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A Pair-Trade Primer

Tired of the roller coaster? Try pair trades to smooth the ride


Buy-and-hold investors have to be nauseous from recent market activity. Thursday’s plunge in the market had stocks down approximately 4% across the board. That is a big swing no matter how you cut it.

The natural response to such market volatility is to run for the hills. The safe havens of Treasuries and gold are booming right now. Even diehard buy-and-hold investors are liquidating stocks, as evidenced by the outflow of $40 billion from long-term mutual funds.

Given the rapid rise in gold and Treasury prices, these safe havens may be a bit pricey. Treasuries in particular look vulnerable given the rational argument that rising deficits require more bond issuance. Eventually, buyers will demand higher rates, sending pricing lower.

I’m not sure what to make of gold. It certainly looks most certain to increase in price if the policy response to slower growth is printing money. It is easy to see the inflationary argument as a reason to own gold. That said, looking rationally at current prices gold owners can’t help but see bubbly characteristics in that market.

As an alternative to those safe-haven investments, I have another idea that doesn’t involve being completely out of the stock market. Instead of a long-only strategy, I encourage investors to use an absolute return approach using pair trades.

A pair trade simply means owning a stock long and pairing that position with an equal-value trade of a stock short. The basic goal of this approach is to not lose money. If stocks go down, the short position will increase in value. The flip side is that if stocks go up, the short position will decrease in value.

On the surface it might appear that such an approach is a zero-sum game. It is not. Because the market is inefficiently priced some stocks go up higher or fall further than other stocks. Pair trades can capture arbitrage gains by capitalizing on pricing discrepancies.

Using a basic example, a pair trade of a stock that is undervalued on the long side with a short of an overvalued stock will not only protect capital on the downside, but generate positive returns that can be fairly significant.

Using pair trades with a portion of your portfolio makes sense in this volatile market. Here is an example of a pair trade to help you get started:

Long Zipcar/Short LinkedIn

The initial public offering, or IPO, market is very inefficient. Hype and momentum pervade stocks that have newly come to market. Fundamentals rarely matter. Instead, IPO’s are priced based on future expectations. It is a real crapshoot for sure and fertile ground for pair traders.

In the IPO market, I like to own stocks without the hype paired against a trade short of a stock that has shot to the moon. This year’s IPO market has given us plenty of candidates to pick from. One of the most hyped stocks that recently came to market is LinkedIn (NYSE:LNKD).

The social networking site that is redefining how the job market operates found no shortage of interested takers when it came to market in May. Selling for an initial price of $45, shares quickly rose above $100 per share in that first day of trading. There was bit of a pullback before the stock raced back over $100 before the recent market correction.

The pullback in stocks hit LinkedIn hard. Shares are down 21% since the close on July 22. Even with the selling, this stock is still a good short candidate in a pair trade. Analysts expect the company to break even in the current fiscal year and earn 38 cents per share in 2012. At current prices, shares of LinkedIn are valued at 214 times 2012 earnings.

Now that is the kind of hype that can be shorted in a pair trade. I don’t care what the growth prospects are for LinkedIn, that price is just way too much, especially in a double-dip recessionary environment.

On the flip side of the coin is Zipcar (NASDAQ:ZIP). The trendy urban alternative to car ownership came to market in April at an initial offering price of $18 per share. As per usual, the stock soared 54% when it went public. The gains did not stick. Shares drifted lower after the offering as the hype crowd went elsewhere. Before the market correction, shares of Zipcar fell to the low $20 range.

Since the close of the market on July 22 shares of Zipcar are down 16%. A pair trade with LinkedIn at that time would have yielded positive returns to absolute return investors. Zipcar now trades for just over its $18 IPO price, making it an attractive candidate for the long side.

The story for Zipcar is intriguing and investors no longer have to pay a premium IPO price. Both Zipcar and LinkedIn face competition, but I simply like the Zipcar story more than LinkedIn’s. Given the low barrier to entry, LinkedIn is vulnerable to a MySpace flameout.

Zipcar must face the traditional rent-a-car business with its model, but the Zipcar brand and its first-mover advantage provide the company with a more certain future, in my opinion. In fact, don’t be surprised if Zipcar is acquired by one of the rent-a-car concerns down the road.

For a pair trade I like Zipcar on the long side and shorting LinkedIn.

Jamie Dlugosch does not own a position in any of the stocks named here.

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