How a Ratio Pairs Trade Works

01/19/2011 7:01 am EST

Focus: STOCKS

The battle of footwear giants is heating up while the temperature is falling in much of the country. How can you capitalize on it? Here’s an idea: Buy Deckers Outdoor (DECK) and short Crocs (CROX) at a ratio of 1:5. Let's examine the trade.

Deckers, the makers of Ugg boots, has had a strong run from October to December and has consolidated since then. But now it looks poised to move higher with a rising relative strength index (RSI) bouncing off of the 50 level and the Moving Average Convergence/Divergence (MACD) indicator improving and nearing a bullish cross. Look for DECK to retest the highs of December at $87.50 in the short run. Below is the chart for DECK.



Click to Enlarge

Crocs, the makers of those ugly plastic shoes and flip flops, however, has been having a tough time of it the last month after reaching its high in December. In fact, on Friday, it fell below the 50-day simple moving average (SMA) and looks like it may continue lower with support at $16 and then at $15.49, the longtime support/resistance area.

Below is the chart for CROX.



Click to Enlarge

Now look at the ratio chart of the two stocks below:



Click to Enlarge

This chart shows a consolidating range for the ratio over the last six weeks between 4.40 and 4.80 after a move higher from 3.8. Notice the MACD is about to cross higher and the RSI is rising.

Also note that the recent move higher began when the 50-day SMA crossed higher through the 200-day SMA. If the ratio can break above the range, there is resistance at 5.20 and then 5.60.

The trigger to enter is a ratio above 4.85. If DECK moves to $87.50 and CROX moves to $15.49, the ratio would be 5.64, making it the target for the trade.

The trade should also be exited if it moves against us with a stop loss set at a ratio of 4.7-4.75.

By Greg Harmon, trader and blogger, DragonflyCap.com

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