This Trade Can't Miss

Market volatility is a double-edged sword. Although it gives opportunistic investors the chance to scoop up shares cheap, it can also paralyze investors with fear and drive them from the market.

We saw that in March 2009, when stocks were as cheap as they'd been in years -- yet investors were pulling enormous sums of money out of stocks.

There are, however, strategies to cope with volatility, and they're as applicable to today's market as they were in March 2009. I highlighted one of them in a recent column about high-quality companies with dangerous currency exposure in the current global economy.

Rather than sell out of these companies altogether, or suffer through a wild currency ride, it's possible to hedge out that currency exposure and keep your portfolio on a much more stable path.

That, however, is just one way to limit volatility in your portfolio. I'm back today to discuss another.

Not a bizarre reality television show
Although it sounds a little kinky, pairs trading is a conservative technique that savvy investors can use to make money in the stock market without taking on the risks associated with going long or short a single investment.

Basically, a pairs trade identifies securities that tend to be correlated, and then takes action when that correlation gets out of whack. This generally means that an investor will go long one of the stocks and short the other stock, and make money as the relationship between the stocks reverts to the mean.

While this may sound complicated, it's actually quite a simple, lower-risk money-making tool. Furthermore, it renders market activity irrelevant. Even if the whole market crashes, the money you lose on your long position will be balanced out by the money you gain on your short position.

Here's how it works
The first step to a pairs trade is to identify companies that tend to be correlated. Obvious examples here are virtual duopolies such as Coca-Cola (NYSE: KO  ) and Pepsi (NYSE: PEP  ) , Home Depot (NYSE: HD  ) and Lowe's (NYSE: LOW  ) , and UPS (NYSE: UPS  ) and FedEx (NYSE: FDX  ) .

If you go back and look at how these companies have traded relative to each other over time, you end up seeing a fairly predictable pattern.

Pair

10-Year Avg. EV/Sales Ratio

Current EV/Sales Ratio

Coca-Cola/Pepsi

1.7

1.6

Home Depot/Lowe's

1.1

1.1

UPS/FedEx

2.3

1.8

Source: Capital IQ.

In other words, Coke has generally traded for a 1.7-times premium to Pepsi, Home Depot a 1.1-times premium to Lowe's, and UPS a 2.3-times premium to FedEx.

And while Coke and Pepsi and Home Depot and Lowe's remain appropriately correlated, UPS today is being awarded just a 1.8-times premium to FedEx (versus its average of 2.3-times). If you expect the relationship between UPS and FedEx to revert to the mean, then those two stocks may be ripe for a pairs trade.

So are they?
If you take a look at a chart comparing the stock performance of each company over the past year, you can see that FedEx has handily outperformed UPS. That explains why we have our discrepancy -- but is it warranted?

While FedEx has been able to maintain better gross margins than its competitor in the face of rising fuel prices and depressed economic activity, UPS remains the largest shipping company in the world. Unlike FedEx, it's also already unionized, which it means it doesn't face that looming unknown. And finally, the company remains in good financial condition, with more than $3 billion in cash on its balance sheet and the capacity to generate at least $3 billion per year in free cash flow.

This, in other words, is an opportunity ripe for a pairs trade. If the global economy improves, UPS stock should rebound sharply, making up ground on FedEx. If it doesn't, then FedEx stock should flounder more than UPS stock. Either way, if you buy UPS and short FedEx, you should be able to capture a meaningful amount of low-risk profits.

More where that came from
Pairs trading is just one strategy you can use to protect yourself against downside in the stock market, while preserving your opportunity to bank profits for the long-term. Furthermore, it's one way the portfolio management team at Motley Fool Pro expects to make money in all types of market environments. By judiciously employing tools to produce absolute returns, regardless of how the market performs, investors can avoid volatility, and profit whether the market is down, flat, or up.

If you'd like to learn more about ways you can do that (and who wouldn't in these volatile times?) and get a free report with five strategies to grow your wealth in a volatile market, simply provide your email address in the box below.

Tim Hanson does not own shares of any company mentioned. Home Depot, Coca-Cola, and Lowe's Companies are Motley Fool Inside Value recommendations. FedEx is a Stock Advisor pick. Coca-Cola, PepsiCo, and United Parcel Service are Income Investor selections. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Coca-Cola. The Motley Fool has a disclosure policy.


