Dealing a Winning Pairs Trade

"Earnings and economic data have turned, and we are now in the sweet spot of the recovery. Stocks are sure to head higher."

1. Financial Losers: Bank of America, Citi 2. Cell Therapeutics on Dilution Watch: BioBuzz 3. The Six Top Tech Stocks of 2010 4. FedEx: Analysts' Upgrades, Dowgrades 5. Dry Bulk 2010: Five Stocks to Watch

"The Fed is going to raise rates by March, which will begin putting the brakes on the economy. All the good news is priced in. Stocks are ahead of themselves and are due for a fall."

After an eight-month rally, the ongoing debate between bulls and bears seems more heated than ever. Sometimes when the future looks uncertain, a relative value trade, also known as a pairs trade, makes sense because its outcome doesn't really depend much on the market's direction. Instead, a pairs trade attempts to profit from the pricing discrepancy of two securities.

So how does a pairs trade work? You can execute it by holding a long position in one stock and simultaneously maintaining a short position in another stock. A profit or loss is a result of the change in the spread between the two companies.

A good place to start in selecting the two stocks is to look at comparable companies in the same sector, thereby reducing the industry risk. For example, if you were long an auto stock and short a gold stock, the auto sector could sell off at the same time the gold stocks rally, and you'd lose on both sides of the trade. But by choosing a long and short from the same group, you eliminate the sector risk because the stocks will most likely move in the same direction.

Let's look at a few examples.

Long Gymboree/Short Children's Place

Gymboree (GYMB - commentary - Cramer's Take) is a specialty retailer of children's apparel and accessories. With a 10-month-old daughter, let me tell you, I know a little about this company. My wife shops at Gymboree and at the company's new line of retail stores, Janie & Jack. On Wednesday mornings, my wife and daughter go to a parent-child developmental play class called Gymboree Play and Music. One of my daughter's favorite toys is a clown called -- what else? -- Gymbo.

---

Charles L. Norton, CFA, is a principal of GNI Capital, Inc., a registered investment adviser that manages a hedge fund, GNI Partners, L.P., as well as discretionary private client accounts. Norton had been a vice president in the equity research department of a New York-based hedge fund, where he was also a registered representative managing discretionary private client accounts. Prior to his experience on the buy side, Norton worked in the investment banking division of Salomon Smith Barney, where he was an analyst in the health care group, reporting directly to the head of the group. At time of publication, neither Norton nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Norton cannot provide investment advice or recommendations, he welcomes your feedback.