Home | Get Started Right Away With Our Free-To-Use Dow 30 Stock Scans

Trading Inter Market Spreads - A Fresh Look At The Simple Pairs Trading Strategy...

By Shiraz Lakhi, Developer & Founder: clickCharts.com

It is rare to find independent traders who think beyond the simple, single-directional 'buy-long' or 'sell-short' approach to trading stocks. Once in a while however, you come across an idea, which, once grasped, permanently reshapes the way you view and trade the market. It is in this spirit of open minded inquiry that I first became captivated by a predominantly favored strategy among a growing number of successful home-based independent (and professional) traders, known as the pairs trading strategy.

Much of my work since - including the ongoing development of my stock rankings site clickcharts.com - has been rooted in effectively finding a heavily oversold stock/index/ETF which I trade 'against' an overbought stock/index/ETF...

Over the balance of this page, I will demonstrate the method I use, with clear examples to show you precisely how you can apply the pairs strategy towards trading two closely related markets. This can be the Dow vs any sector ETF, a Nasdaq 100 stock against another Nasdaq 100 stock, SPY vs QQQQ, Starbucks vs Coffee Futures, Google vs Yahoo, or any other interesting pair.

Everything covered on this page is completely free. All the information you need to find excellent, newly developing pairs trading ideas within any market/group is also free. From a personal point of view, pairs trading has become a rewarding strategy of choice. I also enjoy teaching, and freely sharing insights with fellow independent/home-based traders - individuals who may be considering a more superior way to trade the markets, as opposed to outright/speculative long or short trades.

Once understood, pairs trading is in fact a very straightforward trading strategy, providing a 'market neutral' approach to participating in the markets. To keep things simple I am going to focus on 12 closely related markets for this exercise...

Listed below are 3 major index ETF's plus 9 key sector ETFs's. For those not in the know, ETFs allow you to trade stock 'sectors' or major 'indexes' as opposed to individual stocks. For instance, you can trade the Technology Sector ETF (symbol: XLK), the Healthcare Sector ETF (Symbol: XLV), the S&P 500 index ETF (Symbol: SPY), or any other index/sector ETF, in exactly the same way you would buy/sell stocks via an online broker. Below are the 12 markets I will focus on for this guide...

Each one of the 12 ETFs listed above follow natural, cyclical patterns, and are 'correlated' to a high degree with each other. In other words, one ETF generally moves in a similar pattern (day to day % movement) to another ETF. At times, Technology 'overshoots' Healthcare, and tends to move back to equilibrium. Other times, Consumer Staples underperforms Consumer Discretionary, and tends back to equilibrium. It is this recurrent 'divergence' between two markets, followed by the statistically probable reversion back to the mean, which opens up actionable, short term pairs trading opportunities...

Let's get into this in more detail. Firstly, what do I mean by 'market neutral'. Market neutral means that I am not taking an outright/speculative long or short position in any one stock or ETF. Instead, I am trading two markets simultaneously, one long and the other short, both in equal dollar amounts, at the same time.

By trading market neutral, you are not overly concerned about whether a stock/ETF is bullish or bearish. Instead, you are interested only in whether stock/ETF 'X' will outperform stock/ETF 'Y' over the next few days/weeks.

The best way to see this is by plotting a chart which shows two ETFs on the same chart, with their daily % changes over the past 12 months. The chart allows you to see not only the similarity of day to day movement between the two markets, but more importantly, identify where the two markets diverge, and open up pairs trading opportunities...

Below is a potential pairs trading opportunity between XLU (Utilities Sector ETF) and DIA (Dow Jones Index ETF)...

Notice how the chart clearly illustrates the daily '% changes' between these two ETFs, which have diverged to a point where the gap represents a potential trading opportunity to go 'long' the undervalued ETF and 'short' the 'relatively' overvalued ETF.

The way to trade this information would be to go long XLU and at the same time, short DIA in equal dollar amounts. Example, enter long 1,000 shares XLU at $30.64 (value $30,640), and at the same time short 295 shares DIA at $103.99 (value $30,677), which almost exactly balances/equalizes the dollar value on both sides.

