simple andrequires little math. Fundamental analysis scares most people, who associateit with countless hours of reading and extensive research. And while for theanalyst this is exactly the case, I will boil it down to some commonsense applications based on what we have already covered. This chapter will start withtechnical analysis, skip over to fundamentals, and then tie the two together.
TECHNICAL ANALYSISMoving AveragesAs previously stated, one of the most important aspects of technical analysisis major moving averages, like the 50 and 200-DMAs. Why? The reason thesetwo moving averages are so vital is that the bulk of the world’s investors whokeep an eye on technical analysis, watch the 50- and 200-DMAs. When a bigpart of the trading population may be making a decision based on two littlelines on a chart, then the little lines become very important. In essence, theybecome self-fulfilling prophecies. At the same time though, I would be hardpressed to say that tons of traders are making decisions based on the moving averages. In other words, it’s hardly likely that many people buy a stockjust because it bounces on the 50-DMA. However, it is very rational to saythat many more people are watching the stock with a closer eye as it nearsthe moving average. Simply put, moving averages are like alert beacons inthe night—something you want to pay close attention to when near.We can even do statistical analysis on the two moving averages, to findout when the pair is spread apart on a 50-day historical basis. However, bydoing so we are analyzing data that is already analyzing data. In short, we areapplying statistics to something that is already lagging. If we were to do so(but we’re not), then it would be much wiser for us to use an exponentialmoving average, rather than a simple moving average.As previously stated, the 50- and 200-DMAs can cause a stock to ricochet off the average or plummet through. Why? As a trader, if you have1 million shares to sell at the best possible price and you know the technical
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world will likely buy a stock as it hits a major moving average on adescending move, would you wait for a bounce to sell? Of course youwould, as you would want to get the best possible price. Most traders handling order flow never look at a moving average as a “reason” for enteringor exiting a trade, but they do take notice of the occurrence, and soshould you—even when you are looking at statistics. Ok, so how does thishelp me with pairs? If you are about to buy a stock and it is trading underthe 200-SMA, and your sole reason to buy it is because of statistics, mayberethink the trade. Don’t trade, you say? Yes, perhaps wait and see if thestock moves back above the 200-SMA before entering either side of thetrade. Common sense tells us that regardless of statistics, the 200-SMA—that is hypothetically just above our imaginary stock—will pose substantial resistance. Thus, why take the chance on having one side of our tradefail? However, if we are aware of this commonsense scenario, and thenwait for the stock to ascend above the moving average, we are much saferin the long run in both directional and pairs trading. So how do you put thisinto practice? Imagine that you are about to enter a pair that has beenexpanding for some time. The pair is close to three standard deviations,and the density curve is nearing a historical outlier. You are prepared totake the position, when you suddenly notice that the long side of yourtrade has a 200-SMA a half point above where you are thinking about entering the trade. The commonsense solution is to simply wait until the longside of the trade ascends above the moving average and builds a base. Youmay lose a little of your potential profit in doing so, but your risk has beenminimized substantially. Think about it, taking the position ahead of the200-SMA is similar to trying to speed across train tracks ahead of anoncoming locomotive. While you may make it, overall, you’re taking a verystupid chance. Why not play it safe and let the train go by? And that wouldbe the same for waiting for a major moving average to be on the correctside of your trade before taking a position. This is technical common sensewhen pairs trading.
Stochastics and Other IndicatorsOther indicators like stochastics and moving average convergence divergence (MACD) are hardly ever reliable as a leading indicator for a position.They can be, however, a good confirmation tool when taking a directionalposition. In pairs, they can also help us decide whether the pair has room toopen up more or whether it will begin to reconverge. Let’s look at a fewstocks, just to see how this could be used in our pairs strategy.
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FIGURE 27.1 Microsoft
Figure 27.1 depicts Microsoft over 2003. As you can see, we have addeda MACD and a slow stochastic. While we would never use either of theseindicators to actually implement a position, we can use them as a confirmation of momentum within a stock. If you look at line 1, you will see thatit coordinates with the MACD in the lower indicator window. When theMACD crosses above the 0 line, the stock clearly has more room to run up.If we were considering shorting the stock as a pair, this would clearly be thewrong time. However, if the statistics prompted us to buy Microsoft, thenthis would be a good time to do so. What’s more, if you look at the stochastics at this time, they are clearly headed higher, while traveling in theupper portion of the indicator’s range. This also would lead us to believethat the stock has more upside room left. Again, we would not use theMACD or the slow stochastic as an indicator to institute a position, butwould look at it as a possible confirmation to the signal the descriptive statistics are giving us.
