muchdifferent than the next. Thus, while I may have mentioned an 11 percent stop(5.5 percent per stock) for KLAC/NVLS, the same risk may not be acceptablefor an investor with a smaller account. Think about it for a moment. If youlose 20 percent on $1,000, then you have to make back 25 percent to breakeven. Every time you lose money, it becomes harder and harder to makethe money come back. I know that I have outlined this point twice in thischapter, but that’s how vitally important it is to remember.One of the most incredible slogans of trading I have ever heard is “80percent of success is just showing up.” I cannot commend this statementenough. As an example, in the summer of 2001, I was in a pair of truckingstocks. At the time, I was not using the density curve, and had not figuredout how to accurately time the entry of my pairs yet. What I quickly discovered was that often, I had to sit on losing trades before they came back andmade money. Fortunately, all did; however, I partly attribute the winningstreak to dumb luck. Anyway, I had been sitting in the trucking pair for aboutsix weeks and was approximately five points out of the money when ananomaly occurred. The NASDAQ had a plethora of problems with its systems and decided to keep the market open for an extra hour to allow tradersa chance to make up for the lost time during the trading day. When 4:00 P.M.EST rolled by (the normal closing time for the exchanges) I looked aroundthe trading floor and discovered—to my dismay—that almost every singleother trader had already left for the day. The lack of liquidity before the closegave the other traders an excuse to go play golf. However, I stayed becauseI remembered reading about low-volume days before holidays when themarkets went haywire, and I was already losing huge in my trucking pair anddidn’t want to come into any nasty surprises the following day. So I stayedand watched. Amazingly, the electronic communications network (ECN)activity was incredibly robust for both of my stocks. I began to see bids andasks build like the trucking stocks were tech highfliers. By this I mean thatthe buyers and sellers were stacking up tremendously on the bid and ask in
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both stocks. My first thought was: Can this be real? Then I surmised thatthere must have been institutional players out there who either had somehuge orders to run—and saw the late day as an opportunity to move someserious volume—or that someone, somewhere was panicking.Regardless, the bids were building on the stock I was long, and the askswere piling up in the stock I was short. My heart began racing—the pair thatI had just been five points out of the money on was now three points in themoney . . . then four points, then five points. I immediately marketed out ofhalf of both positions, and put the other two halves further out of the moneyto see if I would be hit. Amazingly, my orders were immediately taken, and Iwalked away with a huge 10-point profit. Next thing I knew, I was standingon the top of my desk swinging a golf club, screaming at the top of my lungsin victory elation. I had just recovered 15 points. When I came to my senses,you could hear a pin drop. The only people in our office were the branchmanager and compliance director, who were staring at me like I was a madman. And I was. I quietly put down my golf club, stepped off my desk, andleft as quickly as possible.The most amazing part of the whole experience is that I learned youcan’t make money if you aren’t there. I later thought about the situation, andalso realized that I didn’t have to be there at all. I should have had orders outstanding in our system at my profit levels, whether I was out of the moneyor not. After all, that is the one benefit that computers give us: the ability toease our day-to-day activities. No matter how you slice it, though, I was therewhen the other traders went home, and I made money because of it. When Igot into the office the next morning, both stocks opened at where they hadbeen trading at noon the previous day. It was like nothing had everhappened. I waited all morning for our manager to come inform me that thetrades were unreasonable and that they had been broken; however, suchnever occurred. I won because I was there, I won because I was there, I wonbecause I was there. And you will too.
INTRADAY PAIRSIntraday pairs often involve more risk than normal pairs, as intradaymovements can be less correlated than longer-term swings. On a valuationlevel, two stocks may trade closely together over a long period of time.This is because the stocks may have similar business models, assets,price-to-earnings (PE) ratios, earnings, or a variety of other congruous itemsthat cause institutional investors to see the companies as complementary.
