A Quasi Pairs Trade For Dow Traders

| About: The Coca-Cola (KO)

Investors have eagerly anticipated the Dow's (NYSEARCA:DIA) recent run to historical highs but now find themselves wondering if putting more cash to work is still a good idea. There are no shortages of bulls out there and for good reasons. Bulls point to tailwinds in housing markets and low-yielding fixed income instruments in addition to attractive equity valuations as catalysts supporting the Dow's next move higher. On the other hand, skeptics of these Dow levels argue that the market is fragile and buyers have become exhausted. They point to the lack of political and macro risk priced into the market and that equity trading volumes have been so light. Both are valid points of view and quite frankly, this is what makes a market. There is a consensus that a pullback is imminent, but investors that have been waiting for a pullback over the last couple of months have missed out on some extraordinary intermediate-term gains. A crafty way for Dow traders to continue participating in this market is through Coca-Cola Co. (NYSE:KO) and Procter & Gamble Co. (NYSE:PG) options.

PG and KO do not seem to make a good traditional pairs trade due to correlations between the prices breaking down but the two companies do have many similar characteristics. Both companies are defensive consumer plays with similar yields. Both have large international sales exposure and are components of the Dow Jones Industrial Average. These companies are also well represented in the ETF and mutual fund universe so most retirement portfolios have exposure to these companies in one way or another.

The motivation to pair KO and PG comes from valuation and the price action that both stocks have been exhibiting since the beginning of the year. KO has been a lagging stock relative to other Dow names and PG has been steadily powering higher. PG now trades at 4.5X forward earnings while KO trades at about 2.5X forward earnings.

The chart below shows the normalized closing prices of KO and PG over the last 265 trading days, which is about one year beginning March 1, 2012.

Normalized prices are used instead of the actual prices because this transformation enables a more accurate comparative analysis between the different stock's price movements. Correlation between KO and PG over the period of observation did not become statistically significant until last September. The correlation between the prices remained around 0.75 until it started to weaken and eventually dropped out in January of this year. The correlation between KO and PG has remained insignificant ever since then. Due to the correlation breaking down between the stock prices, pairing these stocks together in a traditional pairs-trade is not a reliable trade. The KO - PG normalized price spread is plotted below.

The spread between the two normalized stock prices during this period is slow turning around zero. The price spread trades in a very tight range whenever the two stock prices are highly correlated and a very wide range during the times that the two stocks are not correlated. During the first half of this period, Coca-Cola hugely outperformed Procter & Gamble until the summer of last year when Coca-Cola experienced a sharp increase in price volatility. The price volatility in KO has since abated, but PG has been exhibiting outstanding price action which has continued to pressure the KO-PG spread downward. The normalized price spread has just recently returned to zero as Coca-Cola has been rallying over the last week.

The KO-PG price spread will continue to increase given one or more of the following conditions,

  1. The price of KO increases as the price of PG decreases.
  2. The price of KO remains stagnant as the price of PG decreases.
  3. The price of PG remains stagnant as the price of KO increases.
  4. The price of KO increases at a greater rate than an increase in the price of PG.
  5. The price of PG decreases at a greater rate than a decrease in the price of KO.

Three out of the five scenarios include the price of Procter and Gamble decreasing while only one out of the five include the price of Procter and Gamble increasing. The inverse holds true for Coca-Cola. Given this information, buying a KO April 39/41 strike bull put spread and using the credit to finance the cost of a PG May 72.50 strike put will provide a conservative approach to a KO-PG quasi pairs-trade. Ideally, the KO spread will expire out of the money and the PG put will be sold at some point during the life of the trade for a profit. This is also a flexible trade that can be managed easily given any changes in the trading environment.

As of the end of trading on March 22, 2013, the KO bull put spread could be purchased for a 0.92 credit while the PG put could be purchased for a 0.62 debit. This trade would provide a net credit of 0.30. The key to this trade is to capture a credit for a couple of reasons. First of all, anyone shorting PG over the last couple of months have realized that it is very difficult to lean against this stock even though the valuation seems a bit stretched here. Investors want to put cash in the market and Procter & Gamble is a great defensive name with a decent yield. Moreover, the stock is in some very strong hands. Receiving the credit will allow the overall position to still be profitable even if PG continues to rally and the PG put becomes worthless. The position will breakeven as long as KO is at $40.70 per share by the April expiration. This scenario would most likely take place if PG and KO continued to participate in a Dow rally.

This position can also be easily adjusted if the broader market pulled back. If KO and PG were participating in a broader 3-5% pullback, the trader could simply buyback the short leg of the KO bull put spread and would then be long puts on KO and PG. These puts could subsequently be sold at good profits as the prices of both stocks fell. There are also a variety of other ways the position could be altered to capitalize on the independent price movements of the stocks.

This trade offers a great way to stay in the market while the Dow remains near all-time high levels. The success of the trade assumes that Coca-Cola's and Procter & Gamble's stock prices remain uncorrelated and that one or more of the aforementioned scenarios takes place. Moreover, the trade can be easily adjusted to accommodate a variety of market conditions. Market participants that are currently nervous about committing large amounts of new capital to this market can still profit from leveraging small amounts of capital through this trade.

Disclosure: I am long KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short PG

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