VolumeVolume is one of the most important indicators of a stock’s direction. Sohow can we use volume as an indicator for entry into a pair? We will look
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for volume moves before entering a pair, and as a guide for further expansion or contraction. Looking at the following picture of ExxonMobil, wecan see that volume gave us some pretty interesting ideas as to the direction of the stock. First, the volume spike labeled #1, came as the stockwas in the middle of a pullback. Increased volume was a looking glass intoinstitutional order flow, and indicated that many holders of the stockwanted out. If we were given a statistical signal to enter the stock long onthis particular day, the increased volume would have been an indicator tostay out of the trade until further expansion occurred. Though the volumedump rebounded slightly in the following two days, overall, it was an indication that many traders wanted out of the stock, at least short-term. Conversely, if the descriptive statistics gave us a signal to sell ExxonMobilshort, while taking a long position in another stock, we would have definitely been on the right side of the trade. If we actually look into the newsof the stock on that particular day, I’m sure we would find some sort ofevent that triggered the sell-off. However, one thing that technical analysis does for us is to allow us to “infer” that something has transpired without actually having to sift through the news. As diligent traders, we woulddefinitely want to find out what that event was; however, for the sake ofexample, it is enough for us to know that whatever instigated the sell-off,was enough to increase volume above the average daily volume. Thismere inference is enough for us to assume that more selling will ensue.Further looking at the chart, we clearly see that our volume-driveninstincts were right on, as the stock continued to decline several points inthe following days. Though much of this seems like commonsense knowledge, many traders make the mistake of overlooking such obvious indicators of a stock’s near-term direction.Line 2 shows the exact same thing. The stock witnessed above average volume on an ascending day, when the stock was clearly in theprocess of a reversal. The increased volume indicated that the stock hadmany buyers trying to get in, potentially after whatever news drove thestock down in the first place dwindled. Many traders use volume as anindication of capitulation, when picking either a top or a bottom. Whilethis is true in some cases, it can be a horrible mistake to always assumethat increased volume indicates a reversal. As Figure 27.2 proves,increased volume in the middle of a move actually signifies that the sparkhas generated interest and is in the process of a continuation pattern inwhatever the current trend may be. Never rule volume out, as it is one ofthe most important factors of investing. Volume is the empirical backingof a stock’s direction.
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FIGURE 27.2 Increased Volume
FUNDAMENTALSWe have already covered what fundamentals are; now we will directly seehow we can use them to further validate or negate our statistical signals.The fundamentals we will be using are a little looser than technical analysis, as fundamentals can always become overextended. However, it isimportant to remember that institutional money always looks at fundamentals and can easily begin unloading positions when a stock becomesovervalued. In essence (other than news), fundamentals are the catalystthat controls the cyclical buying and selling of stocks. We will not dive intocomplex math here; instead, we will attempt to find a few mainstream numbers that you can use to find a “rough” benchmark for your individualstock’s valuation.
Price-to-Earnings (PE) RatioAs we all know, PE can be a good sign of investor dedication to a stock.However, it is important to remember that PE is generally thrown out thewindow when it comes to high-flying technology stocks like eBay and Amazon.com. These stocks trade at incredibly high multiples in relation to earnings and, thus, do not give us an accurate picture of valuation when observed
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in terms of PE. Some technology stocks don’t even have PEs, as they have noearnings. Let’s examine a few stocks just for the sake of argument.When finding a stock’s PE in relation to the historical average, Smartmoney.com has a great tool under the “Key Ratios” tab, once a stock isselected. We will look at Intel, to start our brief analysis. We can see inFigure 27.3 that Intel is currently trading with a PE of 48.70. While this ishigh for most standards, it is also far below the five-year high of 203.10. Theindustry average is 148.80. So what is our conclusion here? First, the stockis trading with a high PE in relation to traditional fundamental valuation.However, it is not completely exuberant given that the historical high andindustry average are far above the current number. While I would personallybe skeptical about taking a huge long-term position in the stock, it would notbe completely out of reason to take a short-term pairs position, as the PE isnot overextended. Let’s look at another example.