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Regardless of fundamentals, however, during intraday trading, the stocksmay be at the mercy of order flow. Order flow, as I define it, is all intradaybuying and selling that affects the price of a stock significantly in one direction or another. Order flow is similar to the current of a stream; it is whatpushes a stock. Much like a flat stream can meander, or a rapid stream canhave many different sets of underlying currents and movements, it isextremely hard to predict the precise currents when you are in the water.The only thing you are sure of is that you are at the mercy of the flow of currents. And while swimming downstream in the water, you can get stuck inan eddy or smash into an unseen rock at any moment.When you are transacting a 100-share trade, you are not adding substantial order flow to a stock. However, when your 100 shares coupled with 100other people’s 100 share orders decide the direction of a stock, the result isorder flow. Keep in mind that this definition differs from person to person.The problem is that order flow is nearly impossible to figure out. If youwatch a level II screen and look for larger buyers and sellers, you will almostnever be able to see who is doing what. Five years ago, trading was a different story; however, now with many ECNs (e.g., Island, Instinet, Brut, Arca),market makers, specialists, and traders, the game has become very complicated. Seasoned traders may disagree with me, though for the averagetrader, order flow is impossible to accurately predict 100 percent of the time.As a result, it may be better for us to sometimes step away from the streamto observe the overall direction. Then if we can map out a safer course fromafar (swing trading), we may then have less misfortune running into unseenobstacles when we are in the water.The intraday pairs trader is at the mercy of order flow, which is theprimary catalyst behind his or her trading actions. He or she is seeking tocapitalize on order flow that drives two stocks apart or brings them backtogether. The main issue here is that as an individual trader, you will neverknow when substantial market moving, or individual stock-punishingorder flow will begin. Why? Simply put, you are not on the trading desk atMorgan Stanley, Goldman Sachs, Merrill Lynch, Janus, or any other financial institution that runs huge orders. And even if you are on one of thosedesks, you still cannot predict what will happen with order flow, unlessone of your buddies on another desk calls you and tells you. And that’s oneof those little illegal things the Securities and Exchange Commission(SEC) and the National Association of Securities Dealers (NASD) highlyfrown on!Say we are trading a hypothetical intraday pair that has spread wideopen, and we think it’s going to collapse back into the mean by the end of
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the day. The hypothetical pair of stocks we are trading are: long ReportedMiserably Inc. (NYSE: RMI) and short Beat Estimates Corp. (NYSE: BE). Thepair has spread open—meaning that even though RMI missed earningsestimates and BE came in above estimates, the stocks are doing the opposite of what they should. By this I mean that your gut instinct tells you thatRMI should go down, while BE should ascend. Even though you may perceive that the two stocks “ought to” move in one direction or another, theycertainly don’t have to.In another scenario, what if Crazy Hedgefund X has been building ashort position for months on end in a stock that is about to report, becausetheir analyst knew the stock would miss earnings estimates? This is a “buythe rumor, sell the news” scenario for Crazy Hedgefund X, and now thetraders will cover their huge short position into weakness, betting that suckers like you and me will be shorting after earnings. The end result of yourintraday trade is that the stock may never come back and you will have toclose your trade out a big, fat, stinky loser. What if we leave it open thinkingthat it has to recover some of the lost ground in the next few days? After all,we’re hedged—right? Wrong again.What if you are on the losing side of a larger pairs move and it’s beginninga two-month divergence away from you? You would then be horribly wrongand have to sit in your losing trade until it either comes back or a margin callsells you out of the position and you lose all your money. Do you see therisks here? Intraday trading is extremely dangerous and should be left to thepros who have outstanding money management skills, plenty of expendabledollars to throw away (and the understanding that they probably will), ahighly advanced technical analysis program, outstanding trading platform(like Tradestation), and nerves of steel. I’m not saying you are not this certain well educated, or well-tooled person; after all, you might be! However,for most people, intraday trading can be far above the acceptable level ofrisk tolerance!
