Playing the Long Apple / Short XLK Hedged Pair Trade

 |  Includes: AAPL, XLK
by: Shiraz Lakhi

One of the core trading strategies I regularly bring into play starts by focusing on a watch list of around 40-50 stocks, which are both fundamentally strong (businesses exhibiting dynamic management, continual innovation, solid growth prospects, a low price-to-cash-flow-ratio (P/FCF), plus strong institutional/insider - smart-money - buying), and within a long-term, rising price-trend "relative" to the overall industry sector.

In order to check the trend (relative to market sector), for each of the stocks on my watch list, I continually keep track of what is known as the stock/ETF "ratio" chart.
AAPL XLK Ratio Chart With Equilibrium Overlay

The ratio chart plots the daily stock price divided by the sector ETF price. A continually rising ratio chart (as shown in the AAPL/XLK example above) instantly indicates that the stock has proven to consistently "outperform" its sector. A continually declining ratio chart indicates that the stock has proven to consistently "underperform" its market sector.

AAPL fits well within a fundamentally positive criteria - on a consistent basis - appearing within my radar screen to go long AAPL/short XLK each time AAPL corrects to a certain point relative to the sector, within the ratio chart.

A few pointers on what I look for in a fundamentally robust stock, taking AAPL as a near-perfect example (in my opinion, undervalued).

With a price-to-earnings-growth (PEG) ratio of just 0.78, a price-to-free-cash-flow (P/FCF) ratio of 13.74 (over 7% of the overall valuation of the company comprises of free cash flow), an ultra-low - virtually nil - debt-to-equity ratio, over 70% of the outstanding shares institutionally owned, with virtually zero outflows, and an analyst mean target price of $450 a share, puts AAPL firmly within my watch list to check against the sector ETF (the AAPL/XLK ratio chart).

As can be seen in the above example, which shows the ratio chart for AAPL/XLK (Apple vs. the overall technology sector), you can see two indicators which I have plotted, on to the ratio chart.

The first indicator is the long term, triple-equilibrium trend line (in blue). The second, a simple 14 day moving average of the ratio (in red).

By applying the two indicators, I can determine to what degree the stock (NASDAQ:AAPL) is overvalued or undervalued relative to its sector (NYSEARCA:XLK).

Whenever the ratio drops below a rising equilibrium trend line (blue line), and drops below its 14 day moving average (red line), without any significant fundamental shift (in other words, the stock remains fundamentally strong), I wait for the ratio to reverse back up (note: if the ratio continues to drop day by day, no trade is initiated).

On confirmation that the ratio has reversed back up (from falling to rising), I wager on the ratio climbing back up toward equilibrium.

To capitalize on this speculation, I enter a new long position in the stock, and at the same time, enter a short position in the sector ETF, in equal dollar value. This long/short, dollar-neutral trading strategy is more popularly recognized by hedge traders as pairs trading.

In this instance, I am entering long a stock I deem to be fundamentally robust, but temporarily undervalued, and simultaneously hedge this position by entering short, the sector ETF, in equal dollar value (or dollar-neutral), which provides some downside protection if I am wrong.

By going long the stock (AAPL in this example) and short the sector ETF (XLK in this example), a trader works to hedge against the overall market risk (in case the currently robust market/trend reverses). In other words, if I am long AAPL and short XLK, and a significant overnight event causes the technology sector (or the entire stock market), to re-open sharply lower, the profit on my short position (in the sector ETF) would generally counter-balance any loss on the long stock position (in Apple).

The key point to grasp: With pairs trading, market direction is of no significance. The pairs traders only objective is to determine whether the selected long stock will do better than the shorted sector ETF.

A significant proportion of my current speculative funds/investments focuses primarily on the above trading strategy.

For each qualifying pair, it is crucial to check the news-flow, imminent earnings reports, announcements, etc., to ensure there is no significant event or adverse earnings, which could make the undervalue potentially long term. For instance, I will not trade any pair where there is an earnings announcement due in the next 14 days.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.