Judging by the response to the

Home Depot

(HD) - Get Report

third-quarter earnings report Tuesday, with investors pushing the stock down 12.5% to $25, you would think the company's management has no idea how to operate a retail business.

At least not like

Lowe's

(LOW) - Get Report

, which has only lost 11.9% year to date compared with a 50.8% drop for Home Depot. The three-year returns, in which Home Depot shares have fallen 53% while Lowe's has gained 52%, hammer home the diverging paths along which investors have sent these two rival home-improvement retailers.

Granted, Lowe's is benefiting from being the smaller of two, with about 800 stores in 42 states, versus Home Depot's 1,400-store national coverage. Lowe's can still satisfy Wall Street's desire for growth by expanding into fresh territories, but once the expansion inevitably tapers off, will the growth rate be that different? Is Home Depot really about to become

K-Mart

to Lowe's

Wal-Mart

? I don't think so. And how can you play this divergence? Pair them up.

What It Means

A "pairs trade" is the simultaneous purchase of one equity and the short sale of another that are in similar businesses. In this case, we're working on the supposition that valuation multiples will converge and the performance and price spread will narrow.

Currently, Home Depot trades at 15.9 times the fiscal 2003 estimate of $1.57, while Lowe's sports a price-to-earnings ratio of 22 times the fiscal 2003 estimate of $1.78. For fiscal 2004, Wall Street expects Home Depot's earnings to rise around 17% to $1.81, while Lowe's is seen growing more than 18% to $2.10.

We can't ignore the possibility of an unlimited loss (the short position can theoretically go to infinity while the long goes to zero) associated with a traditional equity pairs trade, but using options will tilt the risk/reward in our favor.

Here's one possible options strategy. In early trading Wednesday, with Home Depot at $25 and Lowe's trading at $39, you could have bought the Home Depot May 25 call at $3.40 and sold the Lowe's April 40 call at $3.90. Thanks to Lowe's higher stock price, we'll get a net credit of 50 cents, or $50 per pair, even though the shorted Lowe's call is a dollar out of the money and its expiration is one month earlier.

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.

Should this scenario play out in the next five months, you would realize a gain of $418 ($32.58 - $25 - $3.40) on the Home Depot call plus profit of $190 ($40 + $3.90 - $42) on the Lowe's call for a total profit of $608 per pair. Had you paired 100 shares of Lowe's and 100 shares of Home Depot, the profit would have been only $458. That's because you would make a profit of $758 on the long position in Home Depot's stock ($32.58 - $25), but lose $300 on the Lowe's short position ($42 - $39).

Of course it may not play out that way at all; Lowe's shares may continue to run away from Home Depot's, in which case you have unlimited risk whether you've paired up using either options or stock. But that's why they call it speculating.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Steve Smith.