CHAPTER 20
Trading anActual PairIntroductionTrading Diary—The BeginningHistorical Time Line ofDivergence Events
INTRODUCTIONThe next portion of the book was a bit of a gamble. With only a few weeksleft to my publishing deadline, I decided that drab information presentedin typical book form no more helps you learn how to trade pairs than reading a VCR manual does in helping you be actually able to program yourVCR. Thus, I decided to switch directions and discard a good part of thebook and put a trading diary in place. Here, I will walk you through a pairstrade—day by day—to show you exactly what I am looking for when Iapproach a pair and how I trade it. Furthermore, we will track the pair withreal money on a daily basis. This is a real pair, with real money, and I willtell you play by play exactly what I am thinking—win or loss. At the pointwhen I am writing this, I have no idea whether the pair will be a winner orloser by the time I close the position on November 14, 2003. I will useeverything that I have brought forward in this book in the upcoming trade.Moreover, we will look at the trade on a statistical, fundamental, and technical basis, and will incorporate all of our market knowledge in an attemptto make money. I would like to again reiterate that this is a gamble, as I donot know what the outcome of the trade will be by the time this book goesto print. However, the lessons here should be timeless and invaluable, aswe will work with two oil companies—an industry that really doesn’tchange all that much. This is a little nerve wracking, but exciting at thesame time. As a trader, I have built my career on taking calculated chances,so this trade will be very interesting, as it is calculated chance as well.Here we go!119
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TRADING DIARY—THE BEGINNINGSeptember 26, 2003: Today, I was looking around the market and noticeda possible pairs divergence that may be worth looking into. I used to tradethis pair quite a bit, but have not looked at it in about two years. The twostocks I noticed were Apache Oil (NYSE: APA) and Anadarko Petroleum(NYSE: APC). I absolutely cannot believe the divergence of these two stocks!When I traded them in 2000 and 2001, they were one of my best pairs with acorrelation of just under 90 percent. However, it now appears the correlationmust have dropped substantially, given the immense amount of divergencethat appears to have taken place. Looking at Figure 20.3, you can clearly seethat throughout 2001, Apache and Anadarko traded quite closely to oneanother. The chart says a few important words about the two companies:“similar business models.” However, the chart also shows that aroundJanuary 2002, the two stocks began a divergence that would carry bothequities far apart. We must try and figure out what happened at the time—and why Wall Street perceived so much change. Our goal is to then seekto understand whether the two stocks will come back together and, ifso, when?First, let’s begin try to understand the two companies themselves, and seeif we can uncover any similarities in their business models or financial statements. According to a press release distributed by the company, Apache is “alarge oil and gas independent with core operations in the United States,Canada, the UK North Sea, Western Australia and Egypt.” According toYahoo.com, at of the end of 2002, Apache had 637 million barrels of crude oilin reserves, along with just over 4 trillion cubic feet of natural gas.Anadarko Petroleum’s press releases say it is “one of the world’s largestindependent oil and gas exploration and production companies. Houstonbased Anadarko is active in the U.S., Canada, Algeria and Qatar and is executing strategic exploration programs in several other countries.” At theend of 2002, Anadarko had 2.3 billion barrels of oil equivalent provedreserves. Taking a look at the balance sheet, as of June 30, 2002, Anadarkohad over $20 billion in assets, while Apache had just under $12 billion.Our immediate impression here is that both companies are independentswith relatively similar goals. While total tangible balance sheet assets differ,both companies are operating in the same independent oil ballpark. Thus,we know why the charts have historically been quite comparable to oneanother—the companies were both pursuing similar types of business.Looking back in time, we will scan the news around the beginning of 2001to see if there were any apparent signs of the divergence about to take place.
