Set Up a Pairs Trade With Lowe's and Home Depot

By selling the shorter duration call we can hope to take advantage of a slightly lower theta (the rate of value change over time), and since the maximum we can make on the short call is the sale price ($390 per call in this case) the sooner it expires, the better.

How to Play It

Assume both stocks are unchanged or decline between now and April 18 and the calls expire out of the money (even though the Home Depot call still has a month remaining, I'm assuming it has essentially no value for the example's sake). If you spread 10, that is, bought 10 May Home Depot 25 calls and sold 10 April Lowe's 40 calls, you would have a $500 profit.

Had you used the underlying stock to create the pairs trade, both the risk and reward would have been greater, as they are dependent on the differential in the relative price declines of the two stocks.

But what we really want is for the prices to converge. Bringing the P/E levels being awarded the two companies closer would certainly achieve that.

If Home Depot's P/E moves up to 18, still below its 20% five-year growth rate, and using the current fiscal 2004 EPS consensus estimate of $1.81, the stock could trade at $32.58 a share. Dropping Lowe's to 20 times fiscal 2004 estimates of $2.10 values it at $42 a share.