MILLBURN, N.J. (
) -- Not all trades or investments are fundamentally driven. Over the years, I have successfully identified many "pairs" trades, which are based on statistical analysis. Here I'll highlight several opportunities to engage in long/short pairs arbitrage.
Pairs trades are constructed by pitting a long position against a short position. When possible, you should seek out pairs of stocks in the same industry or sector.
Furthermore, the dividend yields of both sides of the paired trade should be roughly equal to each other.
Lastly, you want stocks that have been trading for at least five years, which will ensure that there are enough data points to make the relationship statistically sound.
This is a trade of patience and not one of instant gratification. It may take weeks or months for the relationship to revert to its mean value. However, when that does occur, the returns may be substantial and worth the wait.
The pricing relationships represented in the following graphs have been normalized to closing prices on Jan. 3, 2005. All stock prices are adjusted to reflect stock splits.
As you can see, the historical price relationships of each stock in the pair will vary such that one stock will outperform the other at some point in time, only to converge later on. This process is referred to as mean reversion.
Here are three pairs-trade examples. The following charts are from Telemet Orion.
1. Kellogg vs. General Mills
: Now is the time to buy
2. Eli Lilly vs. GlaxoSmithKline
: Now is the time to Buy
3. Kohl's vs. TJX
: Now is the time to buy
How can an investor take advantage of this opportunity now and in the future? Let's use the Kohl's-TJX pair as an example.
In the third chart above, KSS is depicted in yellow, and TJX is depicted in red. When the yellow line is above the red line, KSS is rich relative to TJX. The trade then sets up to buy TJX and short sell KSS. This opportunity occurred in late 2006/early 2007. When the two lines converge at the same point, as they did in late 2007, the stock prices have mean reverted, and the trade should be unwound for a profit. Conversely, if the red line is above the yellow line, you would buy KSS and short sell TJX and unwind when the stock lines met once again.
The beauty of these trades is that they are not correlated to any stock index. This is not to say that pairs trades are perfect. Something can always go wrong. For example, if one is short a stock and the company is taken over, then the trade will generate a large unexpected loss as the pricing relationship is no longer valid. Furthermore, if one is long a stock and the company has some unexpected operational or non-operation event, a significant decay in the pricing relationship could also occur. But these risks are no different than the risks associated with the normal trading of an individual stock, long or short.
Please note that due to the constraints of retirement accounts, which do not permit short selling, these trades cannot be accomplished in such accounts. Furthermore, short-selling requires maintaining a margin account and is predicated on the ability to borrow stock to deliver against the short position.
Finally, do not attempt to enter into only one side of the trade (that is, long or short only), because this will not provide the expected results presented in the graphs above. In fact, doing so could result in unwanted risks and potential losses.
-- Written by Scott Rothbort in Millburn, N.J.
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At the time of publication, Rothbort had no positions in stocks mentioned, although positions can change at any time.
Scott Rothbort has over 25 years of experience in the financial services industry. He is the Founder and President of
, a registered investment advisor specializing in customized separate account management for high net worth individuals. In addition, he is the founder of
, an educational social networking site; and, publisher of
. Rothbort is also a Term Professor of Finance at Seton Hall University's Stillman School of Business, where he teaches courses in finance and economics. He is the Chief Market Strategist for The Stillman School of Business and the co-supervisor of the Center for Securities Trading and Analysis.
Mr. Rothbort is a regular contributor to
TheStreet.com's RealMoney Silver
website and has frequently appeared as a professional guest on
Fox Business Network
and local television. As an expert in the field of derivatives and exchange-traded funds (ETFs), he frequently speaks at industry conferences. He is an ETF advisory board member for the Information Management Network, a global organizer of institutional finance and investment conferences. In addition, he is widely quoted in interviews in the printed press and on the internet.
Mr. Rothbort founded LakeView Asset Management in 2002. Prior to that, since 1991, he worked at Merrill Lynch, where he held a wide variety of senior-level management positions, including Business Director for the Global Equity Derivative Department, Global Director for Equity Swaps Trading and Risk Management, and Director for secured funding and collateral management for the Global Capital Markets Group and Corporate Treasury. Prior to working at Merrill Lynch, within the financial services industry, he worked for County Nat West Securities and Morgan Stanley, where he had international assignments in Tokyo, Hong Kong and London. He began his career working at Price Waterhouse from 1982 to 1984.
Mr. Rothbort received an M.B.A., majoring in Finance and International Business from the Stern School of Business, New York University, in 1992, and a B.Sc. in Economics, majoring in Accounting, from the Wharton School of Business, University of Pennsylvania, in 1982. He is also a graduate of the prestigious Stuyvesant High School in New York City. Mr. Rothbort is married to Layni Horowitz Rothbort, a real estate attorney, and together they have five children.