A Gasoline-Real Estate Pairs Trade for the Summer

I enjoy formulating strategies. I realized this while researching this article. I find it interesting how, to me, a strategy is first only a hint, more of a suspicion than a certainty, a feeling that the market is vulnerable. For me, fleshing out an idea requires a quiet mind and a bit of time to allow the pieces to show themselves. But my point is that the stock market is one of these chaotic systems formed of many tiny pieces. Staring at it in one's mind's eye is an exercise in letting your brain deliver a pattern, in this case, a strategy. This can be meditative. It can be fun. It can be profitable.

Today I am describing a pairs trade. Pairs trades are plays in which you go long one stock and go short another, in the hope that the combined risk will be less than the risk of doing the two trades separately and at different times. Normally the risk you wish to avoid is an unwelcome movement of the stock market as a whole. For instance, you think stock L is likely to go up. You would like to buy it. But if you do, the market might go down, and take L down with it, despite L being a good stock. So trading L alone has market risk.

Now, say there is a stock S which you think will go down. Like L, it has market risk too - if you go short S and the market goes up, you lose. You would like to do both these trades, but you see that if you do the long L your money will experience the first risk, and when that trade is over, you can do the S trade, and you will experience the second risk too. Your money was exposed to two risks, one after the other. The brilliant idea behind a pairs trade is that if you do both trades at once, the two risks are the same but opposite in effect and therefore the risk is canceled or reduced. By doing both trades at the same time, you will experience reduced risk overall. This is because the market would have to go down to hurt your L trade, but it would have to go up to hurt your S trade. The market cannot go up and down at the same moment. Therefore, risk is reduced. Got it?

There is also a risk reduction due to diversification - instead of putting all your money into L or S, it is split between them, therefore diversification is also working to reduce risk.

A traditional pairs trade involves figuring the value of the variable "beta" for the stocks being traded. Beta is the ratio of correlated movement in the stock to movement in the market as a whole. I don't want to get into a detailed explanation of beta here - there are many places on the web where you can read a more academic explanation of beta. Suffice it to say, that when trading two stocks L and S, risk is minimized when the ratio of dollars invested L/S equals the reverse ratio of the betas, BetaS/BetaL. If you are trading like this, you are acting a lot like a hedge fund.

However, I personally don't feel that beta as published on the web is that useful. Beta changes, from month to month. Unless you are pairing an extreme mover like a casino stock with a flatline stock like a utility, beta values which are long term averages have got to be relatively inaccurate. Not only that, the two stocks I am looking at seem to be relatively independent of beta in the conventional sense, at least in the recent term. Without strong market or sector correlation, a pairs trade is less dependant on beta.

Now the stocks. The first, the "L" stock, is United States Gasoline, UGA. Gasoline in the US normally increases in price for the summer, due to vacation driving. But this year we also have the re-inflation effect which causes oil to go up, combined with the weakening dollar, which causes oil to go up also. UGA is a fund which trades front month contracts, and it has recently moved from contango to backwardation - meaning that current stock has gone from being cheaper to more expensive than stock in the pipeline. UGA may be in for quite an increase in the coming month.

The second stock, the "S" stock, is commercial real estate. This week, the REIT GGP finally gave up and filed for bankruptcy. Wall Street prognosticators have been predicting that the REIT sector was in for a severe second round of shakeouts this summer, and the failure of GGP gives the appearance of it being true. I use a personal bellweather, Urstadt-Biddle Properties, UBA, as an indicator because it is one of the most favored and solid of the REITS, but even its behavior lately shows considerable weakness. I feel that the market is coming to accept that there will be more failures.

The diagram shows proportional behavior of UGA, SPY, and URE. Note the change in each at about the beginning of May. URE began a bouncy downtrend averaging about 4% down per week. UGA began a smoother uptrend of about 8% per week. SPY is moving approximately sideways.

Taking on the trade simply involves buying UGA and shorting URE. Instead of trying to strictly abide by a ratio of implied beta values, I suggest simply dividing the stakes to be used into two and using each half for each stock. Also note, that instead of shorting URE, you can instead go long SRS which is the inverse ETF. And of course, you can use options instead of actual equity, making adjustments to allow for the placement of the strike prices. If you are trading options, I will leave those calculations to you. Note that even if we are not dependent on market beta in this trade, this can still be called a pairs trade, because the correlated element is the economy as a whole, not the market.

As the chart shows, there is an unbalanced market component in URE. Shorting URE means shorting the market as a whole, to some extent. A more exacting trade would be to make a pairs trade of short URE and long SPY, so that the market component was reduced. This would make the overall play a threesome. If this appeals to you, you will need to do some graphical analysis to determine the short term beta for URE, and that will take a bit of judgement. Beta for SPY is 1, of course.

I have in mind holding this trade for a fair amount of time, perhaps a month or more. If needed you can sell out and reinstate the trade later, if the market moves in an extreme way. Or, if URE becomes too volatile, you can abandon it and just keep the long UGA.

Though I talk about reduced risk in this article, this remains a risky and speculative idea. If you make this trade, you must watch it carefully and be ready on short notice to declare the trade over. Don't attempt this unless you understand why it might win and why it might fail. It is by no means certain that the pair trade will reduce risk of doing these two trades separately. If you do try it, please let me know if it worked for you, and if you modified it, or improved on it. Keep positive by making a mental image of Americans getting in their cars and driving this summer to browse all those going-out-of-business sales in the big empty REIT-owned shopping malls. Good luck!

Comments

[ECONOMICS 101:]

Vittorio Vic De Zen previously of Royal Group Technologies says Yikes, this is a complicated trade.
He will stick to what he knows and I will do the same.
"Do what you know and know what you do"!!!
By Johnathan Vrozos
johnathanvrozos.com
johnathanvrozos.ca

May 25 08:22 AM

[JerryV:]

It makes sense that URE is more bouncy, since this is an Ultra (2X) ETF. Since this can whip all over the place, it may be safer or at least more controlled to use IYR for the short side of the pair. In any case, gasoline and real estate is an interesting pair.

May 25 02:56 PM