Pairs Trade: Apple and PSQ

Posted on January 17, 2011 by

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AAPL Will Drop on Tuesday

I was saddened to learn that Steve Jobs is taking another medical leave. However, this provides an investing opportunity — in particular a pairs trade.  I’ll enter this trade on Tuesday January 18th, and you can follow the progress right here!

AAPL’s drop would have happened today (Monday January 17, 2011), but the US markets were closed for MLK day. The intuition that a drop is likely is supported by two pieces of evidence: 1) It just happened in Europe; The markets were open there and AAPL saw a drop of 6.8% while the rest of the market was flat, and 2) AAPL dropped 7% the last time he took medical leave, two years ago.

AAPL dropped 7% on January 15, 2009 when Steve Jobs announced medical leave. Notice how AAPL and MSFT move counter to each other over the following weeks.

The Opportunity

In cases of bad news for good companies, investors often overreact.  Their selling drives the stock down further than it deserves. That’s what happened last time Jobs announced a medical leave (see figure).  Smart traders saw that as an opportunity to buy AAPL at a discount.

When we see bad news like this for one company in a sector, we often see other stocks ramp up as investor’s dump the “bad” stock for other similar equities.  You can see that behavior in the figure from 2009.  But just as the prices diverge on the bad news, over the following weeks, they converge back towards equilibrium.

In the case of AAPL this week, the way to act is take a long position in AAPL and an equally sized short position in a similar equity, such as MSFT.  This is a pairs trade. There was a very similar opportunity in 2010 when Toyota was hit by a number of vehicle recalls.  The pairs trade then was Toyota versus Honda.

The Apple story will unfold over a week or so, so it is not necessary to jump in at the open on Tuesday, in fact I recommend against that.  AAPL will likely gap down at the open, and is not clear which way it will go after the gap.  Wait for the price to stabilize… then act.

How long to wait?  I’d be in by the close on Tuesday.

But there’s more…

Buying AAPL is just one side of the equation.  We can also reduce risk (hedge) by taking a balanced counter position. There are a number of alternatives here including shorting a similar company (like Microsoft), or by shorting a technology ETF like XLK.  Choosing the other half of the pair is easier in sectors where the companies are very similar (like Delta Airlines vs American, or Pepsi vs Coke).  It is more challenging when taking a bet with a singular company like Apple.

AAPL and PSQ nicely mirror each other.

Also, shorting is not available to everyone, and I’m interested in learning more about how to take advantage of inverse ETFs.  So I’m going to recommend PSQ, the ProShares Short QQQ.  PSQ is focused on daily investment results that correspond to the inverse (opposite) of the daily performance of the NASDAQ-100 Index.  Observe how nicely PSQ mirrors AAPL’s movement lately (figure).

One problem with this is that AAPL is a major component of the NASDAQ-100, so to a smaller extent we’re betting both for and against AAPL.   That will reduce our upside somewhat.  I’d prefer a more focused inverse technology ETF, but I want to avoid the ultrashort versions (like REW).  If you know of a better choice than PSQ, let me know!

In the end, this trade is perhaps more of a bet plus a hedge than a pairs trade.

The Trade

On Tuesday January 18, 2011 we’ll BUY AAPL, and BUY PSQ in equal amounts.  I’ll update this blog as the trade unfolds.

Tuesday Open

AAPL gaps down at the open

9:59 AM: AAPL gapped down 7% at the open.  It immediately bounced up 3% (dead cat bounce), but is now trending down.  I’m looking for a stabilization before entering a position.

10:19AM: AAPL seems to be settling at around -4%.  The market is flat, so we have confirmation of the information-based move.  We’re probably seeing only -4% because of the anticipation of a good earnings report.  If it is still at -4% after 11:00AM I’ll call that “stable” and enter the trade.

10:30AM: AAPL started inching up, so I bought 15 shares at $335.63 ($5034.45), and 150 shares of PSQ at $33.22 ($4983.00)

13:35PM: AAPL is up to $343.80, PSQ is down to $33.02.  Overall, we’re up about 1%

4:00PM: AAPL closes at $340.65, PSQ closes at $33.00. Up .75%

After the close: Apple announces profits up 78%.  Wow.  What will happen tomorrow?  Probably a strong gap up.

Exit Plan

After those amazing earnings, I expect a gap up in the morning.  In after hours trading AAPL is up another 1%.  IBM also had a nice earnings report. One possibility is that all this good news will lift the NASDAQ-100 overall as well (countering our position).  I think though that the market will follow more slowly, so if we see AAPL pop, then stabilize in the first 30 minutes, that’ll be a good time to exit.

If things go differently we’ll wait until we see +2%, or 5 days, whichever comes first.

Wednesday Open

9:30AM: Indeed there was a +2.3% gap up at the open ($348).

10:00AM: I expected to see the market rise with AAPL’s opening pop, but it didn’t. Instead, after the open both AAPL and the market were declining steadily.  This indicates to me that the play was over.  We’ve already made 1%,  so I exited the positions: SELL AAPL@$343.15, and SELL PSQ@$33.15.

We made $112.80 on AAPL and lost $10.50 on PSQ.  Net result: +1.0% on the overall trade.

Lessons?

Overall, I was quite pleased with this trade.  If we had played it using AAPL only we could have made 2.2%.  But the added protection of PSQ made the overall play much less risky.  I’ll take 100 basis points at low risk every time I can get it.

One potential modification that would have made this deal more profitable would have been to enter AAPL and PSQ at the opening cross.  I’ll give that some thought.

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Posted in: stock pick, strategy