Pair Trade: The Medical Equipment Industry

A very effective strategy for trading in these volatile markets where oversold indicators are at extremes is pair trading. Using a combination of fundamental and technical strategies, you select the strongest and the weakest names in a very specific industry and go long the strong name and short the weak name in equal dollar amounts.  Pair trading can be simple in concept, but can be one of the most complex types of trading in practice.

The strategy effectively captures the spread between the over-performer and under-performer without the need for a directional view on where the markets are heading. This simple hedge against the market captures the relative strength and in volatile markets is even more effective because the magnitudes of the moves and divergence from a correlated move are at extremes.

Fundamentally, we will look for divergences among various valuation metrics and despite overall market movements, the stronger name justifies a higher trading multiple than the weaker name, and is expected to outperform in the long run. Also, we will observe fundamental anomalies among the stocks in each industry group compared to the group itself that would suggest a move away from the mean reversion level.

On a technical basis we will use very simple support and resistance levels to determine stocks with the biggest upside/downside potential on a volatile industry moves. This will allow us to capture the maximum differential return.

We have selected 34 well-defined industries where we will highlight what we feel is the strongest name in the industry, and the weakest name in the industry. Simply by going long the strongest name and short the weakest name, traders can capture the differential of returns no matter which direction the market heads from here.

Although the equity long-short trade is effective, using options is a way to use leverage to augment returns. Using single options is one strategy, buying a call on the strong name and a put on the weak name, but you are battling time decay and potential drops in volatility (Vega) that cuts into profits.

Vertical option spreads are the safest and best way for pairs trading, and under the right circumstance you can find long and short verticals in two stocks that generate a small credit while keeping yourself hedged with smaller exposure to gamma, theta, and vega. It is important to put the same dollar amount into each leg of the trade, such as buying two $2 verticals and selling one $4 vertical. This strategy is more complex and takes practice to build to proper execution skills, but can lead to consistent long-term positive returns.

For further details on the art of pair trading please consult “The Handbook of Pairs Trading: Strategies Using Equities, Options, & Futures,” by Douglas Ehrman.

As for the trades that look the best among the industry groups, we will begin with the following industry:

Industry: Medical Equipment

Long: Mine Safety Appliances (MSA), $23.91: Mine Safety shares are extremely oversold and are now sitting right near support from early 2004 at $22.75. With a PEG of 1.06, a forward PE of 10.67, and reasonable debt levels; MSA looks stronger than many of the stocks in this industry. 

Trading at a discount to its industry, yielding a dividend of 4.02%, and trading at only 0.78x sales it is easy to see how much stronger this company is than Wright Medical (WMGI), which looks to be a laggard. Insiders also feel that Mine Safety is cheap, as we have seen multiple buys the past few months. With MSA down 45.68% on the year, we expect it to outperform much of the industry, but relative to WMGI, it should outperform substantially.

Short: Wright Medical Group (WMGI), $20.29: Wright trades at a forward P/E of 23.6, which far exceeds the Industry average of 15. Shares currently trade at 1.87x book value, which is a premium for a company that has shrinking margins and slowing growth. 12.43% of the float is short, and operating margins are approaching 0 (currently at 1.16%). 

For the year, Wright is down 27%, compared to the industry being down 42.24%. Shares have some support at $18, but have limited upside with $22.50 serving as resistance. At current prices, Wright has an EV/EBITDA ratio of 13.94, which is a 40% premium to the industry average.

“Fight Card”

The Trade

MSA: Long 1 March ’09 $25/$30 vertical call spread for $1.50

WMGI: Short 2 February ’09 $22.50/$25 vertical call spreads for $0.75 each

Disclosure: none

Comments

[trader717:]

Hey Joe. I go to Bentley now and noticed your background. It's interesting you study technicals and fundamentals as do I. I am looking into pairs trading as well, as eliminating that market risk at this point seems most logical. Is there an email address I can reach you at?

2008 Nov 09 08:14 PM