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Prepare for anything with pairs trading

Carl Capolingua Carl Capolingua 22/02/2023
Prepare for anything with pairs trading Prepare for anything with pairs trading
Prepare for anything with pairs trading Carl Capolingua

Download Carl's Bear Market Survival Guide e-Book:
https://www.thinkmarkets.com/au/lp/2022-bear-market-survival-guide-ebook/

 

Highlights of this Article:

  • What strategies to trade in a sideways market trend
  • What is Pairs Trading?
  • Pairs Trading strategies 
  • Pairs Trading case study: Walmart (WMT) vs Home Depot (HD)
  • Pairs Trading case study: McDonald's (MCD) vs 3M Co

"Be a bull in a bull market, be a bear in a bear market, and when the market can't decide which direction to go, run like a startled burglar!"

This is a motto which has served me well for many years. I prefer not to let my opinions get in the way of following a good trend – be it up or down. So even if I believe the worst economic conditions are ahead, I must continue to trust the market's uptrend until it bends. Similarly, as optimistic as I might be during a market meltdown, I must refrain from the urge to try and pick the bottom.

I am a trend follower, so these are the steps I always follow: Step 1: Identify the trend. Step 2: Identify the strength and sustainability of the trend. Step 3: Apply capital accordingly in line with the trend as indicated by Steps 1 and 2.

When a trend isn't apparent, or the market is in a sideways trend, I find the best thing to do is move to the sidelines and wait out the prevailing indecision. There will inevitably be an uptrend or a downtrend eventually. Patience is a virtue!

It is possible that after 2022's bear market, and January's (miraculous!?) bounce, we could be moving back into a period of indecision in the market which could result in trendless trading in global stock markets for some time.

There are several strategies to employ during an expected sideways trend. One I have used with great success in the past is applying options spread strategies (e.g., bear call spread plus bull put spread) to profit from the price of an asset remaining within an expected trading range. I'll leave that complex strategy to another article, but another strategy which has proven effective is pairs trading.
 

Pair me up Scotty!

A pairs trade involves simultaneously entering a long and short trade on two different assets. For those not familiar with the term "long", it refers to the act of buying an asset first and selling it later with a view to profiting from an appreciation in the price of that asset. A "short" trade on the other hand involves selling the asset first and buying it later with a view to profiting from a depreciation in the price of that asset.

The goal of pairs trading is therefore to select an asset which is expected to appreciate in price and one which is expected to depreciate. Generally, the assets are of the same asset class, for example, they are both stocks.
 

But first, the long and short of going short

Short selling is often a contentious topic with investors. How do I sell something first if it's not currently in my portfolio? Well, if we're talking plain vanilla stock trading – you don't. Let's put that in the too hard basket (due to the complexities of stock borrowing arrangements). Much easier, is to use a contract for difference (CFD). A CFD simplifies short selling by dispensing with the need to own an asset prior to selling it. Simply, we enter into a "contract" to settle the "difference" in a stock trade. 

how to short sell 

So, for example if we short sell one Tesla CFD (which corresponds to one Tesla stock) for $500, the aim would be to buy it back at less than $500 in the future. Let's say Tesla is trading at $200 a week later (tears for Tesla shareholders!). The difference in our CFD trade is +$300 (i.e., $500 - $200 = $300). The lower the Tesla price goes (e.g., $100 = +$400 profit etc.), the better. In fact, if Tesla were to go bankrupt and be delisted from the stock market, it would be our best-case scenario! We'd make a $500 profit!

Clearly, if the price of Tesla goes up, we're going to have a negative difference in our short CFD trade. Our initial starting point is $500, and we'll lose $1 per 1 CFD of Tesla we're short. In theory, Tesla's price could go up to any number, $1000, $2000, and beyond. So short selling isn't without risks, and for this reason, we should always exit at a price which represents the maximum risk we're prepared to take in a trade. In our Tesla case study, we may set a stop loss to exit our short when the price gets to $600, and therefore limit our risk to $100.
 

Pairs trading strategies

Pairs traders will often target stocks in the same sector, but which are expected to diverge in terms of earnings performance, and therefore their stock price performance. Consider the market leader in a particular sector has often achieved that status at the expense of a less nimble competitor. 

Usually, earnings outlooks for companies are reflected their stock price charts. So, a company whose earnings are expected to improve generally coincides with an up-trend in its stock price. The greater the perceived improvement in that company's earnings, the steeper its price appreciation on its price chart. The opposite is often true. A company whose earnings are expected to deteriorate, or even simply to not grow as fast as its competitors, will often coincide with a flat or downward trend in its stock price.

The pairs trader therefore has two ways of identifying opportunities within stocks of the same sector. They can go long the sector leader in terms of expected earnings and short the laggard, or via the charts, go long the sector chart with the strongest uptrend, and short the sector chart with the weakest uptrend/strongest downtrend.
 
