$XLK Technology vs $XLF Financial Pairs trade reversal
One of the hidden strategies most people don’t talk about is “pairs trading”. Some people talk about it but still the concept is not done right. I learned this powerful strategy in the institutional world.
What is pairs trading? Pairs trading is a hedge based strategy. The goal is to trade one instrument and hedge with another instrument. For example, if you like to trade Apple stock, you buy that instrument. To hedge it, you should sell their major competitor. As long as you limit your risk and make sure you get a 3:1 ratio, you will make money. This strategy is executed every quarter so it starts to create a “residual” income every quarter.
The key is to make sure at least one of the instruments move in your direction. To do this, we use technical analysis to determine the following:
- Which/When instrument to buy
- Which/When instrument to sell
This month, $sector $ETF. They are the technology etf $XLK and the financial $XLF.
Here is the monthly chart of $XLK vs $XLF. From the chart, you can see that technology was leading the financials until late 2012. In July 2013, technology again started to led financial until the US elections. Starting in 2017, technology again took over and now we are a point of retesting the higher, the major resistance.
In all the bullish moves where technology has led financial, the move occurred slow compared to what has happened this year. This year move has occurred in a very short time. This increases the probabilities of a pull back once the major resistance is tested.
We have place an alert at the major resistance. Once price has gotten there and we see a confirmation on a lower time frame, we will look for a $pair trade to go long financials and short technology with options.
Last month update Pairs trade Update.
Last month, we did an article on $UNH vs $CI. Here is the article: https://www.ichimokutrade.com/c/us-stock/unh-vs-ci-pairs-trade-battle-who-is-winning/
Here is weekly chart of $UNH vs $CI. The red line represents the support that price need to hold in order for us to go long on $UNH and short on $CI with options. Initially, the support held and price got to resistance (black dotted line). However, price went back to the support and then broke it. Therefore, the bullish setup never really occurred.
Some people asked if we should look at going doing the reverse since price is going down. This would be a good idea but the problem is that price is going through the cloud for the bearish side. There are many supports due to the cloud so the probabilities are not good to think about an opposite trade.
In conclusion, we have to wait patiently for price to break the resistance to break the bottom part of the cloud before we can look for a pairs trade.
Below is the weekly chart for the $BA vs $LMT pairs trade. Two months ago, we spoke about going long $BA and shorting $LMT with options for a pairs trade. Here is the current chart:
Here is an example of one way to do an option strategy in pairs trade. In the example, we place two vertical spread trades. We did a bullish vertical spread trade on $BA. The risk graph is below. We risked $126/contract for a max reward of $374. This is a 3:1 reward/risk ratio for this spread.
Below is the risk graph for $LMT. We did a bearish vertical spread. The risk was $118/contract with a max reward of $382.00. This is a 3:1 reward/risk for the spread.
The goal for this strategy is to keep the same risk for both vertical spreads and have a potential 3:1 reward/risk on both individually. Right now, the $LMT is -113.05 and $BA is up +231.37.
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