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 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.
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.
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.