FIGURE 27.3 Intel
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Looking at Figure 27.4, we can see quite a different story for ExxonMobil than that of Intel. First, the historical PE range is substantially lower forthe oil stock than for the chip maker. The five-year low for ExxonMobil is13.70, while the high was 38.60. The stock is currently trading with a PE of14.80, which is definitely on the low end of the historical range. At the timethat this was written, oil was trading at close to $33 a barrel, a very highprice for crude by any measure. However, the elevated price of oil alsomeans that companies like ExxonMobil will report great earnings, at leastfor the current quarter. Given this knowledge, we would infer that ExxonMobil has upside room left in the stock. Thus, if our descriptive statisticsgave us a buy signal on ExxonMobil and a sell short signal on another oilstock, on a fundamental PE basis, we would not have to be extremely worried about taking the long side of the trade. Of course, there are many otherfactors to consider, and we never take a position based purely on PE. But,at least in this scenario, the PE would give us some positive confirmation
FIGURE 27.4 ExxonMobil Corp.
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to possibly institute the pairs trade, knowing that the fundamental PE forthe long side is in our favor.
Price-to-Sales RatioAnother important tool of five-minute fundamental valuation is the price-tosales ratio. This number gives us some indication as to where a stock is trading in relation to revenue. The higher the value, the worse off a company is. Ina nutshell, any number above 3.0 is very bad. Thus, if our statistics give us asell short signal on a stock and it is trading at 6.0 times sales, we can feel fairlycomfortable that some institutional money may be thinking that the stock isovervalued as well. While the price-to-sales number varies from sector to sector, we can be assured that we simply want the lowest number possible.We will use Qualcomm as our example of price to sales. Figure 27.5shows that the stock is presently trading at 11.98 times sales. Even though
FIGURE 27.5 Qualcomm
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the five-year high for the price-to-sales ratio is 46.73, 11.98 is very high. Asa fundamental trader, I would not touch this stock on the long side with a10-foot pole. The problem is that while trading at almost 12 times sales, therisk to reward is not in our favor. Using some of our previous knowledge,the PE is at 58.90. While this is a far cry from the high of 235.30, it is stillexorbitantly high for any stock, even if it is in the technology sector. Thus,if our statistics gave us a buy signal for a pair between Qualcomm andanother wireless stock, there better be a pretty darn good reason to takethe position. Otherwise, I would let this opportunity go by, as missed moneyis better than lost money.
KBH HOMES AND TOL BROTHERSNow that we have covered a few basics, let’s put it into practice. We will useTol Brothers Inc. and KBH Homes as an example. (That’s Tol Brothers thehome builder, by the way—not the cookies.) If we look at our descriptivestatistics page, we see that the pair is trading just over ⫺1 standard deviation from the mean. This would indicate that we would be thinking aboutbuying Tol Brothers, while selling short KBH Homes. Keep in mind that asthe pair is only trading just below ⫺1 standard deviation, we would notactually consider the pair for convergence but, instead, for continued divergence. The pair is currently at ⫺27.79, while one standard deviation is at⫺25.34. Looking through the pair data, we can see that the pair has recentlytraded as low as ⫺39.66 on June 17, 2003 (Please reference the spreadsheetlocated on the CD-ROM.) And ⫺39 is just one point from the second standard deviation of ⫺40.88, which would have been a risky, but potentiallygood place to insititute a convergence trade. However, now that the pairhas collapsed, we want to see if there will be any more divergence opportunities. We will start with technical analysis, and then look into eachstock’s fundamentals. (See Figure 27.6.)As Figure 27.7 displays on KBH Homes, the stock has recently fallen outof bed, marked by a large-volume day—above the average daily volume. Tome, this indicates that many larger players decided to exit the stock. It hassince been building a base and is trying to hang in there. However, daily stochastics have since bounced and could now easily turn down for another legsouth. The MACD has recently crossed beneath the 0 line and could (as historically shown) fall further negative should the stock break horizontal support. Thus, given that the statistics are indicating that we may want to sellshort KBH Homes, the technical analysis side of the trade is confirming that
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FIGURE 27.6 Tol Brothers
FIGURE 27.7 KBH Homes
