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Long Exxon vs. Short Chevron: Attractive Pair Trade

Following the Exxon/XTO deal, entering the pair now would offer an attractive risk/reward ratio with less directional exposure.

The announced deal by Exxon Mobil (XOM) - Get Exxon Mobil Corporation Report to buy XTO Energy (XTO) was the companies' largest purchase in roughly 10 years. The announcement of that deal also had the effect of pushing the ratio spread between Exxon and its integrated peer Chevron (CVX) - Get Chevron Corporation Report to the bottom of a 10-year trading range. Set-ups such as this can be of value to short-term traders and to dedicated portfolio managers.

At times, equity pairs are pushed to extreme levels due to near-term momentum or short-term fundamental catalysts. When this happens, various trading types can enter the pair with close technical stop-outs and look to profit from the relationship reverting toward normal levels.

There are other times when the pairs blow out into new territory from long-standing ranges. These blow-outs could very well signal fundamental changes being priced into the market for one of the companies, which would be very important to all involved in the sector.

Price Analysis

: Prior to the deal, XOM's performance had already lagged CVX's by 17% since March 2009. The mid December takeover news and the following market reaction increased that underperformance to 23%.

The weekly chart below shows the ratio spread for going long Exxon and short Chevron.

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After a period of weakness ending in the mid '90s, XOM went on to outperform CVX by 65% in the four-year period between 1997 and 2001. Since that 2001 peak, the ratio spread has swung back and forth within the 10-year range mentioned earlier.

The red box outlines where the pair currently trades in relation to the multi-year range and the solid red line marks the median price of the pair for the last decade.

Clear Stop-Outs; High Risk/Reward

: A roughly 3.5% technical stop-loss (range bottom) exists near current levels. If the pair reverts to the mean of prices for the 10-year range, entering the pair would offer a risk/reward ratio of just under 3:1, while a rally to the range's upper end would improve that ratio to nearly 7:1.

With volatility returning, attractive pairs trades can allow traders to play a sector with less directional exposure.

Jim Stellakis has over 15 years of experience in technical research and trading; he has focused primarily on the energy and utility complex at investment and trading firms such as Bear Wagner, Touradji Capital, and Millennium Partners. He is currently an independent trader and adviser to buy-side portfolio managers. Stellakis' work focuses on two areas of technical research: relative ratio analysis and price analysis of commodities using Ichimoku analysis. He is a Certified Market Technician (CMT) and holds a Series 86 license (Research Analyst). He graduated with a B.S. in Finance from St. John's University.