A Pairs Trade in Regional Banking

02/08/2011 5:00 am EST


While doing my homework for today’s trading, I noted that the charts of the regional banks still looked good. Of course, there are some regionals that are better than others, and a pairs trade can take advantage of that and reduce the downside risk.

Here’s the set-up:

Below is the chart for Regions Financial (RF). This is one of the better-looking regional banks. Notice the price is pushing the Bollinger bands higher off of back-to-back strong up moves.

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The Moving Average Convergence/Divergence (MACD) indicator has turned positive and is crossing higher and the Relative Strength Index (RSI) is heading higher. Additionally, the 50-day simple moving average (SMA) is crossing higher through the 100-day SMA. This looks to move higher to resistance at $8 and then $8.55. This would be a good long play in itself.

Now look at the chart below for Zions Bancorporation (ZION) below. This stock is also moving up, but not quite as strongly. It is still tangling with the long-term support/resistance area at $24.10 and then resistance above that up to $25 or so. The RSI is rising, and it has support from the MACD, which is about to cross. But as it is reaching the Bollinger bands, they are not expanding like we see in Regions Financial. This is not a horrible set-up, but clearly not as good as RF.

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The Trade

Now look below at the ratio chart of Regions vs. Zions. This ratio has been in an up-trending channel since mid-November, but there are indications that it may be about to break out higher.

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First, the ratio just broke through both the 100- and 200-day SMAs. Next, it has touched upside resistance at 0.326 as the channel is about to cross that level as well. Third, it is pushing the Bollinger bands to expand as it is piercing the top band. It will get support moving higher from a MACD that has just turned positive and has crossed and an RSI that is rising towards the technically overbought line.

Trade Idea: Long three lots RF vs. short one lot ZION on a break of 0.326; stop at 0.319

Going long Regions vs. short Zion with a target of at least the 0.351 level would net $1.72 - $1.82 per pair traded, with downside risk at $0.55, a 3:1 reward/risk ratio. If it can get to the past high at 0.376, then the payoff is $3.20 - $3.68 per pair traded. This is done with no cash outlay.

Remember to scan for these types of opportunities when you find a hot sector. You may be able to improve your risk/reward ratio by adding the short side.

By Greg Harmon of Dragonfly Capital

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