Want To Try Pairs Trading? Here’s A Short-Term Setup I Like
In a previous article I had written
about trading predictability and how these leads to profitability.
One sector that I watch for this is within the cruise ships:
(
CCL |
Quote |
Chart |
News |
PowerRating) (Carnival
Corporation) and
(
RCL |
Quote |
Chart |
News |
PowerRating) (Royal Caribbean Cruises). CCL is the market leader
with the larger market cap and has been priced higher based on some basic
fundamentals:
| Â |
CCL |
RCL |
| Market Cap | 43 B | 9 B |
| P/E | 20.2 | 17.67 |
| P/TB | 3.59 | 1.91 |
| P/FCF | 55.76 | 13.76 |
From the fundamentals I would prefer to be short CCL and long
RCL.
Here is how the individual charts look, first CCL:
When pair trading it is important to look at the underlying
stocks to see if there is an obvious reason why you would not enter a trade. In
this case there is no new highs or lows being formed by CCL, it is business as
usual. Business as usual is a great thing for pair traders as it lowers the
probability of an extreme event or break out occurring.
Now for RCL:
At this point the symmetry of the charts should show that we
are dealing with a highly correlated spread. RCL shows nothing on an individual
basis that would stop us from buying the stock.
To be capitally balanced on the spread a ratio of 0.85 will be
used. This means that for every 100 shares of RCL that is bought, 85 shares of
CCL should be shorted.
On to the good part, here is the spread chart over the last
65 trading days, or quarter roughly:
You can see from this that the spread has been range bound
over the last 65 days. This creates opportunity for the short term and long term
trader! Look how consistently we have been pulling back off of 0 on the spread
number. This predictability is where there is the greatest profitability for
traders.
Fundamentally we have shown that the spread should be short
CCL and long RCL using the 0.85 ratio, now it is just a matter of watching for a
good technical entry. Patience is important when trading so wait for some place
close to 0 on the spread number before going short the spread.
Here are some guidelines that I would use trading this:
Entry: Short at 0
Stop: 0.5
Profit Target:
Short Term: -2.5 (Technical Level)
Long Term: -15 (Fundamentals)
The short term profit is just looking at the previous pull
backs of the spread and where it would be trading. The long term profit target
is calculating where CCL would have 140% of the price to tangible book value
(P/TB) of RCL to bring the spreads fundamentally in line.
Now just to watch the trade set up and to execute well to make
sure we have compounded probabilities: technicals, fundamentals and your
execution.
For more information visit our website at
www.pairtrader.com
Darren 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.