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At the beginning of 2001, oil began to climb back over $20 per barrel, basedon a possible U.S. oil workers’ strike and an explosion at a Kuwait oil field.However, just prior to these events, both Apache and Anadarko had reportedearnings for the fourth quarter of 2001. Apache matched Wall Street’s earnings estimates and announced a 31 percent climb in 2001 production, whichwas the largest production increase Apache had ever seen. In addition,despite an annual 16 percent decline in oil prices, Apache also mentioned thatcash flow from operations increased by just under $2 billion. Investors happilyembraced the news reported by Apache as a sign of stability and growth. Theactual date that Apache reported on was January 31, with the stock closing at$48.49. After Apache reported, there were no significant up or down gradesthat immediately drove the stock in one direction or another.Anadarko, however, warned a few weeks earlier, painting a differentpicture than Apache’s optimistic outlook. One difference that Anadarkoalready faced going into earnings was that the company had recently begunslowing its drilling program in July 2001. The result was slower fourthquarter volumes and not so stellar earnings. Then, one day before earningswere to be released, Anadarko announced that it would correct a 3Q01accounting error, which amounted to just over $1 billion. For the 4Q01,though, Anadarko reported 41 cents a share, with a 41 percent decline in revenue. Anadarko cited the tough year as being mostly caused by lower energyprices. In addition, Anadarko also stated that it would push some of its naturalgas developments to the side and wait for prices to become more attractive.Then, to add icing on the cake, the company forecasted 1Q02 earnings of 25cents a share, versus the consensus expectation of 34 cents. Not good.This was the beginning of Anadarko and Apache’s divergence, though itwould take a little time still before the two stocks really began to buildmomentum away from one another. In fact, if we take a moment and look atour spreadsheet to analyze the pair using only the price data up to January31, 2002, we will see some pretty amazing things. Figures 20.1, 20.2, and 20.3show the Main page, the Pair Data page, and the Individual Charts page. Youwill quickly notice on the main page that the two stocks were 66 percent correlated at the beginning of 2002. You can also see this directly on the Individual Charts page, where the two charts give an immediate visualrepresentation of how closely the two traveled together.On the main page of the spreadsheet, we know that the two stocks were66 percent correlated, while also trading in between the mean and ⫹1 standard deviation. The differential mean on January 31, 2002, was ⫺4.55, whilethe actual differential was ⫺0.64. If we had been extremely watchful of thepair, we would have been able to infer that with the difference in earnings news
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FIGURE 20.1 Main Page
(both stocks were trading just above the sell side of the mean) that divergence was about to take place.Just to clarify, when I say sell side of the mean, what I am saying is anyvalue above/greater than the mean. All differential and ratio values above themean infer that the pairs trader would sell Apache Oil and buy Anadarko. Conversely, any number below the mean would allude to buying Apache Oil andselling short Anadarko. Thus, because the differential and ratio are presentlyabove the mean, we will think only about shorting Apache and buyingAnadarko. The setup for these two stocks in January 2002 proved to be the perfect divergence situation, where two companies with an extremely high correlation would begin to change not only fundamentally, but also in the eyes ofWall Street investors. We will continue to walk forward in time, while goingover the news that surfaced, to see if we could have perceived more divergence.
HISTORICAL TIME LINE OF DIVERGENCE EVENTS4/8/2002: Apache fires its auditor and hires Ernst & Young, while also selling $400 million worth of 10-year notes.
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FIGURE 20.2 Pairs Data
4/16/2002: Anadarko files to sell a $1 billion mixed shelf offering. Accordingto CBSmarketwatch.com, the company would “offer shares of common andpreferred stock, debt securities, depositary shares, warrants, and purchasecontracts and units.” Anadarko intended to use the proceeds for “general corporate purposes.” However, anytime you have an offering, you generally havemore stock, which means added saturation, translating into sluggishness forthe stock price.
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FIGURE 20.3 Individual Charts
4/23/2002: Apache is upgraded to Strong Buy by A.G. Edwards.4/25/2002: Anadarko reports wounded 1Q02 earnings, still citing the sameexcuse of lower energy prices. Apache also reports lower earnings on a yearover-year basis. Crude oil had been falling and was near $27 per barrel.5/15/2002: Coverage of Anadarko initiated at Prudential with a Hold rating.I would like to take a moment and comment on the general crude situationin the spring of 2002. The price of crude had been struggling, as inventoriesseemed to be building on a national level. There was concern that OPEC(Organization of Petroleum Exporting Countries) nations were cheating ontheir quotas, and supply seemed to become more and more abundant.Despite specific news related to crude, Apache and Anadarko were definitely heading down different roads, as Apache seemed to be findingupgrades, while Anadarko was not quite earning a windfall of complimentsfrom analysts. At the time, it felt like Anadarko didn’t see much hope forfuture gains in crude, and thus preferred to taper its drilling operations morethan Apache. The two companies’ divergence felt motivated by Apache’shunger to succeed and Anadarko’s complacency to just barely get by.
