that is expected to underperform. For example, we recommend opening a long position in MYL along with a short position in TEVA. The strategy attempts to profit regardless of the average direction of the industry group.
If biotech stocks fall, we expect MYL to fall less than TEVA. The profits from the short position should offset the losses in the long MYL trade. Similarly, MYL should outperform when the group trends bullishly offsetting the losses from the TEVA short.
In the chart above, you can see MYL and a comparative relative strength analysis comparing it to TEVA. Just like a regular stock chart, the relative strength line between the two stocks has ups and downs but the trend is clear. The recent downtrend on MYL seems to be mostly profit-taking after the company reported stellar earnings in February. If relative performance bounces back up as expected, this would be the right time to accumulate a paired position.
As a side note, although it is a long-shot, a potential merger between TEVA and MYL has been rumored for a long time. The average premium paid to the target (MYL) in this situation is 30% while the acquirer (TEVA) drops an average of 3%. That would be a great windfall and isn’t outside the realm of possibilities. Keep in mind that a similar situation is playing out in the merger between Actavis (ACT) and Forrest Labs (FRX).
A pairs trade has disadvantages, as well. If a trader is extremely confident in the upside of a particular company then an outright long position will perform better. However, we think taking advantage of a disconnection between the relative, intrinsic value of these two firms in this market will help increase the potential for profits even if the biotech-bubble finally pops in 2014 or 2015.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.