How To Add A Paired Trading Method To Your Trading Toolbox To Make Money Even As Stocks Continue To Consolidate.
Many traders and investors feel that you need to choose the right direction on a stock to make money trading. Sure, there’s a kernel of truth in that. However, astute traders know that dampening directional bias and focusing on comparative relative performance can also be a highly profitable and less risky way to make a profit.
Looking at two stocks that normally trade in a similar way, called correlated, but start trading differently, or diverge, a pairs trade can arise by going short on the relative outperformer and going long on the relative underperformer. The gain is then realized when these two stocks go back to the more traditional relationship.
A quick look at the recent performance between the S&P 500 (SPY) and NASDAQ 100 (QQQ) shows how the two have broken up in recent months, as can be seen in the chart below. These two traded in a similar fashion until early 2002 when SPY outperformed QQQ dramatically. The performance gap is now close to 18%, creating a relative value trade by shorting SPY and buying QQQ.
A look back at the relative performance between tech giant Microsoft (NASDAQ:MSFT) and oil giant ExxonMobil (NYSE:XOM) over the past three years shows how much performance ultimately rolls back. The chart below shows how Microsoft stocks, which were such a huge outperformer until late 2021, have underperformed former laggard ExxonMobil over the past three years.
At its widest, MSFT was up nearly $140% over the past three years, while XOM was essentially flat. That huge performance gap has now been sharply knocked back the other way. XOM has now overtaken MSFT by nearly 25% over the same period. ExxonMobil’s stock has nearly doubled this year, while Microsoft’s stock has nearly halved. Taking counter-trend positions at extremes by shorting the outperformer and buying the underperformer usually pays off.
That said, ExxonMobil is now starting to look at something extreme comparatively. A look at the price action between XOM and oil prices will show how much.
Oil prices and oil inventories are normally well correlated, which makes intuitive sense. The chart below of the relationship between XOM and West Texas Intermediate Crude ($WTIC) shows that the two were pretty much in lockstep until July. Thereafter, crude oil prices continued to fall as XOM price exploded higher. In fact, XOM stock is now trading at the largest comparative premium to oil prices in decades.
A look back at the last time oil prices rose and then fell sharply in 2007 shows that XOM’s stock price also fell. The most recent rapid rise and fall in oil prices this year has now led XOM stock prices to reach new all-time highs, even after oil returned many of its big gains.
Oil stocks like XOM should be cautious in the future unless oil prices rise significantly. Shorting XOM stocks and buying oil is starting to look attractive on a comparative basis.
This type of relative value, or pairs trading, is a core strategy we employ in the POWR options portfolio.
But instead of going short and buying stocks, we use bearish put and bullish call options to structure our pairs trades. This significantly lowers the initial cost of the trade, but still has a very similar approach. In addition, we use a similar comparative performance approach for stocks in the same industry which should be highly correlated.
Below is a 6-month chart of a past trade at inception on two drink stocks. The POWR options portfolio bought bearish puts on the lower-valued and better-performing MNST and bullish calls on the Buy rating and underperforming PEP. Note that the performance gap was over 15%.
The comparable 6-month chart below from just a few weeks later shows how PEP has outperformed recently, closing that performance gap dramatically by more than 12% to about 2.5%.
Our pairs trades have paid off well in the POWR options portfolio so far. Below is a table of all past pairs trades and closed results so far.
The table shows how any pair trading involves buying a bullish call on a Buy-rated stock and buying a bearish put on a lower-rated Neutral or Sell stock.
The average profit is just over $150 per pair trade or about 15% considering the initial combined outlay of about $1000 ($500 per call purchase and $500 per put purchase).
The holding period averages less than 10 days, with two of the trades closing the following day when the stock bounced back.
While we still pick individual stocks, both with bullish calls and bearish puts in the POWR Options portfolio, the addition of the pairs trading methodology has improved performance and reduced overall risk, especially in a consolidating market.
What to do?
If you are looking for the best options trading for the current market, check out our latest presentation Trading options with the POWR Ratings. Here we show you how to consistently find the best option trades while minimizing risk.
If that appeals to you, and you want to learn more about this powerful new options strategy, click below to access this timely investment presentation:
Trading options with the POWR Ratings
All the best!
Editor, POWR Options Newsletter
SPY shares closed at $389.02 on Friday, up $9.04 (+2.38%). Year-to-date, the SPY is down -17.15%, versus a % increase in the benchmark S&P 500 index over the same period.
Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as Market Maker for First Options in Chicago. He appears regularly on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His overriding passion is to make the complex world of options more understandable and therefore more useful to the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.
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