Pairs trading explained and how to execute one with options

Pairs trading is a market-neutral trading strategy that involves simultaneously buying one asset, such as a stock, and selling another related asset. The idea is to take advantage of the relative price movements between two highly correlated assets, typically within the same sector or industry. These might be stocks, commodities, or even currencies. We will review a pairs trade candidate and how to execute it with options. The two assets are chosen because they usually move in tandem due to their relationship. For example, two companies in the same industry, perhaps competing with one another, like Ford and General Motors, may be highly correlated. The idea with pairs trading is that, from time to time or over time, there may be a divergence or spread in their prices. In pairs trading, a trader may bet that this divergence is temporary and that the prices will converge again; this is frequently a short-term bet based on correlations and price behavior. The famous hedge fund Renaissance Technologies, founded by mathematician Jim Simons, is known to exploit these types of divergences. Alternatively, another form of pairs trading takes a longer-term and more fundamental perspective. An investor may notice that one company within an industry is better positioned or better operated and, therefore, likely to outperform one of its peers. To take advantage of this, the investor may go long the anticipated winner while shorting the anticipated loser, potentially leading to significant long-term gains. Since you’re speculating on both the long (buying) and short (selling) sides, the strategy is not theoretically dependent on the broader market going up or down. Instead, it is taking a more targeted bet that may be more resistant to market volatility. Nike vs. Lululemon Well-known athletic apparel companies Nike (NKE) and Lululemon Athletica (LULU) aren’t direct competitors. Nike is best known for athletic footwear, apparel, and even equipment and has sponsored some of the most famous athletes on some of the world’s most prominent athletic stages, including, perhaps most famously, Michael Jordan, Tiger Woods, and Serena Williams. By contrast, Lululemon produces a narrower range of products, focusing on fitness pants, shorts, tops, and jackets for yoga, dance, running, and general fitness. While Lulu does sponsor some athletes in a variety of sports, including DK Metcalf of the Seattle Seahawks, NBA player Jordan Clarkson, and Tennis player Leylah Fernandez, these markets and sponsoring famous athletes are not quite the cornerstones of their sales and marketing approach that it is for Nike. In any case, both companies’ athleisure products also serve as everyday casual fashion apparel. Nike is a much larger company, but Lululemon has outperformed over the past five years from a growth and profit perspective. Revenues at Lulu have more than doubled over the past five years. Nike revenues have grown far more slowly. Earnings per share at LULU have tripled even as they stagnated at Nike. One area where Nike has grown relative to Lululemon is their valuation multiple. At current prices, investors are paying 20 times next year’s earnings estimates for Lululemon and nearly 30 times next year’s earnings estimates for Nike, even though Lululemon has been growing much faster. One interpretation is that investors believe Nike will regain its mojo and return to growth; however, this may not be achievable with the stretched consumer. Of course, that may explain why investors are not pricing Lulu in a way that suggests its growth will continue. The trade One way to bet on the valuation difference while muting the risks associated with athleisure and the stock market more broadly is by taking a long bet in Lulu hedged with a short bet in Nike. One could affect that trade with the stock or use options structures on both because this is a longer-term bet. When using options for these types of trades, it is critical to minimize “decay,” aka “theta.” This is because this is a trade that is expected to play out over time, and paying out large amounts of premium on both the long and the short bets may create a headwind that’s difficult to overcome. Offsetting in-the-money debit and credit spreads such as those below can create short-term equity-like exposure without significant decay, while capping the worst-case loss that an outright position in the underlying equity would exhibit – a risk-mitigation technique that can be particularly important on the short side. Long LULU : Buy LULU Dec. 20 $280 call Sell LULU Dec. 20 $330 call Short NKE : Sell NKE Dec. 20 $70 put Buy NKE Dec. 20 $85 put DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. 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