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) and selling Intel ( INTC), 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) against Google ( GOOG) 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.

But beware, the assumption that there is a level of price correlation between the two equities often leads investors to have a false sense of security that a paired trade is less risky than being outright long or short a single issue. The reality is that a paired trade is not a hedged position.

This is not an effort to put a negative spin on the technique, but understanding the risks involved is essential to successful application of any strategy. It might help if you consider a paired trade as a position in which you need to be right twice to make money, and you have two chances to be wrong and lose.

Options Can Eliminate Ways to Go Wrong

In some situations, using options can reduce the risk of a paired trade, and of course it can complicate matters in others. But in most cases, I would suggest using fairly long-dated options. This will give your thesis time to play out and reduce the impact of time decay. Let's look at some possible positions and their relative merits.

Buy and short call options: The capital requirements will be moderately lower than the all-stock position, as the long call requires only its initial cost. The long call's downside risk is also limited to that initial cost, thereby somewhat reducing one of the two ways you can be wrong.

The disadvantage is that the short call will provide only limited downside protection. It might make sense to use only slightly in-the-money or at-the-money calls to reduce your cost and risk, but the use of short calls that are deeper in the money will help you gain more downside protection. You can play with the numbers and find ratios and dollar amounts to find one that fits your expectations and risk threshold. This type of position can, of course, also be established using puts.

Buy calls and buy puts: Obviously this will have a lower cost and reduced risk compared to the all-stock position. The main disadvantage is the time decay. You will need the value spread between the two issues to move substantially in your predicted direction to overcome the erosion of the options' premium. If both stocks stand still, the position will lose money. In this case, it definitely makes sense to use long-term and somewhat deep-in-the-money calls.

Sell calls and sell puts: The initial capital requirements will be nearly equal and the risk is just as great as the stock-only position. But the potential profit is limited to the amount of premium sold. The main attraction of employing this strategy would be to take advantage of time decay and rich premiums. In this case, it definitely makes sense to use short-dated options and not go too far into the money. Even if both stocks remain unchanged, this position can make money.

Some Candidates

When Dell ( DELL) lowered revenue and profit forecasts last week, investors were trying to determine if the issues were specific to Dell or a sign of trouble for the whole PC industry. It seems that the shortfall was the result of a shift in Dell's marketing from low end to higher margin products and is therefore a Dell-specific issue.

While I'm not pounding the table or wildly bullish on the PC sector in general, I do believe this provides a small window for some of the also-rans to gain back a little market share. I think going long Gateway ( GTW) and short Dell could prove profitable over the next eight to 12 months. I'd look to buy calls in Gateway and buy put options on Dell.

With Gateway currently trading around $3.10 and Dell near $29 per share, one could buy the Gateway January 07 $2.50 calls for around $1.10 per contract and buy the Dell January $30 puts for around $3.50 per contract.

To keep the dollar amount invested in the pair, one would buy at least three Gateway calls for every one Dell put purchased. The position makes money if the price spread between the two stocks converges over the next 14 months. The maximum loss is equal to the total cost of purchase of both the puts and calls.

Another possible pair involves going long the International Securities Exchange ( ISE) and short the Chicago Mercantile ( CME). The ISE is the leading options exchange, and with option volume growing at nearly 50% year over year, faster than any other trading product, the ISE's revenue and profit growth should outpace that of the CME in the coming year. The ISE shares are trading around $28, while the CME is around $388 per share. So in this case, one would purchase ISE calls and CME puts on approximately a 13-to-1 ratio.

Remember, paired trades require one to be right on two stocks, not just one, but options can expand the range in which you can be wrong and still make money.
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 was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback; click here to send him an email.

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