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6/17/2002: Anadarko announces that it unearthed gas wells in Louisianaand Texas.7/10/2002: The price of crude continues to bobble, trading under $27 perbarrel. Halliburton (NYSE: HAL) came under scrutiny about possible accounting fraud issues. First Albany makes comments that the firm expectedseveral independent oil companies to beat earnings, including Apache.7/25/2002: Finally, an upgrade for Anadarko by Salomon Smith Barney,which upped the company after it announced that it had beat earnings. However, Anadarko also stated that its second-quarter profit had declined 40 percent due to lower natural gas prices. Looking forward, the company loweredits 3Q02 earnings estimates to 60 cents a share, while analysts had previouslybeen anticipating 77 cents. No matter how you slice it, July’s earnings forAnadarko were not all that bright. Apache Oil also reported on the same day,singing tune of lower revenue. However, Apache’s production declined only5 percent year over year. The company went on to state that it was expecting its twenty-fifth year of growth, while also focusing efforts on expandingits drilling prospects. Purely from an investor’s perspective in late July, itseemed that Apache’s attitude toward business was aggressive and optimistic, while Anadarko’s was complacent and passive. Further divergencewould continue.9/30/2002: Anadarko Petroleum offers to buy Howell (NYSE: HWL) for$265 million. Anadarko intended on putting $200 million into one of Howell’sWyoming properties to increase reserves by 150 million barrels. In the longrun, this appeared to be a good move by Anadarko; however, in the nearterm, investors smelled cash outlay.10/24/2002: Apache reports in line with Wall Street estimates at $1 ashare. Though Apache did not blow away investors’ expectations, the silverlining was that the company had drilled 259 wells during the quarter. Evenmore incredible, Apache’s president mentioned that the total expense for the259 wells was the same as what 200 would have cost in 2001. Apache wasbecoming more cost efficient and was taking advantage of higher crudeprices to explore for more energy resources. (EN 20.1)10/31/2002: Anadarko Petroleum beat earnings and then raised its 2002profit target. However, cash flow declined to $539 million from $735 millionone year earlier.11/22/2002: In the article “Apache Oil-Drilling’s Outspoken Captain,” byCBSMarketwatch.com’s Lisa Sanders (EN 20.2), the following appeared:“Plank has an avowed distaste for carrying debt. At a time when many
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energy companies are battling to shore up their standing with Wall Street’sstrict credit-rating agencies, it’s the only one of its peers that can boast an ‘A’rating, thanks to its 33% debt-to-capitalization ratio. By comparison,Anadarko Petroleum’s debt ratio is at 45%, Burlington Resources is 51%, andDevon Energy weighs in at 61%, according to Standard & Poor’s. All three arerated in the ‘BBB’ category.” Clearly, we can see that Apache’s dedication toaggressive, low-debt growth was separating it from the pack, and Figure20.4, a chart of Apache and Anadarko from 1997 to December 2002, showsexactly what I mean.1/13/2003: Apache enters an agreement to purchase Gulf of Mexico andNorth Sea property from BP for $1.3 billion. Though the acquisition is heavyin the cash outlay department, it will increase Apache’s year-end assets by14 percent. Though this is good news in the log run for Apache, investorsmay think otherwise and begin to drive the stock down.1/30/2003: According to Yahoo.com, Apache earned $1.24 a share, versus 53cents a share in the 4Q01. Unfortunately, analysts were expecting $1.28 a share;thus, Apache did not meet its earnings mark. However, investors continued tocheer the stock, which closed positive on the day, despite lackluster earnings.1/31/2003: Anadarko reports earnings for the fourth quarter, stating thatearnings more than doubled from the previous year. In 2001, Anadarkoearned $108 million, or 41 cents a share. In 2002, the company reported $309
FIGURE 20.4 Apache Oil versus Anadarko
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million, or roughly $1.20. However, sales volume equaled 197 barrels of oilequivalent products (including natural gas), down from 199 million barrelsin the prior year. Obviously, higher energy prices helped to bolsterAnadarko’s bottom line. Looking forward, Anadarko mentioned that salesvolume for 2003 would come in 2 million barrels below previous estimatesof 203 million. Anadarko was having production trouble because of theVenezuelan oil workers’ strike. In addition, Anadarko expected first-quarterearnings to come in at $1.15 a share, or 5 cents below the consensus estimate.Toward the end of January, the United States was urging the United Nationsto seek a resolution that would authorize military action against Iraq, andwar uncertainty