Pairs trading, once mainly a strategy for institutions, became possible for individuals with the advent of the Internet, thus giving all traders access to a wealth of real-time information and online brokerages.
It is a market-neutral strategy that takes advantage of a certain imbalance in the stocks, funds, bonds, commodities or currencies in focus. In other words, it does not depend on the broader market making a directional move.
Pairs trading involves a long position and a short position in a pair of highly correlated assets, and the strategy is thought to lower risk because it creates a natural hedge.
Traditionally, investors would look for two stocks in the same sector, preferably in the same subsector, that showed good positive correlation. Therefore, if the two stocks were to diverge, a pairs trader would buy the stock of the underperforming company and sell short the stock of the outperforming company. The trade would be profitable if the spread between the two stocks narrowed (that is, the stocks' prices again moved closer together). Looked at this way, pairs trades are simply market bets on a mean-reversion move.
Both companies operate in the same sector (energy), as well as in the same subsector (integrated oil companies). Not surprisingly, their stocks have historically moved in tandem. Looking at the weekly chart of XOM (blue) and CVX (red), we can see the positive historical correlation between the two.
However, since the beginning of October, XOM has rallied strongly while CVX has more or less remained flat, causing a major near-term divergence in the stock. While at some point the prices of these stocks will likely move closer together again, my bet for the coming weeks is that XOM will continue to outperform CVX.
The technical picture for XOM looks much better than that of CVX, as we will see in the charts below in a minute. Additionally, from a fundamental point of view, the recent surge in XOM was spurred last week by the announcement that Warren Buffett 's Berkshire Hathaway (NYSE: BRK-B) purchased 40.1 million shares of XOM, bringing its total stake to 1% of the company, valued at more than $3.7 billion.
This investment is Buffett's largest new holding since buying shares of IBM (NYSE: IBM) in 2011, and with this news, it is likely that other big money investors will view the company in a favorable light and consider buying the stock.
XOM is up more than 12% since early October, and it is currently trading just above a resistance area around the $95 mark, which dates back to late 2007. With momentum on its side, it now looks to be merely a matter of time until the stock definitively breaks past this multi-year resistance area.
On the daily chart below, XOM admittedly looks overbought in the immediate term, as the vertical slope is somewhat unsustainable. However, note that on Friday, XOM broke out of a multi-day consolidation phase, which is healthy from a technical perspective.
Moving on to CVX, the multi-year chart, while not as bullish as that of XOM, also doesn't look overly bearish, which confirms the long-term positive correlation between the two stocks. CVX is holding its 2009 uptrend quite well and is forming a bullish wedge of sorts. Upside momentum, as measured by the relative strength index (RSI), still has plenty to prove before becoming bullish.
Next, on the daily chart, CVX has a confluence resistance area made up of its 50-day, 100-day and 200-day simple moving averages (blue lines), as well as its 61.8% Fibonacci retracement of the swing from the September highs down to the early October lows.
For now, the bullish momentum from the Berkshire investment in XOM, as well as the bullish technical setup on its charts, looks to favor Exxon Mobil's continued outperformance of Chevron in coming weeks.
Action to Take -->
-- Buy XOM above $95 and sell an equal number of CVX shares short at $120.50 or higher (The current price spread at these levels is $25.50.)
-- Set stop-loss spread at $3.50 (This will be a mental stop in which if either position or the combination of the two shows a $3.50 loss, both trades should be closed.)
-- Set price target spread at $7.50 in four to 10 weeks (When either position or the combination of the two shows a profit of $7.50, both trades should be closed.)
This article was originally published on ProfitableTrading.com
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