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Just look within the semiconductor industry at Advanced Micro Devices (AMD) and Intel (INTC).
AMD climbed 1,221.99%.
INTC, with dividends, returned 126.39%.
But there’s a problem.
Semiconductors notoriously hit boom and bust cycles. No matter which of these companies you own, those busts will drag down your returns.
That’s why you should consider pairs trading.
Investors can hedge sector or industry risk by buying one company and betting against another.
I know this probably sounds cumbersome and more work than it’s worth, but it’s relatively simple to understand and evaluate.
Today, I’m going to show you how.
Pairs Trade BasicsWith a pairs trade, you want to remove sector or industry risk. To do this, you buy one stock (go long) and sell another (go short).
Semiconductor companies are notorious for the oscillating boom and bust cycles with their inventory, which leads to periods of expanding and contracting margins. This leads to periods of expanding and contracting margins.
Since both AMD and INTC are prone to the swings in the sales prices of microchips, both stocks should rise and fall along with these cycles.
When the boom cycle hits, both stocks will rise. However, the price appreciation you make on AMD (going long) is offset by the losses you incur on INTC (going short).
Conversely, during a bust cycle, your losses in AMD are offset by the profit you make off price drops in INTC.
Over time, you expect that AMD will either appreciate more or drop less than INTC, creating a profit off of the difference in the performance between the two.
Take a look at the comparative performance of each stock over the last decade.
The blue line represents AMD’s percentage change starting from 2012, while the orange line represents the percentage change for INTC during that same time period.
Early on, INTC outperformed AMD.
That all changed in 2017 as AMD’s business took off while delays in product launches set INTC back multiple times.
At its peak, late in 2021, AMD outperformed INTC by more than 2,000%!
I want to look at that period in a bit more detail.
In this chart, the blue line represents the share price of AMD using the right axis, while the orange line represents INTC’s share price using the left axis.
Green two-way arrows highlight periods where both stocks rose or fell in tandem. Red two-way arrows point out divergences between the stocks’ price action.
While they both tended to rise and fall together, their start and end points were very different. In 2017, INTC traded around $37, while AMD traded at $15.
By the end of 2021, AMD traded at more than $160 per share, while INTC peaked at just over $68 per share.
This chart shows that though the cycles often impact the prices of both stocks in the same direction, AMD saw larger percentage gains overall.
Creating a pairs trade that buys AMD and sells INTC short reduces the volatility in your returns by limiting the impact of the industry cycles.
How to Create an Effective Pairs TradeThe most straightforward way to create a pairs trade is to buy one stock and short another.
However, most investors are leery of short-selling any stocks, and rightfully so.
Instead, I prefer to use options strategies.
For example, let’s say I wanted to create a pairs trade with INTC and AMD.
Right now, AMD trades around $97, and INTC trades around $47.
I could invest $4,700 in AMD to buy 48 shares of stock.
Then I could buy one deep-in-the-money put option for INTC, say at the $30 strike price, that expires in one year.
By going deep in the money, I ensure that the price of the option’s delta is as close to -1 as I can get.
Option Minute: The delta of an option tells you how much the price of the option will change for every $1 increase in the price of the underlying stock. Deep-in-the-money put options approach -1, while further-out-of-the-money put options approach 0. At-the-money put options, where the strike price equals the stock’s current price, have a delta of -0.5.
Since each option controls 100 shares of stock, and the stock currently trades at $47, I’m effectively betting against 100 x $47 = $4,700 worth of INTC stock to match my investment in AMD.
Why am I using the $47 as opposed to the $30 strike price for this calculation? Because the price of the option will already include the $47 – $30 = $17 of intrinsic value (the value of an option if I exercised it immediately).
Now, I can also use other options strategies such as credit spreads to try to earn income through this process.
Choosing the Right StocksYou can create pairs trades out of any two assets. However, there are a few guidelines to keep in mind:
- Pick stocks that have a common external (macro) influence that you want to remove.
- Consider the volatility of both stocks. You may need to compensate if one company’s stock doesn’t move around as much as the other. This is a key tool we incorporate into our TradeSmith Finance stock analysis.
- Make sure both stocks are liquid.
- Look for entry points when the weaker stock outperforms the stronger one for a period of several weeks.
- Try to avoid industries and sectors with parabolic trends, such as oil and gas.
Looking across the markets, where do you see a juicy pairs trade worth investigating?
Email me your ideas.
While I can’t answer your emails individually, I promise to read every one.