Posted on Thursday, June 9th, 2011 at 2:39 am.

In the current market environment, traders need as many tools as possible in order to profit from ever changing market conditions. So far, we have seen tight ranges on most stocks. While this may seem difficult to profit from, there are many market neutral strategies that can be used. Many times, traders get intimidated by the term market neutral because it means we are getting away from the buy and hold strategies that we all are used to.

One strategy that can be very beneficial in today’s markets is the use of pairs trading. Pairs trading refers to taking opposite positions in two different stocks that have shown to have correlation. While this can be a complex strategy to use at times, the concept behind it is very basic. You want to find two stocks that are historically correlated and then profit from the times when this correlation temporarily breaks down. What you want to do in a pairs trade is look for situations where one of the stocks looks cheap or expensive relative to the other. We would buy the one that looks cheap and sell the one that looks expensive.

The first thing you want to do is find an example of two stocks that are highly correlated. A good example of this would be Coca-Cola and Pepsi. Taking a look at the chart in Example 1 showing our two stocks, you can see that there is a correlation. Next, you will find the spread between the prices of the two stocks. To do this we will look at the price of one stock minus the other. We will want to look to see if that spread is historically high or low. To do this you will need to go back in time and find the mean of the spread between the two. In this example I found that the historical spread between the two falls in a range of $5 and $8 and the current spread is $3, which would be low. With the expectation that this spread will go back to its mean of $7, we would buy the cheap stock and sell the expensive stock at the same time. We would exit both positions once the spread got back to $7.

Let’s walk through the example with Coca-Cola and Pepsi in more detail. Going back to December of 2009, thecorrelation between these two stocks temporarily brokedown. Knowing that these two stocks have proven tobe correlated going back in time, I am going to try andprofit from this current break down. Taking a look backat the historical spread between the two stock prices, wesee a range of between $5 and $8. Back in the middle of December the spread narrowed to around $2 (12/19/09).With the expectation that the spread between the twostocks would go back to around $6, we would have boughtthe stock that looked cheaper (Pepsi) and sold the one thatlooked more expensive (Coca-Cola). Looking at the charton 12/18/09 in Example 2, you can see how the price ofPepsi retreated while Coca-Cola held up nicely. While the correlation seemed broken, we would expect it to correct atsome point. If our expectations proved correct, we would profit from Pepsi rising and Coca-Cola falling in price. Once the spread between the two stock prices got back to$7 we would close both positions. As you can see below, once the spread between the two corrected back towards its mean, the correlation between two resumed.

While this is a very basic example of a pairs trade, I hope you can see the potential in this strategy. We aren’t bettingon the direction of the overall market at all in this trade.We are looking at historical data and then placing a bet ontwo correlated products following their patterns of pricemovement. Our example looked at two different stocks. However, different ETF’s or index products make good candidates as well.

These setups don’t occur all that often, but when they do they provide a very low risk opportunity to book some profits. Forming a watch list of stocks that tend to show correlation is a great way to benefit from these situations.

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