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Creating a Pairs Trade With JC Penney and Kohl's

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A pairs trade can allow for profit if a stock moves up less relative to its sector or a different stock.

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About a month ago, one of my firm's clients called with an idea that JC Penney (JCP) was overvalued and wanted to see if we could make a play on it to the down side. Don't get me wrong; overall, he was bullish on the market and thought that the newly named CEO would be able to eventually turn around the company, but his thesis was that the market reacted too quickly to the anticipated changes.

For those of you not following the story, in October 2011, JC Penney hired Ron Johnson, the guru who engineered Apple (AAPL) to become arguably one of the greatest retailers in history. When the company announced that it was revamping its brand and would roll out a new pricing strategy at an investors meeting on January 26, JC Penney stock shot up from $34 to $41 a share in a single day.

He also stated at that time the company would handle this transformation without borrowing and would fund the transformation with cash flows from operations. See the Wall Street Journal article here, titled, "Penney CEO Says Profit Won't Suffer." All of this led traders and investors to make a notable play in the markets.

Let's get back to the trade. Since we were bearish in the midterm time frame, we wanted to be efficient with our cash and not tie too much up, so we decided to use options. Add to that the market in general was in a bullish run, and we wanted to pair it up as an offset. Meaning that we were really playing an underperformance vs. a straight bearish move. Creating a pairs trade would allow us to profit if the stock moved up less relative to the sector or a different stock.

We picked Kohl's (KSS) as the a stock that we theorized would outperform for two reasons. First, it had been doing well in same-store sales but had not participated in the industry's rebound, so we thought it was due to catch up. Second, and most importantly, Kohl's has historically moved with a high correlation to JC Penney. The recent moves of both companies had put them significantly out of alignment and any reversion back to the mean would yield a profit.

So on January 31, we put a bear put spread with strikes 36/47 on JC Penney and a bull call spread on Kohl's with strikes of 41/52. The trade cost us about $10,000, and if we were right on both symbols would be worth $20,000. Because we used a pair, we assessed we would only hit the max loss on one of these, so our true risk was closer to $5,000. As we decided to go midterm, the July and August expiration periods were chosen.

Fast forward to earnings on the morning of February 23. Kohl's, which had made a nice run from 46 to 52 in the last month, announced disappointing results for the fourth quarter. The stock took a beating yesterday to the tune of about 6% and pulled back to 49. Still in our profit range, but it certainly stung a little.

Add to that this morning, February 24, JC Penney announced a loss of $87 million or a $0.41 loss per share compared to $1.13 earlier the previous year. See summaries here from FT Press and Wall St Cheat Sheet.

One would have thought that this would have been good news for our bear trade, but alas, the position has only moved down marginally as of the first hour of trading, holding between 42 and 41. As it turns out, our trade will have to wait longer to hit our profit goals. We're not at a loss, but we're not cashing the register, either. The total trade as of this morning was profitable to the tune of about $700, but earlier in the week it was good as $2,000.

Two lessons to report here:

1. My firm and I are glad to be hedged. Things may not go as you want them to go, and being hedged sure helped in two ways. Our downside on both trades was limited and we used a pairs trade to offset the broader market momentum.

2. It's tough to be a contrarian and fight the tape. As we're seeing, it can take time to get this kind of trade right. Clearly the investor community is still smitten with Johnson's plan and certainly holding up the market. The Apple loyalty has a halo effect, and despite losing money in the fourth quarter due to one-time charges (which from the description in the article, don't really seem like one-time charges to me), JC Penney holds its price. So when fighting the market momentum of both of these stocks, we're glad to have given it enough time to work.

Bottom line: We're going to stay patient in this trade for another quarter, and use the time we afforded ourselves in the first place.

Happy hedging!

Editor's Note: For more from Jay Pestrichelli, go to Buy & Hedge ETF Strategies.
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No positions in stocks mentioned.
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