Content Highlights:
1. What is a Divergence Pairtrade, and how does it work?
2. How do I access the Divergence Pairtrade Live Picks at Tradetrek.com?
3. How do I read and understand the Divergence Pairtrade chart?
4. How do I trade stocks following the Divergence Pairtrade strategy?
What is a Divergence Pairtrade and how does it work?
A Divergence Pairtrade is a trade between two stocks that exhibit a "diverging" relationship: one stock is a relatively stronger performer while the other is a weaker performer. To make the trade you buy the stronger stock and simultaneously short sell the weaker one. In this way, you are market neutral and will capture the relative value between the two stocks.
For example, if you are unsure about the market direction in the next few months, but you believe that PepsiCo, Inc. will outperform Coca-Cola Company, you can make a Divergence Pairtrade by buying $20,000 dollars worth of PEP and simultaneously short selling $20,000 worth of KO. If you are correct about the relative performance of the two stocks, you will make money no matter where the market goes. Let us demonstrate this point by using the following hypothetical scenario analyses:
Let us assume, today, PEP is trading at 45, KO at 46, and the Dow Jones Industrial Average is at 10,950. You buy 444 shares of PEP and short 434 shares of KO.
Scenario 1. DJIA goes up to 12,500, PEP goes up to 53, and KO moves up to 50
You will make: 444 x (53-45)= $3,552 from the PEP trade
...And at the same time...
You will lose: 434 x (50-46)= $1,736 from the KO trade...your net profit is $1,816.
Scenario 2. DJIA goes down to 9,800, PEP drops to 40, and KO moves down to 38
You will lose 444 x (45-40) = $-2220 from the PEP trade
...And simultaneously...
You will gain 434 x (46-38)= $3472 from the KO trade...your net profit is $1,250.
In this example, you make money whether the market moves up or down, because your assumption---that PEP shall outperform KO---is correct. However, in reality, this relative performance view can often go wrong. The key to the success of the Divergence Pairtrade strategy is to identify relatively stronger and relatively weaker stocks.
The Tradetrek Divergence Pairtrade model uses the past performances of stocks as a clue to find possible relatively stronger and relatively weaker stocks for making Pairtrades. Our computers search for all possible stock pairs that show smooth and stable divergence trends and will promptly post them on the web with optimized trading rules such as cut-loss levels and profit targets.
Such divergence pairs are just candidates for good Divergence Pairtrades. Users will have to do research on the pairs to independently verify that a candidate is indeed a pair with a likely stronger and weaker performer.
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How do I access the Divergence Pairtrade Live Picks at Tradetrek.com?
Accessing the Pairtrade feature is easy. First click on the "Quantitative" category on the navigation bar as pictured in Figure 1. Then, click on the "Pairtrade Live Picks" button on the secondary navigational bar and you will arrive at the Pairtrade Live Picks. Divergence Pairtrades are listed on the right half of the screen.
Figure 1. Accessing Pairtrade Live Picks
In order to view a particular Pairtrade, please click the 
button and you will see the detailed Divergence Pairtrade page with the Pairtrade chart, as shown in Figure 2.
Figure 2. Divergence Pairtrade from the Pairtrade Live Picks feature
How do I read and understand the Divergence Pairtrade chart?
In Figure 2, the Quote Panel indicates that the Pairtrade recommendation is to long (buy) 1,000 shares of Boeing Co (NASD: BA) and short 2,265 shares of Ford Motor Co. (NYSE: F). One can of course scale it up or down proportionally, e.g., long 100 shares of BA and short 230 shares of F. The "Entry" prices, 65 for BA and 28.78 for F, are the last prices at the time the Pairtrade was picked and they are good references if one wants to execute the Pairtrade. The amounts listed under the "Capital" heading are the buying power required to do the Pairtrade without margin. In reality, you can use the commonly available 50% margin and the actual capital required is only half of the number posted, e.g., $129,996.7/2 = $64,998.35. The other numbers should be self-explanatory.
