This Simple Strategy Provides Excess Gains without Market Risk

Amy Calistri's picture

Friday, June 4, 2010 - 6:08pm

by Amy Calistri

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 investment strategy.

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 retailer Home Depot (NYSE: HD) 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 Lowe's (NYSE: LOW) 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 BP (NYSE: BP). Initially the oil spill looked minor. But as the days passed, BP's problems became more pronounced. If you placed a pair trade -- long ExxonMobil (NYSE: XOM) 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 performance of Coca-Cola (NYSE: KO) and Pepsi (NYSE: PEP) 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 conditions.

One pair trade on my watch list is Toyota (NYSE: TM) and Volkswagen (OTC: VLKAY). 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.

Amy Calistri does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.