Keen-eyed bullish traders picked up some easy money over the last two weeks as we saw U.S. stocks get brutally oversold and then make a stunning comeback during the holiday-shortened week.
But is it too late to jump on the bull bandwagon?
We’ll get our answer this week as we are about to be plunged into a veritable lollapalooza of economic data. On Tuesday we have the wildly unpredictable Durable Goods number, which is always good for an adrenaline charged shot of volatility.
But the real fireworks will come on Thursday and Friday when we have the second estimate of 3rd Quarter GDP (Thursday) and the Chicago PMI (Friday). The Street's looking for 2.8% on GDP with a hope number of 3%.
For the Chicago PMI, anything above 50 signals expansion, anything below 50 signals contraction. This index has been below 50 for two straight months and the Street is looking for a move higher to 50.7.
One way to play these two important announcements is through a pairs trade.
Let me explain….
A pairs trade is when you buy (go long) and sell short (go short) two stocks in the same sector. For instance, if you wanted to put on a pairs trade in the beverage sector, you might decide to buy Coke (KO) and short Pepsi (PEP). In the words of Investopedia, “This creates a hedge against the sector and the overall market that the two stocks are in”
The key to making a pairs trade work is to buy the stock that is the strongest in the group and sell the stock that is weakest. When attempting this strategy with ETFs you have to take a slightly different approach.
What you want to do is you want to pick two sectors that will be responsive to the upcoming economic news. The two sectors I’ve selected for consideration are the Industrial Metals sector and the Industrial Materials sector. Both of these sectors are very sensitive to economic news.
I’m using the S&P Metals & Mining ETF (XME) and the Materials Select SPDR ETF (XLB) as my trading candidates. On Friday, November 23rd XME & XLB closed at $42.46 and $36.40 respectively.
The next step is to decide which one to buy and which one to short. One way to do this is by simply comparing each ETF’s performance against the other over a six month period.
You can clearly see from the chart above that XME (blue bar) has wildly underperformed XLB. Over the last six months XME has dropped a whopping 22.75%, while XLB has only declined 1.97%.
Here is the theory of the trade, if the economic numbers are good and both ETFs go up, XLB will theoretically outperform XME allowing you to be net profitable on the trade. If the numbers are bad and both stocks go down, theoretically XME will go down more than XLB.
Does it always work this way?
No, it does not. Sometimes the stock you shorted goes up and the stock you bought goes down! So if you are using this strategy, it’s important to use stop loss points. I’d use a $31 stop on XLB and a $46 stop on XME. To make sure you are not doubling your risk, you would split your trading risk between the two ideas: putting half in XME and the other half in XLB. You would want to make sure that if you got stopped out of both trades you would risk no more than 1%-2% of your portfolio value.
For example, if you had a $100,000 portfolio and you were willing to risk 2% of it, that would mean that if you got stopped out of both trades, you would lose no more than $2,000.
Here’s how we figure out the position sizing for each trade:
- Split the $2,000 in risk capital and assign $1,000 to XME & $1,000 to XLB
- Figure out the size of the stop loss in points for each ETF. For XLB it is $5.40 and XME is $3.54.
- Divide $1,000 by the stop loss size to get the amount of shares you can own in each. For XLB we would take $1,000 divided by $5.40 (size of stop loss) = 185. That means we could buy 185 shares of XLB and if we got stopped out we would lose $1,000. If we do the same for XME, $1000 divided by $3.54 (size of stop) we get 280. Meaning we could short 280 shares and if we got stopped we would lose no more than $1,000.
By using this method we have equalized our risk across both ETFs. Even though we own different dollar amounts of each ETF the impact on our portfolio (should we be wrong) is the same.
No matter what trading strategy or tool you use to put on trades, always remember to apply risk management. It’s okay to speculate but it’s never ok to blindly gamble. Remember: if you are trading without a firm risk management process in place, you’re just a few trades away from losing it all.