Case Study 1: Wallmart (WMT) vs Home Depot (HD)
An example of a pairs trade targeting stocks in the same sector is this one using Wallmart and Home Depot. On Tuesday 21 February, both companies reported fourth quarter earnings. Walmart beat estimates as it noted an influx of budget-sensitive shoppers acting upon growing cost of living pressures and seeking cheaper groceries. In contrast, Home Depot missed analysts estimates as spending on home improvement dwindled amidst a slowdown in the property market, and a similar tightening of discretionary spending by consumers.

walmart wmt chart technical analysis

One expects Walmart's defensive qualities should see it ride out any economic storm in 2023 better than the more-discretionary oriented Home Depot. Note, the pairs trader doesn't necessarily expect Walmart to flourish if there's a recession, simply that it will not do as bad as Home Depot. You see, the goal of a pairs trade is to profit from a net move in the prices of the target assets. So, even if Walmart's stock declines because of a deep recession, therefore delivering us a loss on our long Walmart trade, it's expected the decline in Home Depot's stock will be more severe, therefore delivering us a larger profit on our short Home Depot trade.

home depot hd chart technical analysis

Pairs traders may also choose to target stocks in different sectors. Here, the goal remains to find and go long stocks which are expected to perform better under the expected economic conditions, and find and go short those which are expected to underperform.

This version of pairs trading is somewhat riskier than the first. In the first strategy, there is likely to be very similar factors impacting both stocks as they were deliberately selected from the same sector. The factors which trigger a strong performance in the long stock candidate are also likely to trigger a strong performance in the short stock candidate. For example, if consumer spending rebounds, one would expect the performance of both Walmart and Home Depot to improve. If there's a loss on our Home Depot short trade, we should at least make some or all of it back on our long Walmart trade. There is some natural protection – or "hedging" – built into our pairs trade.

In this strategy, where stocks are selected from different sectors, it is possible the conditions which created the strong performance in the long stock candidate are the exact conditions responsible for creating the poor performance in the short stock candidate. For example, consider an oil company and a transport company. The higher the price of oil, generally the higher the price of gasoline, and therefore the lower the profits of the transport company.

Traders should consider the possibility the fortunes of pairs candidates are tied to a particular theme, and understand the elevated risks associated with such a trade. If the theme tying the candidates together reverses, and therefore causes both stocks' prices to reverse and move against the trader, a loss is very likely to be experienced on both legs of the pairs trade. Despite there being one long and one short in the pair, there is in fact no hedge within the trade.

Preferably then, if a pairs trade is to be selected from stocks from different sectors, there isn’t a common theme in play which has influenced their performance in the recent past (unless of course you fully expect the theme to continue to influence prices – just go into such a trade with your eyes wide open!)
 
Case Study 2: McDonald's (MCD) vs 3M Co (MMM)
An example of a pairs trade in different sectors is this one using McDonald's and 3M Co. We all know what McDonald's does! 3M Co is a global diversified industrial conglomerate. Its products are ubiquitous throughout the global supply chain and retail spectrum. It produces over 60,000 different products from Post-it notes, to fire extinguishers, to medical products. 

Is there a theme tying these two together? If there is, it's hard for me to see one. Certainly, McDonald's is the ultimate recession beater. Booming economy, flailing economy…really, does it matter for McDonald's? It loves a booming economy, but its defensive qualities abound in a recessionary environment as consumers tighten their belts (pun intended!).

mcdonald's chart technical analysis

3m Co? There are some defensive qualities in there, certainly on the medical supplies and fire protection systems – when do we not need those? But there's a whole lot more about 3M Co which really loves a strong economy, and this is probably why its stock price chart is one-way traffic down at the moment. However, if we postulate MCD and MMM are moving in different directions because the economy is expected to be weaker in the future, does this automatically mean the MCD chart will fall if the economy recovers and as the MMM chart rallies?

3m co mmm chart technical analysis

Unlikely. I suggest they'd likely both appreciate in that scenario. This isn't such a bad thing as the profit on our McDonald's long will likely help compensate us for the loss on our 3M Co short, and therefore reduce the risk on our pairs trade. So, in short, I don't feel there is a strong theme forcing the charts of these two pairs candidates in opposite directions, and therefore they are indeed a suitable choice for a pairs trade.

Want to apply the pairs trading methodology on USA Stocks? ThinkMarkets offers commission free CFD trading long and short on over 4,000 stocks, indices, commodities, forex and crypto. You can open account in just minutes!

Also, I'm run a dedicated session on analysing USA stocks each Friday at 12pm AEDT. Bring your portfolio along and ask me questions on the stocks you're interested in. I'll give you my best technical analysis of their charts as well as a fundamental valuation.
 


Ausbiz the call with Kyle Rodda >> Pairs Trading With Carl Capolingua, 22 Feb 2023

Available from: https://www.ausbiz.com.au/media/was-it-the-bull-market-we-never-had?videoId=27332
Any opinions, news, research, analyses, prices or other information contained on this website is provided as general market commentary and does not constitute investment advice. ThinkMarkets will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

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