An interesting and usually successful approach to playing volatile markets is the pairs trade. A pairs trade is a rather simple concept. It plays on the relative performance of two equities, whether they are individual stocks, indices, ETFs or a combination of any of these.
Usually, a pairs trade focuses on one industry. The hard part is figuring out which will outperform and when it will occur. The time period is important because we use options for our trades, and timing a move is critical.
Once you figure that out, though, the rest is relatively straightforward. You simply go long the outperformer (in our case, buy a call option) and short the underperformer (buy a put).
The best way to show this trade is through an example. For today, let’s use the retail sector.
Retail Pairs Trade
In looking at retail companies that have outperformed the overall sector, we see that Family Dollar Stores, Inc. (NYSE: FDO) has blown away the overall retail sector, as represented by the SPDR S&P Retail ETF (NYSE: XRT). XRT represents a wide swath of retailers, with FDO comprising less than 2%. In fact, no one stock exceeds 2% of XRT’s total assets.
How striking is FDO’s outperformance? Over the past year, FDO is up more than 60% compared to just 19% for XRT.
Take note of a couple of things in this chart. First, FDO has been sliding lower in relative strength versus XRT for the past month. It’s not that FDO has declined. Rather, XRT has done well in September, gaining around 13% compared to just 2% for FDO. But note that the overall rise in relative strength has been punctuated by these dips several times in the past year.
The second thing to note is that FDO outperformed XRT during the critical holiday shopping season of October through December last year. Guess what’s right around the corner?
One final consideration is that sentiment toward FDO is rather negative right now. The put/call ratio and short interest are high, and we’re seeing some “sell” recommendations among analysts. This pessimism seems rather misplaced given the stock’s success over the past year. That tells us there’s plenty of buying pressure ready to come in from the sidelines, especially with the holidays on the horizon.
Go Long FDO, Short XRT
OK, our analysis says that FDO should outperform retail/XRT over the next couple of months. And this outperformance should occur in both up and down markets. So we buy a FDO December call (remember that we’re looking at this outperformance to play out over the next two to three months) along with an XRT December put.
How will this trade play out? In a bull market, FDO should outperform XRT such that the FDO call will appreciate faster than the XRT put will decline. In a bear market, XRT will underperform FDO such that the XRT put will appreciate faster than the FDO call will decline.
The beauty of the trade is that it hedges our market exposure, so that we expect to profit in any market environment so long as FDO continues to outperform XRT. If both decline, we profit if retail as a whole suffers more than FDO. If both advance, we’re fine as long as FDO does better than other retailers.
Remember, the key to a pairs trade is figuring out which stock/sector/index will maintain a period of outperformance. Then play options that match the time needed for the outperformance to play out. Odds are that one leg will gain and the other will lose. That’s the price you pay for being somewhat hedged against an overall market move. But it’s not a bad place to be in the current market environment.
If you do your homework and determine which equity will eventually come out on top, this strategy will be a winner. Try it on paper a few times to see how you do. Then go for it.
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