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Trading The Dollar-Neutral Spread - How To Hedge A Strongly Bullish Stock Using 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 (high ranking) stock, which I then trade 'against' a heavily overbought (low ranking) stock, within the same industry/sector...
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 trading strategy towards trading two closely (or closely correlated) stocks or ETF's...
One of my favorite (freely available) tools for finding a closely correlated stock which I can potential trade against the strongly bullish stock I am looking at, is the Select Sector SPDR correlation tracker, at: http://www.sectorspdr.com/correlation/
Simply enter the stock symbol you are interested in, and the tracker returns a list of highly correlated stocks. Look for ones in the same industry or sector with a correlation of at least 0.9 (90%+ correlation)...
Whenever I am looking at a stock (stock X) which looks positive (high technical ranking at clickcharts, combined with a high morningstar/zacks fundamental rating), I immediately look for another stock (stock Y) within the same sector, which I find to be overvalued. Effectively, I am looking to go long stock X, and short stock Y, in equal dollar 'value'...
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 learning 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.
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 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 (this is critical).
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 top ranking bullish stocks - my potential stock 'X')...
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.
Hedging a technology stock with it's sector ETF (such as XLK), or index ETF (such as QQQQ) is a better alternative in my opinion than exiting a potentially good stock simply because it hits a stop loss point...
By hedging instead the position (when the stock hits a stop-point), you are mitigating the risk of further losses, but not necessarily completely giving up the potential for the stock to move into profitability. Once hedged, if the market continues downwards, the short ETF will partially (or completely) offset any losses on the long stock...
Once the market recovers and the stock moves into a profit-zone, this is a good time to exit the hedge and let the stock run. Alternatively, you can find an overvalued stock in the same sector to maintain a more advantageous hedge.
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, not only for outright profitability, but also to intelligently mitigate risk.
Question, comments - email me anytime: support@clickcharts.com
Happy Trading! Shiraz Lakhi Founder: ClickCharts.com
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