How many times has this happened to you lately? You carefully
research and buy a stock. The company announces unexpectedly good
financial results. But the stock's price plummets, caught up in one
of the market's now-frequent downdrafts.
You curse high-frequency traders. Your sleep suffers as the market
roils. You even begin to wonder if it's worth all the time and
effort put into researching the investment.
But now is absolutely the wrong time to give up your fundamental
There is a way to put solid research skills to work -- and beat the
market's volatility. But instead of executing one well-researched
idea, consider executing the idea in pairs.
Pair trading is a tried and true method for beating the market. In
fact, studies confirm it produces an average of +11% excess returns
annually -- delivering twice the average gains of the S&P 500.
But the real beauty of this strategy is its ability to produce
positive gains in down markets from poorly performing sectors.
How Pair Trading Produces Gains in Ugly Markets
Say you believed in December 2009 that the home improvement
Home Depot (
was poised to do well, even though housing and broader economic
indicators were still inconclusive. Say you also believed that Home
Depot would do better than its main competitor
based on its historical performance and business plan.
If you bought Home Depot on December 15th, you would've had a small
loss of -0.1% by February 12th. That's still better than the
broader market, since the S&P 500 lost -2.9% during that same
period. And you were much better off than if you had bought Lowe's,
which lost -7.7%.
But if you executed a pair trade -- taking a long position in Home
Depot and taking a short position in Lowe's -- you would have a
+7.6% gain in just two month's time.
Use Pair Trades For Company-Specific News
On April 20th, the Deep Water Horizon oil rig exploded while
tapping a well for
. Initially the oil spill looked minor. But as the days passed,
BP's problems became more pronounced. If you placed a pair trade --
and short BP -- on April 30th, you would have booked a nice +15.5%
gain by now.
Birds of a Feather Flock Together -- Eventually
Another popular pair trading scenario involves finding a temporary
divergence between similar-behaving stocks. For instance the
tend to track each other. But as you can see in the chart below,
there are times when one starts to outperform the other.
Some pair trading investors view this as a temporary anomaly, and
assume the two stocks will converge again in the long run. A pair
trader will short the temporary outperformer and take a long
position in the underdog until they fall back into lockstep.
Take Market Risk Out of Your Investment Equation
Action to Take ----->
As long as you find two similar investments, pair trading allows
investors to practically eliminate market and sector risk it's a
simple strategy, easy to execute -- and perfect for today's market
One pair trade on my watch list is
. A weaker euro will make Volkswagen's cars cheaper in world
markets and I think the German auto manufacturer has an opportunity
to pick up more market share in the foreseeable future. Toyota's
technical woes are temporarily out of the headlines, but a stronger
yen will make Toyota's cars more expensive in world markets -- just
when it is trying to buy back customer loyalty. If I were to
execute this trade, I would go long VLKAY and short TM.
Editor: Stock of the Month, The Daily Paycheck
Disclosure: Amy Calistri does not own shares of any security
mentioned in this article.
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