In Pairs Trading Knowing That Coke Is Better Than Pepsi Can Make You Money…Here’s How
Everyone is looking for
a magical formula to find the fair market value for a stock. News
flash you wont find that here. How can you tell what the price of Coke (KO)
should be: $20, or $40, or $60? With all the uncertainty that is present in the
world it is next to impossible to predict the future price of a stock, will the
sector go up or down, will costs of inputs go up or down, will the market go up
or down?
One of the benefits of pair trading comes from the ability to price stocks in a
relative manner versus an absolute manner. Instead of trying to figure out if
Coke is worth $60, the objective is to figure out if Coke is worth more or less
then Pepsi (PEP).
Consider the following list of fundamentals:
| Valuation Ratios |
Coke (KO) |
Pepsi (PEP) | Industry |
Sector |
S&P 500 |
| P/E Ratio (TTM) |
22.09 | 21.53 | 21.61 | 20.04 | 21.51 |
| Price to Sales (TTM) |
4.71 | 3.14 | 3.65 | 2.44 | 2.98 |
| Price to Free Cash Flow (TTM |
35.43 | 32.6 | 33 38 | .57 | 26.1 |
For all three fundamentals listed you would
prefer to be long the stock with the lower value. This implies that you would
prefer to own Pepsi over Coke. Capturing fundamental differentials in the market
is one of the great advantages of pair trading. By going long Coke and short
Pepsi you can capture the fundamental mispricing.
If you are taking a trade based on fundamentals you need to give it a long time
to bear fruit. The appropriate exit for the trade is when the fundamentals
approach equality. At this time the edge for the trade would be gone.
Notice that this is a very limited list of fundamentals. When doing a full
evaluation of the fundamentals between two companies it is important to analyze
things from many perspectives. Because the two companies should be in the same
sector the weightings and methods for analyzing the companies should be
identical. The method for the evaluation can be specific to your own
methodology; be it analyzing cash flows, expected future earnings or price to
tangible book values.
It is important when looking at a pair that you are truly analyzing two
companies that are similar to each other. In the case of Coke and Pepsi, XX% of
Pepsi’s earnings come from Frito Lay’s and their snack food division. Ultimately
this means that the relative fundamental evaluation does not leave to a clear
conclusion about what direction to be trading the spread.
No matter what time frame you trade a pair the more research you do into the
companies the more confidence you will have in a trade. This will allow you to
trade more profitably, and ultimately that is what we are looking for.
Daren Clifford
Darren Clifford is a professional equities
trader with Bright Trading. Mr. Clifford has recently been ranked one of the top
30 traders under 30 by Trader Monthly magazine.
Mr. Clifford holds a masters degree in Economics from Simon Fraser University
specializing in Financial Mathematical Modeling. He is also the president of
www.pairtrader.com, company dedicated to providing the tools and data necessary
for hedged equity trading.