Pairs trading, once mainly a strategy for institutions, became
possible for individuals with the advent of the Internet, thus
giving all traders access to a wealth of real-time information
and online brokerages.
It is a market-neutral strategy that takes advantage of a
certain imbalance in the stocks, funds, bonds, commodities or
currencies in focus. In other words, it does not depend on the
broader market making a directional move.
Pairs trading involves a long position and a short position in
a pair of highly correlated assets, and the strategy is thought
to lower risk because it creates a natural hedge.
Traditionally, investors would look for two stocks in the same
sector, preferably in the same subsector, that showed good
positive correlation. Therefore, if the two stocks were to
diverge, a pairs trader would buy the stock of the
underperforming company and sell short the stock of the
outperforming company. The trade would be profitable if the
spread between the two stocks narrowed (that is, the stocks'
prices again moved closer together). Looked at this way, pairs
trades are simply market bets on a mean-reversion move.
Another pairs trading strategy is to bet on the continued
outperformance of one stock versus another. Today's pairs trading
idea is to go long
Exxon Mobil (NYSE:
Both companies operate in the same sector (energy), as well as
in the same subsector (integrated oil companies). Not
surprisingly, their stocks have historically moved in tandem.
Looking at the weekly chart of XOM (blue) and CVX (red), we can
see the positive historical correlation between the two.
However, since the beginning of October, XOM has rallied
strongly while CVX has more or less remained flat, causing a
major near-term divergence in the stock. While at some point the
prices of these stocks will likely move closer together again, my
bet for the coming weeks is that XOM will continue to outperform
The technical picture for XOM looks much better than that of
CVX, as we will see in the charts below in a minute.
Additionally, from a fundamental point of view, the recent surge
in XOM was spurred last week by the announcement that
Warren Buffett 's
Berkshire Hathaway (NYSE:
purchased 40.1 million shares of XOM, bringing its total stake to
1% of the company, valued at more than $3.7 billion.
This investment is Buffett's largest new holding since buying
in 2011, and with this news, it is likely that other big money
investors will view the company in a favorable light and consider
buying the stock.
XOM is up more than 12% since early October, and it is
currently trading just above a resistance area around the $95
mark, which dates back to late 2007. With momentum on its side,
it now looks to be merely a matter of time until the stock
definitively breaks past this multi-year resistance area.
On the daily chart below, XOM admittedly looks overbought in
the immediate term, as the vertical slope is somewhat
unsustainable. However, note that on Friday, XOM broke out of a
multi-day consolidation phase, which is healthy from a technical
Moving on to CVX, the multi-year chart, while not as bullish
as that of XOM, also doesn't look overly bearish, which confirms
the long-term positive correlation between the two stocks. CVX is
holding its 2009 uptrend quite well and is forming a bullish
wedge of sorts. Upside momentum, as measured by the relative
strength index (RSI), still has plenty to prove before becoming
Next, on the daily chart, CVX has a confluence resistance area
made up of its 50-day, 100-day and 200-day simple moving averages
(blue lines), as well as its 61.8% Fibonacci retracement of the
swing from the September highs down to the early October
For now, the bullish momentum from the Berkshire investment in
XOM, as well as the bullish technical setup on its charts, looks
to favor Exxon Mobil's continued outperformance of Chevron in
Action to Take -->
-- Buy XOM above $95 and sell an equal number of CVX shares short
at $120.50 or higher (The current price spread at these levels is
-- Set stop-loss spread at $3.50 (This will be a mental stop
in which if either position or the combination of the two shows a
$3.50 loss, both trades should be closed.)
-- Set price target spread at $7.50 in four to 10 weeks (When
either position or the combination of the two shows a profit of
$7.50, both trades should be closed.)
This article was originally published on
An Alternative Way to Play Buffett's Bet on Big
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