A new way to profit from pops and pullbacks with low-risk pair trades

Many traders and investors believe that you have to choose the right direction of a stock in order to trade profitably. Of course, there is some truth to this. However, astute traders know that suppressing directional bias and focusing on comparing relative performance can also be a very lucrative and low-risk way to make money.

Looking at two stocks that typically trade in a similar way, called a correlation, but start to trade or diverge in a different way, can create a paired trade of shorting a relative outperforming stock and long a relative underperforming stock. Profits are realized when the two stocks regress or revert to a more traditional relationship.

A quick look at the recent performance between the S&P 500 (SPY) and the Nasdaq 100 (QQQ) shows how the two have diverged over the past few months, as the chart below shows. The two companies traded very similarly until early 2002, when SPY began to outperform QQQ by a wide margin. The performance gap is now near the extreme, at nearly 18%, setting the stage for a relative value trade of short SPY and long QQQ.

A look back at the relative performance among tech giants Microsoft (NASDAQ: MSFT) and oil majors Exxon Mobil (NYSE: XOM) has highlighted over the past three years how much that ultimately means performance returns. The chart below shows how Microsoft stock, which has performed so well through the end of 2021, has underperformed former laggard Exxon Mobil over the past three years.

From the broadest perspective, MSFT is up nearly 140% over the past three years, while XOM is largely flat. This huge performance gap has now come back sharply in the opposite way. XOM has now surpassed MSFT by nearly 25% in the same time frame. Shares of Exxon Mobil have nearly doubled this year, while Microsoft’s has nearly halved. Taking countertrend positions in extreme cases often pays off by shorting outperformers and buying underperformers.

That said, now Exxon is starting to look a little extreme on a comparative basis. See how much the price action between XOM and oil prices will show.

It is intuitive that oil prices and oil inventories generally have a good correlation. The chart below between XOM and West Texas Intermediate ($WTIC) highlights that the two were almost in step until July. Crude oil prices then continued to fall, while XOM prices skyrocketed. 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 spiked and then fell sharply in 2007 shows that XOM’s stock price has also fallen. The recent surge and slump in oil prices this year has now sent XOM stock surging to new all-time highs, even after oil gave up most of its big gains.

Unless oil prices rise significantly, oil stocks like XOM need to be cautious going forward. By comparison, shorting XOM stock and buying oil is starting to look attractive.

This type of relative value or pair trading is a core strategy we employ in our POWR options portfolio.

But instead of shorting and buying stocks, we use put and call options to construct our currency pair trades. This greatly reduces the initial cost of the transaction, but still takes a very similar approach. Additionally, we use a similar method of comparative performance for stocks in the same industry that should be highly correlated.

The chart below shows a 6-month chart of two beverage stocks at the start of past trading. The POWR options portfolio pairs lower-rated and outperformed MNST puts and calls to BUY rated and underperformed PEPs. Notice how the performance gap exceeds 15%.

A similar 6-month chart a few weeks later shows how PEP has fared recently and has significantly narrowed the performance gap by more than 12% to about 2.5%.

So far, our currency pair trades have yielded good returns in the POWR options portfolio. The table below shows all previous pairing trades and closing results to date.

The table shows how each pair of trades involves buying a call-call option on a buy-rated stock and a buy-put option on a lower-rated neutral or sell stock.

Considering an initial combined payout of about $1,000 ($500 per call buy and $500 per put buy), the average return per pair traded was a little over $150 or about 15%.

The average holding period was less than 10 days, with two trades closed the following day due to a stock pullback.

While we still select bullish bullish and bearish bearish stocks in our POWR options portfolio, adding a pair trading approach can help improve performance while containing overall risk, especially in a consolidating market.

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What’s next?

If you’re looking for the best options trading in today’s market, you should check out our latest demo on how to trade options with POWR ratings. Here we show you how to consistently find the best options trades while minimizing risk.

If this appeals to you and you want to learn more about this powerful new options strategy, then click below to access this timely investment demo now:

How to trade options with POWR ratings

all the best!

Tim Bigham

POWR option communication edit

SPY shares closed at $389.02 on Friday, up $9.04 (+2.38%). Year-to-date, the SPY has lost -17.15%, while the benchmark S&P 500 has gained % over the same period.

About the Author: Tim Bigham

Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Chief Options Strategist at ThinkorSwim, and 3 years as First Options Market Maker in Chicago. He appears regularly on Bloomberg TV and is a weekly contributor to the TD Ameritrade network’s “Morning Trade Live”. His overriding passion is to make the complex world of options easier to understand and therefore more useful to the everyday trader. Tim is editor of the POWR Options newsletter. Learn more about Tim’s background and links to his latest articles. more…

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