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Two weeks ago, I described a potential pairs trade between Juniper Networks (NYSE:JNPR) and Cisco Systems (NASDAQ:CSCO) based on the ratio of their prices and relative valuations (see “Pairs Trade: Cisco Systems Is Catching Up To Juniper Networks“). I used the three-year history to suggest shorting JNPR to hedge a long position on CSCO until the price ratio hit 0.95.

On Friday, JNPR dropped 6% for a total two-week loss of 14% and a 2 1/2 year low versus CSCO’s 7% loss over the same time period. The CSCO versus JNPR price ratio is now 0.90 (click to enlarge images):

CSCO

CSCO's recent sharp out-performance relative to JNPR continues

Source: StockCharts.com

JNPR also happens to be trading where it was five years ago. During these five years, JNPR has out-performed CSCO for all but a few months. I see no reason for the longer-term out-performance to end anytime soon, so around these levels seems as good a time as any to switch the pairs trade to long JNPR and short CSCO.

5-year chart of CSCO vs JNPR

5-year chart of CSCO vs JNPR

Source: Yahoo Finance

Note the particularly extreme divergence in performance that came to an abrupt end earlier this year. Now it seems JNPR’s collapse has reached an extreme along with the historically low valuations.

I am currently invested in CSCO for the long haul. I will soon initiate this pairs trade as a shorter-term trade. However, this is a trade that will likely require some patience, so position accordingly. I recommend shorting CSCO shares (nearly zero chance of CSCO getting acquired before JNPR does) and buying JNPR calls expiring spring of 2012. Assuming CSCO has downside risk at least back to the 2011 (and 8-year) lows, I will size the position so that a 10% loss in CSCO pays for the JNPR calls. A more aggressive trader might overweight the JNPR calls. A more conservative trader might add an out-of-the money call on CSCO to cap potential losses on the CSCO short.

Be careful out there!

Source: Juniper Networks Hits 2.5 Year Low, Triggers Pairs Trade With Cisco Systems