On the Pairtrade graph the green curve that connects the red and blue dots represents the history of the profit or loss of the Pairtrade if it had been put on at the entry prices. In Figure 2 it is identified as the History Curve. Over a period of two months, we compute a daily number by the following formula:
1000*(Price of BA - 65) - 2265*(Price of F - 28.78)
This number is the hypothetical profit or loss if you had bought 1000 shares of BA at $65 and shorted 2265 shares of F at $28.78 per share. It is plotted on the chart as a dot and then connected with the green History Curve for a better visual understanding of the Pairtrades viability. The last point represents the profit or loss now, it is plotted as the cyan colored dot and we will refer to this as the "Tracker." Currently, the Tracker is in the Neutral Zone. The potential for profit looks strong.
If you execute the Pairtrade at the posted "Entry" prices, you are buying at the point represented by the Tracker. If the Tracker moves up, you make money and if it moves down, you lose money. The vertical gray line indicates today, as you can see the Tracker is on the line. The graph displays that the combined Pairtrade position---the portfolio of long 1000 shares of BA and short 2265 shares of F---was in a directional up trend over the past 30 days and it may continue to go up further. This is an indication that in the recent past, BA is a relatively stronger performer than F. Is this indeed a good Divergence Pairtrade? You need to be the judge of that through independent research on both Boeing Co and Ford Motor Co. For example, the user may believe that, the recent slow down of the economy and the high cost of fuels may curb the buying power of customers and reduce the demand for cars, so that Ford may really be a weak performer in the near future. On the other hand, Boeing Co may be boosted by President Bush's plan to strengthen the defense industry. If this view is correct, the Tracker will continue to move up to the green line and beyond. The profit potential is unlimited, but researching the stocks is essential.
If the assumptions are wrong and BA turns out to be a weaker performer than F, the Tracker will move down. If the Tracker drops down to the red line, it is a good indication that the assumptions are not right and the trade may continue to lose more and more money. At this point one should promptly cut loss by unwinding the Pairtrade: sell the long stock and buy back the short stock at a loss. The red line is therefore called the "cut-loss line." The corresponding loss is the "Cut loss limit" posted at the bottom of the Quote Panel. In this case it is $2400.
If the Tracker indeed moves up to the green line, the Pairtrade has made a profit and it is advisable to raise the stop-loss level to protect the profit if the user believes that BA will continue to out perform F, or to unwind the Pairtrade at this point if the user thinks he has made enough profit. The green line is called the "profit target line." The corresponding profit is the "Profit Target" also posted at the bottom of the Quote Panel. In this case it is $3200.
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How do I trade stocks following the Divergence Pairtrade strategy?
Tradetrek provides instructions for how to trade each selected Pairtrade. These instructions are located just below the Quote Panel, see figure 2 above.
The instructions read:
Justify the trade independently before you do it.
Always close trade if the cut-loss limit (red line) is reached.
Take profit or raise stop to protect profit after the profit target (green line) is reached.
The simple rules for raising stops to protect your profit are the following:
Use half of the profit target as your cut-loss cushion: 3200/2 = 1600.
If your profit drops down to the amount equal to the cut-loss cushion, unwind the trade promptly. For example, if you make $3,200 and then the profit drops back to $1,600, get out of the trade and take the remaining profit of $1,600.
Whenever your profit has increased by the profit target amount, raise your stop loss level to your current profit minus the cut-loss cushion. For example, if you make $6,400 and then the profit drops back to $4,800 (=$6,400-$1,600), get out of the trade.
Before executing a Divergence Pairtrade, in addition to conducting research about the fundamentals of the two companies, one should confirm that there will be no earnings announcements over the next 5 days and make sure that the stocks do have liquidity. You can easily review recent news about the stocks since Tradetrek provides current news for each stock next to the graph. One can also look at the Block Trades (Institution Watch) page on Tradetrek to confirm that institutions are not aggressively selling the stock you want to buy and they are not aggressively buying the stock that you want to short. Before you place a Pairtrade, it is a prudent practice to check everything that can detectably affect the stocks, just as you would for making a single stock trade. Divergence Pairtrades present you with excellent opportunities to profit, but you must employ caution when executing, research is truly invaluable before you place your trades.
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