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there may be more downside left. What’s the one thing we have going againstus? The most important thing of all. Taking a short position in this tradewould clearly be trading against the ascending trend. However, sometimesthat’s what pairs trading is all about.Now, looking at the next chart of Tol Brothers in Figure 27.8, we see something else happening. First, the stock has sold off some, but has also built abase after the stock touched ascending support. In addition, the volume spikedown day had a large recovery and did not close near the low of the day. Thismeans that even though many players sold the stock that day, there were alsomany investors waiting on the sidelines to take on new positions. This was agood sign for bulls and shows how volume can show different things on different stocks. If the volume down day had closed near the low of the day, wewould have inferred that buyers were nowhere to be seen. Therefore, taking along position in Tol Brothers would have been much more risky.On the same chart, we also see that the MACD fell much lower thanthat of KBH Homes and could now rebound more easily. This signal coupled with the daily stochastics, which are traveling the upper portion of theindicator window, would lead us to conclude that a short position wouldbe much more risky. As the statistics are indicating, a long position wouldnot be that bad of a decision, as long as a tight stop was instituted justbelow horizontal support, shown on the chart. Our conclusion thus far is
FIGURE 27.8 Tol Brothers
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that though both stocks have recently pulled back, Tol Brothers looks likea better long than KBH Homes, which would bode well for convergencetraders. However, there is considerable risk, and neither stock looks thatenticing.Moving to fundamentals, we see a different picture. KBH Homes is trading with a PE of 7.90, which is about in the middle of its historical five-yearrange. However, the stock is trading at 0.55 times sales, which is very closeto the five-year high of 0.58. Immediately, this is a red flag to us that the stockis getting overvalued in relation to historical revenue, and, thus, we wouldinfer that the descriptive statistics that are indicating a short position is rightafter all. And, if you remember earlier, the stock didn’t look all that attractive on the long side anyway. (See Figure 27.9.)Figure 27.10 displays the fundamentals for Tol Brothers. And here iswhere we see some very interesting things. First, the stock is trading with aPE of 11.10 and has a historical high of 11.00. Wow, is this another red flag orwhat? Technical analysis told us that the stock didn’t look all that bad on thelong side. However, the fundamental picture is much more dim. How can wejustify buying a stock that is trading very close to its historical high in relation
FIGURE 27.9 KBH Homes
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FIGURE 27.10 Tol Brothers
to earnings? If we take our research one step further, we will see that thestock is trading at 1.01 times sales, and has a five-year high of 1.00. Again, thisis another huge warning beacon in the night. Clearly, the fundamental pictureis telling us something completely different than the technical picture, andthe aforementioned data indicates that the statistics may be misleading.So what is our conclusion about this pair? First and foremost, both areoverbought on the two fundamental indicators that we have examined. Andeven though the technical charts indicate that the statistics might be right,both stocks are set up to fall in the near future. One factor that we have notconsidered is interest rates, which are at 45-year lows at the time this waswritten. Historically, one of the last sectors to correct after a recession is residential real estate, which coincides with our thoughts that the endless runfor homebuilders may be ending.The most important thing to remember, though, is that all of the data ismixed, which is clearly not what we want when instituting a pairs trade. Wewant to see that the stock we are shorting is overbought on a technical and
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fundamental basis, while the stock we are buying is oversold—or, at least,undervalued.If I had to guess, I would assume that if the pair reconverges, it will bemostly from KBH Homes falling more than Tol Brothers. However, bothstocks are set up to decline in the future. While I know this goes against thecurrent trend, it is common sense that the price charts are weakening, andthe simple fundamentals are overbought.I would like to point out that we have only covered a few technical andfundamental factors in relation to the pair. Thus, you need to make sure youalso look at things like trend lines, support and resistance, price to book,PEG ratios, cash, price to cash flow, and forward PE.It is vitally important to understand why a stock is doing what it is doing,before blindly trusting the statistics at hand. This is incredibly important, astrading purely off of statistics would be similar to never checking your oiland only depending on the gauges on your dashboard. The gauges can gobad, and are not errorproof; thus, you have to get under the hood and occasionally check for yourself.