Read/Post Comments (14) | Recommend This Article (40)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 10, 2010, at 8:45 PM, foorpool wrote:

    Perhaps it's been around for a while, this is the first I've seen this "yet another MF newsletter", the MFPro. My question to MF is that if you can "win" in any market as is often claimed, why not give your newsletter away since you'll be making your money in the market? If your approaches are a vibrant as claimed, we should all be able to retire early on your fantastic pics. Please be honest with us mortals, MF makes its money on newsletters and subsidizes it with some good stock pics. Why can't you make your fortunes on your incredible abilities?

  • Report this Comment On June 10, 2010, at 8:59 PM, able101 wrote:

    @ foorpool.

    You're a capitalist?

  • Report this Comment On June 10, 2010, at 11:43 PM, xetn wrote:

    "Unlike FedEx, it's also already unionized, which it means it doesn't face that looming unknown. " Are you suggesting that FedEx is about to be unionized?

  • Report this Comment On June 11, 2010, at 12:36 AM, Hungry4truth wrote:

    I must say I agree with "foorpool"! It is difficult for those of us that are inexperienced investors to weed thru all of the "Free Reports" to get even a little direction without having to be lured in to Pay for it. I know it is US that makes the choice but it would really be nice for once to be offered a REAL Top Notch investment subscription with Really Good investment advice or information for "FREE"...

  • Report this Comment On June 11, 2010, at 1:51 AM, cordwood wrote:

    Hungry ...

    Your post postulates an entitlement philosophy conundrum.

    Certainly you don't believe that The WSJ,Business Week,Forbes,etal don't offer information re some "Top Notch" investments....BUT they're not "FREE"...why? because they are businesses...you know.....the ecomic systems' engines that you are wanting to invest your money in to make a profit.

    If by "TOP Notch" you mean infallible,it doesn't exist....on Earth.

    If gratification at the expense of others is your desire , I'd suggest you'd CURRENTLY be right at home in Washington DC .

  • Report this Comment On June 11, 2010, at 5:08 AM, rawlem wrote:

    What would you have paired BP with? Pairs trading theoretically makes sense but still have specific stock risk so not foolproof as headline suggests

  • Report this Comment On June 11, 2010, at 7:48 AM, ryanalexanderson wrote:

    The headline says "THIS TRADE can't miss". Not "THIS TRADE STRATEGY can't miss". Paired trading requires another level of sophistication than regular trading, because you don't have the underlying beta as your safety margin.

    And I'm surprised at the comments complaining about the lack of free advice. These comments are not only silly, but they're posted on an article that explicitly does give specific free advice. The free part of the Fool gives loads of general advice, and occasionally a specific recommendation. What else do you want? A free pony?

  • Report this Comment On June 11, 2010, at 9:30 AM, rfaramir wrote:

    xetn,

    FedEx operates under the somewhat more lax labor rules that airlines operate under. UPS operates under stricter rules. Democrats are trying to pander to labor by putting FedEx under the stricter rules.

    So they are possibly becoming *more* unionized.

    FedEx calls this the "Brown Bailout" http://www.brownbailout.com

  • Report this Comment On June 11, 2010, at 12:01 PM, wwt17 wrote:

    ryanalexanderson, here here!

  • Report this Comment On June 11, 2010, at 4:45 PM, fire56 wrote:

    People want good advice,there's not much out there. I would suggest that all the "know hows"

    put their advice out there first and if it's anygood,

    then we would be more willing to pay for it. Don't hold your breath.

  • Report this Comment On June 12, 2010, at 1:19 PM, Notfooled1 wrote:

    If the "big brains" behind the Motley Fool really knew what they were doing, they would not sell this advice to other people thus skewing their results.

    In fact, the MFs are selling information that lags market performance. Don't be fooled. Seek better choices than those offered by the Motley Fool.

  • Report this Comment On June 12, 2010, at 4:38 PM, istoppucks wrote:

    Notfooled1,

    Just where would we seek those better choices?

  • Report this Comment On June 15, 2010, at 10:46 AM, catalystcorner wrote:

    Hey Tim,

    I saw your post entitled "This Trade Can't Miss" and thought it was a great read.

    I noticed you mentioned doing pair trades in your message, and I thought you might be interested in a free, online Pair Trading Tool. It gives a nice graphical and statistical output to help compare pairs.

    Here's a link if you're interested: http://catalystcorner.com/index.php?m=pair_tool

    Thanks,

    Phil

  • Report this Comment On June 16, 2010, at 11:09 AM, tomd728 wrote:

    Mr.rawlem:

    If you are still out there a BP short to long

    TOT,COC,etc.would have worked very well and

    still has merit as the BP woodshed has a lot more

    pain in it.

    5/16/10

    Good luck,

    Tom

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