A Pairs Trading Idea for Two Major Retailers

01/27/2011 7:07 am EST

Focus: STOCKS

The big box discount superstores Wal-Mart (WMT) and Costco (COST) participated in the stock market rally from the September beginning and are up 20% and 33%, respectively. They have also renewed their runs since the beginning of the year.

Are they still good opportunities? Maybe, but there is a way to trade these without having too much directional bias on either stock.

Let me explain while reviewing a few charts. Below is a chart for WMT:



Click to Enlarge

WMT has been rising since the beginning of the year and last week punched through the $55.35 resistance area. The price moved $4 from $50.50 to the consolidation area at $54.50, so a target for the breakout higher would be $58.50, another $1 higher.

It has a rising Moving Average Convergence Divergence (MACD) indicator and Relative Strength Index (RSI) as well. On the negative side of the coin, however, it pierced the top of the Bollinger bands on Tuesday, and that rising RSI is becoming overbought.

What about COST? Its chart is below:



Click to Enlarge

COST has also been rising off of support at the $70 level since early this year and is now challenging resistance at $73. If it can get through $73, then the target on a measured move comparable to the move from $61.50 up to the consolidation at $71.50 would be $81.50.

On the negative side of the coin for COST, the RSI is peaking and rolling lower, and the MACD appears to be avoiding a cross, kissing and moving away, which will create a more negative indicator. Finally, the bearish “hanging man” candle that printed Tuesday can be an omen for lower prices if confirmed.

Rather than avoiding these stocks until all is clear, there is an opportunity to get involved while putting up less capital by using a pairs trade. Below is the ratio chart for WMT versus COST:



Click to Enlarge

Notice that this pair traded in a tight range for nearly a year between November 2009 and September 2010. At that point, COST started to outperform WMT and drove the ratio lower to its trough at the end of 2009. In the last two weeks, the ratio has come back and stalled at the gap-down level at 0.78. During the run from the bottom, the ratio has seen the RSI move progressively higher along with the MACD. Both show room for more upside. Tuesday, the ratio broke through the gap and the 50-day simple moving average (SMA). It now has resistance in the 0.81-0.82 area, and then the previous channel area at 0.85. That move is a good chunk of change.

Trade Idea: Long 1,000 WMT versus short 800 COST with a target of the ratio at 0.85 and a stop at 0.77.

This is a profit target of $4,080-$4,330 against a stop-out loss of between $1,465-$1,523 and generates a net cash inflow of $708.

By Greg Harmon of DragonflyCap.com

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