Correction or Bump in the Road: Pairs Trades Can Remove Some Uncertainty

• Posted by Greg Harmon
• on February 22nd, 2011

The market pulled back today in a fairly orderly fashion. But it was a very broad pullback. Is this an indication of a top and further pullback to come or just the first real dip for months? Just Monday night I posted a chart for Costco, ticker: COST, suggesting it was heading higher toward a target on a measured move at 80.50. The chart still looks strong but who wants to be long if we are about to have a major pullback? Conversely, the chart for another large discount retailer Target, ticker: TGT, looked broken and headed lower. But it has already moved lower and is near a key support level. It may still move lower, especially with the market breeze behind it, but if the wind changes that support may hold. So what to do?

Pairs Trade

At times like these pairs trades can take some of that uncertainty out of the picture. One way to reduce some of that uncertainty is to trade the relationship between two stocks. Below is a ratio chart for COST vs TGT. Notice that the ratio of COST to TGT has been moving higher. In fact out of the channel from October through the beginning of January it has moved higher in 3 steps of about 0.08 -0.1 and retraced about 50% of that move each time before moving higher again. A 50% retracement this time would just fill the gap up. But just because it has happened before does not mean it will happen again. One could look at Monday’s action as confirmation of the gap up and look for a continuation higher.

There are 2 trades to be prepared for.

Trade Idea 1: Long 2 lots COST and short 3 lots TGT
On a hold of the ratio above 1.43 enter the trade as a continuation, with a stop loss at the bottom of the Friday gap up candle at 1.43. The ratio has moved back into the Bollinger bands and they are expanding so it is more than a remote possibility that it will continue higher. This is the aggressive trade. A more conservative variation on this trade would be to anticipate and wait for a gap fill pullback to 1.41 and hold there, before entering the pairs trade long. Understand that waiting may have you missing a move higher if it does not retrace. A target on the upside might be a symmetrical move of another 0.09 to 1.52.

Trade Idea 2: short 2 lots COST and long 3 lots TGT
Using Monday’s high of 1.477 as a stop do the reverse trade looking for a gap fill or lower. The Relative Strength Index is overbought so it is not a crazy idea that pullback could continue. A more conservative version of this trade might be to wait for a fill of the gap and continuation lower to enter this trade. A traget on the downside might be the 1.34 low.

(As always you can see details of individual charts and more on my StockTwits feed and on chartly.)

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