Another example is provided here, for a potential pairs trading opportunity developing between XLP (Consumer Staples Sector ETF), and SPY (S&P 500 Index ETF)...

The way to trade this information would be to go long XLP and at the same time, short SPY in equal dollar amounts. Example, enter long 1,500 shares XLP at $27.05 (value $40,575), and at the same time short 365 shares SPY at $111.01 (value $40,518), which almost exactly balances/equalizes the dollar value on both sides.

Pairs trading can be adapted to your own selection of stocks, ETF's, commodities, bonds, or any other market where you find strong correlation between a pair (similar pattern of movement over a period of time), and where emerging 'divergence' opens up pairs trading opportunities as outlined above.

The markets I personally focus on daily are the Nasdaq 100 stocks (note I provide a complete bullish/bearish stocks scanner specifically for Nasdaq 100 stocks at clickcharts.com designed to find potential pairs)...

Whenever I see a Nasdaq 100 stock which has become heavily oversold (multiple green lights), and likely to rally, I do not trade that stock as an outright/speculative 'buy-long'. Instead, I look for another Nasdaq 100 stock, which has become heavily overbought. I then plot a 12 month chart of the two stocks with their daily percentage changes, similar to the charts shown above, to identify the overall relativity and recent divergence between the pair. Once I see a good opportunity to go long the undervalued stock, I go short the overbought stock at the same time, in equal dollar amounts.

For instance, today I am looking at NIHD vs PAYX as part of my research before Monday's open...

Another way to trade an undervalued Nasdaq 100 stock would be to simply hedge a 'buy-long' position with the Nasdaq 100 ETF (symbol: QQQQ). Again, plot the 12 month chart of stock X vs QQQQ, ensuring stock X is negatively diverged compared to QQQQ. This provides a perfectly balanced, dollar neutral, true hedge position on stock X.

It is highly recommended that you learn as much as you can about pairs trading, and there are some excellent resources on the subject. My assurance is that it is time well spent. Chances are, you will likely go back and forth between trading outright long/short positions in stocks and trading pairs. Ultimately, the advent into pairs trading will rule predominantly in your mind as a definitive, superior approach to trading the markets.

Happy Trading!

Shiraz Lakhi

Founder: clickCharts.com

Important Information & Terms Of Use: The contents of this website, online charts software and accompanying web pages, are the sole property of clickcharts.com. All rights reserved. Any reproduction, passing on, lending, hiring, copying, or reselling of this content, in any original, edited, or adapted format, without the prior written permission of the owner, is strictly prohibited. The free charts and all related content supplied within this site are a technical treatise, aimed purely to educate users on the technical aspects and value of intelligent, mathematically based stock market analysis by way of charting and advanced indicators, and neither the charts nor the contents of this website, constitutes in any way or form, an invitation to buy or sell stocks or any other financial instrument, and is not calculated to lead directly or indirectly to persons doing so. The user of this site fully accepts that the developers, author, and owners of the site, are purely educators of continually improving, evolutionary trend charting technology, a method found to be valuable by them, which the user may find useful when embarking upon trading as a basis upon which to build his/her own trading programs. The developers, author and owners of clickcharts.com are not investment advisors, thus any decision to embark upon trading with real funds based on any information contained in this site, is the users' own, sole decision and responsibility, and any subsequent profits or losses resulting from participating in the markets with real funds, rests solely with each individual person/user, and not with the developers, author or owners of clickcharts.com. Further, the user accepts that the data and chart information is not guaranteed to be accurate at all times, and that the publisher is not accountable for any errors. The user is advised not to rely solely on this data, but rather to double check any data points published via his/her own independent sources. Information on this web site may contain links or references to other web sites, known as sponsored links. The user accepts that clickcharts.com is not responsible for any product or service offered by way of these sponsored links, and due diligence is recommended. Note: All stock data quoted is at least 20 minutes delayed. The user understands and acknowledges that as a general rule, past performance is not necessarily indicative of future performance. Users who wish to receive bulletins via email/SMS accept that delivery cannot be guaranteed. © 2009 Shiraz Lakhi / Clickcharts.com. E&OE

Home | Subscription Info | Privacy Policy | Shiraz Lakhi | Sitemap