MOVING AVERAGES AND SUPPORTAND RESISTANCE AS STOPSLast but certainly not least, I would like to talk about the importance of support and resistance and trend lines as stop loss points for your statisticaltrades. This is very simple, but so vitally important. Statistics can always goagainst us, and thus it is critical that you have concise stop loss points foreach side of your position. If one side breaks down, close the entire position.It’s as simple as that. Moving averages and trend lines are major benchmarksof technical trading. Usually, when one or the other is broken, it signifiesthat some sort of news-related or fundamental event has occurred that iscausing a paradigm shift in the stock. Simply put, if a major moving averageor trend line is broken, something big is happening. Thus, in our pair, we canuse moving averages and trend lines to assist us in making stop loss decisions. Let’s go through a few examples.Figure 27.11 displays eBay and the trading action over the last year whenthis was written. You can clearly see that the 200-SMA would have served asa significant stop loss point had we been long the stock in November. Thestock was sitting just above $50, which was also major horizontal support atthat time. If we were in a pairs trade and the stock had broken down—andwe were long eBay—we would have wanted to close the entire position.
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FIGURE 27.11 eBay
FIGURE 27.12 Marsh McLennan
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However, when the stock sold off, it did not break either the 200-SMA or horizontal support. Clearly, we would have had a great stop loss point on thetrade by using a breach of $50 as our exit signal.Figure 27.12 is a chart of Marsh McLennan, which declined after theinternational mutual fund timing scandal hit close to home with the company’s subsidiary Putnam Funds. The chart shows us that the stock had significant support of the 200-SMA and horizontal support just above $47. Whennews of the mutual fund scandals broke, the stock began to dump. If we hada stop just below the 200-SMA and a horizontal support at roughly $46.99, wewould have saved ourselves much pain as the stock sold off. Though thestock eventually recovered, the chart shows that it was still trading belowthe 200-SMA at the time this was published. As this was a huge warningsign—I would have not wanted to be long this stock.Overall, using moving averages and trend lines is an extremely simpleconcept, but should be readily used when trading pairs. After all, statisticsare not always correct, and thus, we must make sure that each trade hassome sort of stop outside of just standard deviations. I hope that this chapter has been helpful, and I would like to reiterate that though the conceptsare very simple, they are extremely important. This is common sense, whichis the most important factor of trading.
CHAPTER 28
Assorted Adviceto AssistTrading
his is the last moment where I can tell you about some of my experiences trading pairs and what I have learned. First and foremost, neverunlock a pair and close one side of the position, just because it ismaking more money than the other. There will be certain circumstanceswhere you will want to maybe trim both sides or unlock a portion of one sideif you have a plan. However, to just unlock a side merely to book profit is abad, bad idea. Why? Simply put, if anything can go wrong, it always will. Andif you unlock the winning side, the losing side will most likely move againstyou—at lease according to Murphy’s Law. Thus, remember that if you aregoing to shuffle around your position, always have some sort of plan that justifies your actions, and even more importantly, have a predetermined stoploss to close the trade should it move against you.• When trading intraday pairs, it is a good idea to generally take a breakduring earnings season. Why? From my experience, intraday pairs that aremoving because of earnings-related news can very often close at the high ofthe day. This is because the outstanding earnings news has triggered a surgeof order flow, wherein large funds are trying to get either in or out of a trade.Thus, during earnings season, there can actually be more opportunity trading divergence pairs than convergence. The best rule of thumb here, though,is: When in doubt, stay out.• Always update your data once you are in a pair. While this seems likecommon sense, it’s easy to get lazy and not update your data on a day-today basis. If you do not update the data, you will not be able to see theactual statistical numbers moving. And we have to remember that thesenumbers fluctuate on a daily basis—they never remain the same.
