How to reduce risk and increase profits with a pairs trading approach

How we profit from the power of POWR rankings with a powerful NPV and HP pair trading philosophy.

Alfred Winslow Jones is widely credited with creating the first hedge fund, or more accurately “hedge fund”, in the late 1940’s. He supposedly came up with the idea while researching an article on markets for Fortune magazine.

The idea was pretty basic – creating a hedge, or trading pairs, selling stocks he thought would go down in value while buying stocks he thought would go up. It is called a pairs trade as both bullish and bearish trades are done simultaneously or paired.

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

This basically dampens overall market risk. Even better if the stocks sold and bought were in the same sector to greatly reduce sector risk.

This is a core strategy we’ve employed since the beginning in the POWR options portfolio, but with some more advantageous features.

  • We use options, not stocks, to take offsetting short and long positions. Bearish buying puts the “bad” stocks and bullish buying the “good” stocks. This is a much less expensive way to create a covered trade. It also has definite risk.
  • The portfolio relies on POWR ratings to help identify the highest rated stocks to buy with bullish call buys and the lowest rated stocks to short with bearish sell buys. Since inception, Strong Buy (A-rated) and Buy (B-rated) POWR stocks have outperformed the S&P 500 by more than 3x. F Rated Strong Sell and D Rated Sell POWR stocks fell nearly 4 times the S&P 500.
  • Look for situations where lower-rated stocks temporarily outperformed higher-ranked stocks to provide additional expected mean reversion advantage.

We’re going to take a look at a pairs trade recently taken on POWR’s Options Portfolio to help clarify the process. It was a combination of a sell buy on the lower D rated Valaris (VAL) and a buy buy on the higher B rated Helmerich & Payne (HP). Both stocks were in the power drilling industry.

The comparison chart below from Feb 10 shows how lower rated Valaris (VAL) has dramatically outperformed higher rated Helmerich & Payne (HP) by over 50% over the past 12 months, with most of that outperformance starting in the beginning of December. Before that, you could see that the two stocks were more highly correlated – or moved more closely together.

As of February 21, the comparative performance gap has converged to around 10%. Both stocks fell, but VAL fell at a much faster pace than HP.

Originally, on 2/13, the POWR Options Portfolio purchased HP Calls at $5.50 and VAL at $5.00 for a combined outlay of $1,050.

A week later, the convergence turned a profit. POWR Options sold HP calls at $3.50 and VAL options at $9.50 for a combined total credit of $1,300 or a net gain of $250.

The overall gain as shown was $250 total net income on $1,050 invested. This equates to a net return of 23.8% in one week. Not a bad short-term return for a low-risk trade.

All achieved by taking a defined risk bullish call position on the highest rated but underperforming Helmerich and a bearish short position on the lowest rated but outperforming Valaris.

Details are shown below:

2023 could be shaping up to be a year where stocks go nowhere. This is especially true given the hot start to the year after such a dismal 2022.

Investors and traders alike could be well served by putting POWR Options Pairs trading philosophy to work as part of their trading toolbox. Lower risk with still sizable potential returns is a viable strategy in any market, especially the one we currently find ourselves in.

POWR Options

What to do next?

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

If that tickles your fancy and you want to learn more about this powerful new options strategy, click below to gain access to this timely investment presentation now:

How to trade options with POWR ratings

All the best!

Tim Biggam

Editor, POWr Options Newsletter

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

About the author: Tim Biggam

Tim spent 13 years as a chief options strategist at Man Securities in Chicago, 4 years as a chief options strategist at ThinkorSwim, and 3 years as a market maker for early options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His overriding passion is making the complex world of options more understandable and therefore more useful to the average trader. Tim is the editor of the POWR Options newsletter. Learn about Tim’s background, along with links to his most recent articles.


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