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In the stock market, a special "sister" relationship occasionally forms between two stocks. For one reason or another, stocks become "paired" and trade in tandem with one another. This synchrony usually arises because of the unique characteristics of the underlying companies, such as a common product, service, or goal. These "sister" or "paired" stocks trade in similar ways, especially when news hits the wires.

The trading correlation between stocks can be tight or loose, and the correlation can range from inverse to positive. In order to explore this unique market phenomenon, we will look at several real-world examples that are relevant to trading during April 2012: 1) VVUS-ARNA, 2) TRP-ENB, 3) PGLC-CRGC, and finally 4) ZNGA-FB.

Sister Pair #1: VVUS-ARNA

Vivus (VVUS) and Arena Pharmaceuticals (ARNA) are both in the obesity business. Both companies develop clinical drug treatments for the disease and, it seems, are fiercely competing for FDA approval in the same market. Recently, these two stocks have begun trading as paired stocks due to this similar, competitive goal.

During the past week, significant news was released regarding the FDA's opinion of the safety profile of obesity drugs on the cardiovascular system. An FDA panel recommended that companies pursuing obesity drug treatments either come up with new clinical trials to determine the impact of their anti-obesity drugs on heart attacks, or else look at existing data on human trials done prior to drug approval. The news had an immediate impact on the stock price of both Vivus and Arena, and both stocks traded with typical "paired" behavior. (Note that this does not mean that every price tick is reflected in the other stock, but this does mean that almost all news for one company will affect the other company in some way.)

Many traders were confused about Vivus' and Arena's reaction to the FDA news. Some thought that the news was negative for Vivus, similar to the dreaded Complete Response Letter that so often sends stock prices crashing. However, the panel recommendation was more of a precautionary safety measure and did not impact the likelihood of approval of one company over the other, since the recommendation was a blanket recommendation for all obesity drugs. Indeed, a FDA spokesperson later hinted that the approval processes was not derailed. In reaction to this news, the stock prices of both Vivus and Arena rose.

This paired behavior in the stock prices of Vivus and Arena underscores investors' perception of their similarities, as well as market dynamics that couple the two stocks, especially during moments of news relating to their similar medications for obesity. Studying the stock price charts over the last few months, it is evident that the two stocks are becoming coupled more tightly as we approach the final FDA decision on their drug applications. Indeed, Vivus rallied 50% in early February 2012 and later plateaued. Similarly, Arena rallied 50% in early March, subsequently plateauing at around $3 per share.

Sister Pair #2: TRP-ENB

A lesser-known paired stock relationship exists between TransCanada (TRP) and Enbridge (ENB). Both stocks operate in the oil transportation sector, have rallied a little over six percent during the past half year, and share a similar beta: 0.74 and 0.66, respectively. However, the reason for their pairing is not merely technical.

These two stocks are coupled because they are hunting the same "whales" (whales are big customers with deep pockets). Specifically, both companies are competing for oil transportation fees from the Canadian oil sands to the U.S. and the Gulf of Mexico. As most Canadians know, oil sands mining is a booming sector with potential revenue in the billions of dollars.

Currently, TransCanada has more of a presence in mid-Canada and Enbridge focuses on eastern Canada. However, the biggest source of future revenue for both companies would be the Keystone Pipeline, pending regulatory approval. This massive pipeline would immediately and drastically affect the revenues of both companies.

A large part of the future of both companies is tied to the fate of the Keystone Pipeline, with a heavier weighting on TransCanada than Enbridge. The Keystone Pipeline would connect oil sands oil from Alberta in Canada to refineries in the United States. The project has met stiff opposition from environmental, political, regulatory and economic lobbyists in the United States, resulting in the rejection of the original proposal but continuing debate over modified proposals. Ultimately, however, both companies would benefit tremendously from the project's approval and they continue to hunt the same whale customers in the meantime. Because of their close competition and shared dependency on regulatory approval of pipelines, traders should not be surprised to see TransCanada and Enbridge trading in similar ways when headlines cross about the Keystone Pipeline, Canadian oil sands, or oil transportation legislation.

Sister Pair #3: PGLC-CRGC

Stock pairings can also occur in the context of incomplete mergers. For example, two mining companies, Pershing Gold (PGLC.OB) and Continental Resources Group (CRGC), are coupled due to a pending share conversion between the two companies. The conversion, as proposed in a SEC filing, is in the form of four Pershing Gold shares for every five Continental Resources shares. Nevertheless, the ambiguity of the conversion and its timing has created an imperfect arbitrage scenario whereby the shares trade together, but only loosely. For example, Pershing Gold closed down 12.7% on Friday, whereas Continental Resources closed down only 6.6%.

In summary, this example shows that stock pairings can exist whenever deals are created between two companies that correlate their shares but do not precisely define terms of the relationship. In the case of Pershing Gold and Continental Resources, the delay in converting shares has created a "sister" relationship moreso than a pure arbitrage relationship.

Sister Pair #4: ZNGA-FB

The final example of sister stocks is the relationship between Znyga (ZNGA) and Facebook (FB), the private-but-soon-to-be-public social network behemoth. Zynga and Facebook are sister stocks for the most important reason in finance: revenue. Zynga derives almost 100% of its revenues from Facebook, and Facebook derives over 10% of its revenues from Zynga.

This clear interdependency means that both companies' revenues and, therefore, market capitalizations are tightly paired. Although Facebook stock does not trade on a public market, once it completes its IPO, it will not be surprising to see Zynga's shares trade in a similar fashion to Facebook's shares.

Indeed, the sister relationship is almost uncanny when looking at the market capitalizations of both companies. We noted above that over 10% of Facebook's revenues come from Zynga. Likewise, Facebook is valued at almost $90 billion and Zynga's market capitalization is $9.4 billion- very close to 10% of Facebook's valuation. These numbers should not surprise the modern investor. Sister stocks are a natural part of interrelated trading in the market.

Conclusion

Hopefully the reader has enjoyed this brief introduction to sister stocks and paired trading. From semi-arbitrage situations like PGLC-CRGC to biotech news couplings like VVUS-ARNA, sister stock relationships exist across all sectors of the stock market. Paired trading can be a profitable endeavor, but investors must understand that pairings can drift in and out of synchrony. Especially when material changes threaten to decouple sister stocks, investors must be willing to adapt to changing market conditions. In all, sister stock trading can be a fun and enlightening way to trade in unique market situations.

Source: 4 Stock Pairs Worth Watching This Week