How to reduce risk and pump up profits with a pairs trading approach

by Ana Lopez

How we capitalized on the power of the POWR ratings with a powerful pairs trading philosophy on VAL and HP.

Alfred Winslow Jones is widely credited with creating the first hedge fund, or more accurately “hedged fund”, in the late 1940s. He is said to have come up with the idea while researching a market article for Fortune magazine.

The idea was quite simple: create a hedge, or pairs trade, by shorting stocks he thought would fall in value while buying stocks he thought would go higher. It is called a pairs trade because both the bullish and bearish trades are done simultaneously or linked together.

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

This essentially dampens overall market risk. Even better if the short and long stock are in the same industry to significantly reduce industry risk.

This is a core strategy that we’ve adopted from the very beginning in the POWR options portfolio, but with a few more advantageous features.

  • We use options, not stocks, to take the opposite short and long positions. Buying bearish incites the “bad” stocks and bullish incites the “good” stocks. This is a much cheaper way to create a hedged trade. It also has a certain risk.
  • The portfolio relies on the POWR ratings to help identify the highest-rated stocks to buy with bullish call buys and the lowest-rated stocks to short with bearish put buys. Since its inceptionthe Strong Buy (A Rated) and Buy Rated (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 4x the S&P 500.
  • Look for situations where the lower-rated stocks have temporarily outperformed the higher-rated stocks to get an extra head start on the expected mean reversion.

Let’s take a walk through a pairs trade that was recently executed in the POWR options portfolio to shed some light on the process. It was a combination of a put buy on lower-D-rated Valaris (VAL) and a call buy on higher-B-rated Helmerich & Payne (HP). Both stocks were in the power drilling industry.

The comparative chart below from Feb. 10 shows how lower-rated Valaris (VAL) dramatically outperformed higher-rated Helmerich & Payne (HP) over the past 12 months, by more than 50%, accounting for most of this outperformance. started in early December. Before then, you can see that the two stocks were more strongly correlated – or moved 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 combined payout of $1050.

A week later, convergence paid off. POWR Options sold the HP calls for $3.50 and the VAL puts it at $9.50 for a total combined credit of $1300, or a net profit of $250.

The total profit, as shown, was $250 total net profit on $1050 invested. This corresponds 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 higher-rated, but underperforming, Helmerich and a bearish put position on the lower-rated, but better-performing Valaris.

The details are shown below:

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

Investors and traders alike can do well to use the POWR Options trading philosophy as part of their trading toolbox. Lower risk with still significant potential returns is a viable strategy in any market, especially the one we are currently in.

POWR options

What to do now?

If you’re looking for the best options trading for the current 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 that appeals to you and you want to learn more about this powerful new options strategy, click below to access this current investment presentation now:

How to trade options with the POWR ratings

All the best!

Tim Biggam

Editor, POWR Options Newsletter

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

Table of Contents

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 Market Maker for First Options in Chicago. He makes regular appearances on Bloomberg TV and is a weekly contributor to the TD Ameritrade Network “Morning Trade Live”. His main passion is to make the complex world of options more understandable and therefore more useful for the everyday trader. Tim is the editor of the POWR options newsletter. Read more about Tim’s background, along with links to his most recent articles.


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