was causing the price of oil to rise.03/18/2003: Coverage is initiated on Apache by Bank of America with aBuy rating.03/25/2003: CEO John Seitz resigns from Anadarko and is replaced byRobert Allison. Seitz’s resignation came under extreme scrutiny of Anadarko’slagging stock price. However, Seitz’s sudden resignation with little explanation spooked investors, who were already concerned with the weak stockprice during times of rising energy prices. In addition, Allison is 64, and thecompany has a mandatory retirement policy at age 65. Speculation thatAnadarko will become a takeover target begins to surface.I would like to quickly mention that at this time, natural gas was on themove, trading at over $5 per BTU. Geopolitical tensions were causing fossilfuels to find strong gains. Concerning our pair, we can see that divergencewill continue, while Anadarko has internal problems and Apache aggressively progresses toward becoming a more profitable company.4/10/2003: Anadarko is upgraded to Buy at Prudential after the companyincreases its 1Q03 guidance from $1.15 a share to $1.35. However, analystsare still expecting the company to earn $1.48. Earnings per share aside,Anadarko expected $3 per share for cash flow in the first quarter, while theconsensus estimate was $2.96. At this time, the new CEO announces thatthe company expects 5 percent production growth in 2003 and 12 percentgrowth in 2004. Also, he mentions that a 20 percent increase in drillingactivity should result in a 20 percent increase in production volume for thefourth quarter over 1Q03. These are the first positive comments fromAnadarko in a while!4/24/2003: Apache reports that 1Q03 earnings more than quadrupledbased on strapping oil and gas prices. Apache reported $2.10 a share, versus
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the expected $2.02. However, the stock drops two points over the next fewdays after investors infer that part of the quarter’s results came from anearnings charge. The stock will not stay down for long, though, as thecompany expects to retire additional debt in the second quarter, giving it adebt-to-capital ratio under 35 percent, the lowest in the entire industry.(EN 20.3)4/25/2003: Anadarko reports that first-quarter profits have also quadrupled, with the company earning $1.45 a share, versus the consensus $1.43.Though Anadarko guided higher, investors let the shares slip over the nextmonth on concerns of future falling oil and gas prices. In addition, Anadarkomentions that it expects to earn $1.15 a share in the second quarter, farbelow the consensus estimate of $1.43. However, the company also revealsthat it expects full-year earnings to come in at $5.51, above analysts’ estimates of $5.03. The stock will likely go nowhere on this news, as the commoninvestor will probably ask him- or herself: “How can you beat estimates forthe year, when you lowered expectations for the quarter?”4/30/2003: Anadarko updates its 2003-04 production volume forecastsand states that the company expects 2003 production growth to be about5 percent, and 2004 to come in at 12 percent. CEO Allison makes positivecomments that the company has reduced its drilling expenses by about 40percent in certain areas. Anadarko’s optimistic comments are good for thestock; however, the company still appears as if it has lost its hunger forgrowth.5/01/2003: Anadarko files to sell $350 million in five-year notes.5/08/2003: Apache Finance Canada issues $350 million in 12-year notes.Have you noticed some incredible similarities between these two companies yet?05/23/2003: Apache files to sell $1.5 billion in stock and debt (known as ashelf offering). Apache notes that the proceeds will be used for corporatepurposes like paying down debt. While the move is good for the company, itcan also translate to more supply in the stock and can drive the price lower.At this time, the war with Iraq was coming to an “official” close, as statedby the White House. There was speculation that the war premium on oilwould begin to evaporate, which would cause oil to lose as much as $4.00 to$5.00, to around $25 per barrel. Crude was trading at around $29 per barrelat the beginning of summer. However, weekly reports by the Energy Information Agency (EIA) and American Petroleum Institute (API) indicated a
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large divergence in supply levels for the week. Thus, crude was thought tostill have some upside left, as there was still uncertainty in the market.6/2/2003: Apache announces that the company is auctioning off 32 blocksin 18 western oil fields. The sale is part of Apache’s plan rid itself of propertiesthat can be sold to smaller companies.6/5/2003: Anadarko announces that the company is raising its secondquarter forecasts and is also upping full-year guidance to $5.77 a share, farabove the consensus estimate of $5.14. However, the company also lowersits 2003 production goals.