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.

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.