You don’t need me to tell you that the markets have been a mess over the last few weeks.
A Fed meeting compounded by earnings — there’s a lot of uncertainty leading to many fast overreactions.
Remember a few weeks ago, when META’s earnings report tanked the whole stock market…
Only for GOOG to post incredible earnings the very next day and send things moving the other direction.
When markets are this confused, one thing that you have to be able to do is read relative strength.
The Nasdaq is volatile right now. It is unpredictable. Though it has been the kingmaker for many months, right now, it is in a period of uncertainty…
And it’s been weaker than the S&P over recent months.
Just look at the side-by-side…
Strongly correlated, but the SPY has been the stronger index recently.
Even so, trying to guess on one or the other, and being correct on direction, is a tough ask right now.
But there’s one play I LOVE in these kinds of situations…
The Versatile Pair Trade
When two stocks are heavily correlated, and one is stronger than the other, conditions are perfect for a classic pairs trade, what you might have heard me refer to as a Profit Link.
In fact, I placed one this week on the SPY and QQQ.
The concept is very simple: when one stock is stronger than the other, and they are correlated (in ThinkorSwim’s Pairs Trading tool, which is pretty cool, I am looking for a .80 correlation or better), set up the pairs trade.
All you have to do is buy a Call on the stronger stock and a Put on the weaker stock. Late last week, May 1, I placed just such a trade on the SPY and QQQ.
I bought the 24 May $515 Call on SPY, and the $400 Put on QQQ — and I sent this trade alert out to my Profit Links members.
This setup is perfect for volatility. Because if the markets go up, both stocks should go up, and the stronger stock will outperform the weaker stock enough to return a good win. Same is true in reverse.
In this case, the markets headed higher, and yesterday, I was able to close both trades. The SPY trade jumped 154.8%, and the QQQ put lost 82%, but net together they made a 36.37% return!
That’s exactly how this trade is supposed to work.
Now, pairs trades aren’t perfect, they can of course lose money. I would never suggest otherwise.
But these are the conditions they work best in:
- Volatile markets
- On strongly correlated stocks
- Where one stock is seasonally stronger than the other
That was the case with SPY and QQQ last week, and that’s how my Profit Links members were able to close out with a nice win.
Hope you found this helpful!
— Geof Smith
P.S. If you do want to learn more about how I place pairs trades, and get some of my best uranium stock picks, you go watch this free replay of my recent Profit Links event.
