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Paired Trades: Two is Better Than One

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Options can narrow margin of error.

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As we've seen recently, a receding tide may indeed strand all boats. But over time, performance diverges as the superior companies outperform the weaker ones.

The basis for successful investing is determining which stocks are best for the long haul; 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 NASDAQ (NDAQ) and selling NYSE-Euronext (NYX).

One thing to keep in mind when establishing a paired trade: To keep the position balanced, you use a dollar weighting, not an equal number of shares.

For example: If you were looking to pair Yahoo (YHOO) against Google (GOOG), you would buy (or sell) about 25 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's a level of price correlation between the 2 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 isn't 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 2 chances to be wrong and lose.

Options Can Narrow Margin of Error

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 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 2 issues to move substantially in your predicted direction to overcome the erosion of the option's 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.

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No positions in stocks mentioned.

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