Building Without Financing: Sector Pairs Trade

Energy and Basic Materials have taken over leadership in the market and the former leaders Consumer Staples, Health Care and Utilities are are falling back. This was detailed in the weekly sector review (link below). But if you thought there would be a pairs trade between the leaders and laggards you are mistaken. There may still be more to room run but that train has left the station. More interesting is the ratio between the Materials Select Sector SPDR (ticker: $XLB) and the Financials Select Sector SPDR (ticker: $XLF) as illustrated by the chart below.

XLB vs XLF

This ratio has bounced off of resistance at the 2.52 area several times in the last 6 weeks. But with the Moving Average Convergence Divergence (MACD) of the ratio recently crossed positive and the Relative Strength Index (RSI) rising higher it looks like this time it may break through. If it does then a target on a Measured Move (MM) higher is 2.6337. If it fails then the look for a fall back at least to the 2.444 area if not the base near the 100 day Simple Moving Average (SMA) at 2.391. This presents a couple of trade ideas.

Trade 1: Buy 1 XLB and sell 2.52 XLF on a ratio break above 2.525 with a target of 2.6337.

This trade nets from $1.61-1.71 profit per pair if the target is reached. Use a ratio of 2.505 as a stop for a reward to risk ratio of over 5:1.

Trade 2: Sell 1 XLB and buy 2.50 XLF on a break of the ratio below 2.50 with a target of 2.444 and finally 2.391.

This trade nets from $1.03-1.05 for the initial target and $1.86-1.92 for the final target. Use 2.52 as a stop for a reward to risk ratio of over 3.2:1 for the initial target and 5.8:1 for the final target.

I Hate Sauerkraut! – Sector Review

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