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• As a trading idea, I have seen intraday traders trade mergers on a sortof pseudo risk arbitrage basis. What they do is find a pair of stocks that aremerging. Usually, a merger pair is has a predetermined price at which bothstocks have to close. Thus, intraday traders will set up a histogram that is aratio or a differential of the two stocks. The histogram can be anywherefrom 5 to 10 days, and gives visual representation of the pair’s intraday trading range. Then, the trader will simply wait until the pair trades near one endor the other and then scalp the intraday trade for a few pennies or a dime.Does it work? In my opinion, not really. The problem is that the massiveamounts of commissions on an intraday basis can put a serious dent in anyprofits. It is also my opinion that the institutional guys trading the stocks liketo ramp them out of whack once in a while, just to railroad any day traderstrying to actually trade the merger. Thus, my advice is set up a histogram oftwo stocks and watch the merger trade, but do not actually trade it yourselfunless you really know what you are doing. After all, they’re pros who havethe single job of trading mergers, and if you are trying to compete with a fewthousand dollars, well, the house usually wins.• As another trading idea, I have also watched traders set up percentagegraphs (you could say volatility) of three or more stocks benchmarkedagainst an index. The idea is to wait for two- to three-day divergences of thestocks against the index, and then attempt to implement convergence swingtrade or day trade positions. The idea is that on a percentage basis, stocksgenerally revert to the mean for the index they follow. As a good example ofthis, a trader would look at an index like the XOI.X, which is the AMEX OilIndex. Then, knowing that the stocks must trade relative to the index on apercentage basis, the trader will wait for individual stocks to move away fromthe index. Once the stocks have diverged (above the mean), the trader willshort those farthest out, while buying those nearest to the index. This is actually an effective strategy and can provide hedging ideas for naked positions.The faster the stocks, the tougher they are to trade. By this I mean thattrading fast moving technology stocks can be more dangerous than tradingslower utility stocks. Of course, there is always an exception to the rule.However, sometimes trading less sexy stocks like oil or truckers can providebetter results than trading high flyers.• My entire point here is: Don’t rule out slower-moving stocks, as theymay actually provide more opportunity than technology or Internet stocks.If you are looking for stocks that will reconverge, remember that the correlation is the key. The stronger the correlation, the greater the chance thatthe two stocks will come back together. However, it is also important toremember that a strong correlation doesn’t always mean the stocks have to
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come back together. Thus, never bank your account on the correlationalone. If the trade is opening up and moves past the third standard deviation,it may be a good idea to consider exiting your position.• If you are in a swing-trading pair during earnings or warnings season,and one of your stocks warns or reports poorly in a direction that goesagainst your pair, close the entire position. This is important, as sometimeswhen in a pair, we can fool ourselves into thinking that because the positionis a hedge, we will not lose money. However, this is wrong. If one half of thepair is working against you because of earnings-related news, you will mostlikely end up with a huge loser, as institutional money rotates in and out ofthe stocks. If you find yourself ever hoping a trade will come back, close it.• Stay away from biotech stocks. This is my own personal opinion, butone that I find to be very accurate for the average trader. The problem withbiotech stocks is that they are very dependant on Food and Drug Administration (FDA) approvals, clinical trials, research, and many other loosefacets of drug research and manufacturing. Simply put, there is too much tobe quantified, unless you have additional countless hours to do the properresearch to understand what each company has in the works and where revenue will come from. All I am saying is that biotech companies can havehuge surprises, like FDA approvals, which can pound a portfolio should yoube on the wrong side of the trade. Thus, if you are willing to do the researchto uncover each biotech company’s entire repertoire of potential drugs, fine.If you’re not, then, as mentioned earlier, slower-moving stocks with transparent business plans may be better to trade.• Lastly, always put on the short side of the pair first! This is very important to remember, as you will find with some stocks you may not be able toget any shares short, or you may not be able to get an up tick to get into theshort side. Please remember that it is vitally important to always make sureyou first have the short side secured before entering your long order. I generally wait until I know that I actually have the short position, before evensending out the buy order. This is because sending both orders out at thesame time can sometimes result in getting filled on the long side, then having your short order rejected for whatever reason.
CHAPTER 29
The MonitorSheet
ne of the last steps in our book is to use the spreadsheet that monitors many pairs at one time. The spreadsheet can be used as eitheran end-of-day tracking system or can also monitor pairs in realtime if you use a quote vendor that interfaces with Excel. For the mostpart, Excel will pull in quotes from just about any vendor and can be a useful tool in monitoring intraday pairs. The one drawback is that the quotesare not recorded, and thus drop off moment by moment. Imagine a hollowpipe you are pushing dirt through. As soon as you push dirt in one end, itfalls out of the other, and is only in the pipe so long as more dirt is notpushed in. I know this is a rough analogy, but it’s exactly how Excel react