How To Pare Down The Risk And Pump Up The Profits With A Pairs Trade Approach

How we have benefited from the power of POWR ratings with a strong pairs trade philosophy on VAL and HP.

Alfred Winslow Jones is widely credited with founding the first hedge fund, or more accurately the “hedge fund”, in the late 1940s. He reportedly got the idea while researching a marketing article for Fortune magazine.

The idea was fairly simple – to create a hedge or pairs trade by selling stocks he thought would go down in value while buying stocks he thought would go up. It is known as pair trading because both the bullish and bearish trades are done simultaneously – or paired together.

For example, buying Ford (F) and shorting General Motors (GM) would be a classic pair trade if you expect Ford to outperform GM.

This essentially dampens the overall market risk. It would be even better if the short and the long stock were in the same industry to greatly reduce industry risk.

This is a core strategy that we have used in the POWR options portfolio from the start, but with a few other beneficial features.

• We use options, not stocks, to offset short and long positions. Buying bearish puts bets on the “bad” stocks and bullish calls on the “good” stocks. This is a much cheaper way to create a hedged trade. It also has a defined risk.
• The portfolio uses POWR ratings to identify the highest rated stocks to buy with bullish call purchases and the lowest rated stocks to short with bearish put purchases. Since inception, Strong Buy (A-rated) and Strong Buy (B-rated) POWR stocks have outperformed the S&P 500 by more than 3x. The F-Rated Strong Sell and D-Rated Sell POWR Stock are down nearly four times the S&P 500.
• Try to uncover situations where the lower-rated stocks have temporarily outperformed the higher-rated stocks for an added benefit over the expected return to the mean.

Let’s take a walk through a pair trade recently performed on the POWR options portfolio to shed some light on the process. It was a combination of a put purchase on lower D-rated Valaris (VAL) and a call purchase on Helmerich & Payne (higher B-rated HP). Both stocks belonged to the energy drilling industry.

The February 10 comparison chart below shows how lower-rated Valaris (VAL) had significantly outperformed higher-rated Helmerich & Payne (HP) by over 50% over the past 12 months, with most of this outperformance beginning in early December. Before that point, you can see that the two stocks were more correlated — or moving more together.

On February 21, the comparative performance difference converged by about 10%. Both stocks fell, but VAL fell much faster than HP.

Originally, on 2/13, the POWR Options Portfolio bought the HP calls at $5.50 and the VAL puts at $5.00 for a total expense of $1050.

A week later, the convergence brought a win. POWR Options sold the HP calls for $3.50 and the VAL puts for $9.50 for a total combined balance of $1300 or a net gain of $250.

Total profit as shown was $250 total net profit with $1050 invested. That’s a net return of 23.8% in one week. Not a bad short term return for a low risk trade.

All of this is accomplished by taking a risk-defined bullish call position on the higher-rated but underperforming Helmerich and a bearish put position on the lower-rated but outperforming Valaris.

The details are listed below:

2023 could turn out to be a year where stocks go nowhere. This is especially true given the red-hot start to the year after such a dismal 2022.

Investors and traders alike can be well served by employing the POWR options pairs trading philosophy as part of their trading toolbox. Lower risk while still offering significant potential rewards is a viable strategy in any market, especially the one we’re currently in.

POWR Options

What do you do next?

If you’re looking for the best options trades for today’s market, check out our latest presentation, How to Trade Options with the POWR Ratings. Here we show you how to consistently find the best option trades while minimizing risk.

If this appeals to you and you want to learn more about this powerful new options strategy, click below to access this updated investment presentation now:

How to trade options with the POWR ratings

All the best!

Tim Biggam

Publisher, POWR Options Newsletter

VAL shares closed at $65.30 on Friday, up $0.36 (+0.55%). Year-to-date, VAL is down -3.43% versus a 3.65% gain for the benchmark S&P 500 over the same period.

About the Author: Tim Biggam

Tim spent 13 years as Chief Options Strategist at Man Securities in Chicago, 4 years as Lead Options Strategist at ThinkorSwim and 3 years as a Market Maker for First Options in Chicago. He is a regular on Bloomberg TV and writes Morning Trade Live weekly for the TD Ameritrade Network. His overriding passion is making the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR Options newsletter. Find out more about Tim’s background and links to his latest articles.

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