Pairing Up for Profit

The recent rally has prompted analysts, brokers and money managers to pull out the data showing a fourth-quarter rally is all but inevitable and to tell you you'd be foolish not to join in the seasonal year-end festivities.

Certainly catching the wave of a strongly trending market can take a lot of the guesswork out of investing. But be warned, patience and discipline tend to dissolve amid the swirl of activity undertaken to avoid missing that wave. The fear of being left behind leads to decisions that lack a sound investment thesis. A rising tide may indeed lift all boats, but over time, performance diverges as the superior companies outperform the weaker ones.

The basis for successful investing is choosing the better stocks for the longer haul, and the paired trade is one strategy that requires comparisons and qualitative judgments between companies.

In a typical paired stock trade, one simultaneously goes long one stock and shorts a competing company. The idea is that the shares of one will outperform the shares of the other.

Most paired positions are based on fundamental analysis in which the valuation or prospects of one company look more attractive when compared with another. An example might be buying Advanced Micro Devices(AMD Quote) and selling Intel(INTC Quote), or vice versa.

One thing to keep in mind when establishing a paired trade is that to keep the position balanced, you use a dollar weighting, not an equal number of shares. AMD and Intel are both trading around $25 per share, so it's not much of an issue in this case.

But if one were looking to pair Yahoo! (YHOO Quote) against Google(GOOG Quote) you would buy (or sell) about 10 shares of Yahoo! for every one of Google. In theory, this will mean that if both stocks gain (or fall) 10%, the position's net value will remain constant.