How to Pair Trade Two ETFs

03/11/2011 5:01 am EST

Focus: ETFS

Using energy and financials as an example, one trader shows how to capitalize on sector rotation by executing a pair trade featuring ETFs that track each group.

By Greg Harmon

Today's action could be the first sign that there is a shift away from the energy sector (and ETF XLE) and into the financial sector (ETF XLF). Or there might not be, but since every "expert" thinks that is coming, let's examine how to prepare for it.

First, the clues.

The Energy Select Sector SPDR (XLE) has had a hard time continuing its move higher over the last week, and recently, the relative strength index (RSI) is making lower lows.

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The Moving Average Convergence/Divergence (MACD) indicator is now moving lower and has crossed down. Maybe it is cracking. But on the other hand, it has just found support at the 20-day simple moving average (SMA). It is still in the top half of the Bollinger bands and all the SMA's are sloping higher. So maybe it is just in a pullback within the uptrend.the jury is out.

What about the Financial Select Sector SPDR (XLF)?

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XLF closed at a new, higher high on Wednesday (Mar. 9). It also has the RSI rising off of the midline into bullish territory and the MACD is beginning to improve. Looks like it might be time for this ETF to move up. But on the other hand, it could not get through the 20-day SMA, the SMAs are fairly flat, and it has not moved above the middle of the Bollinger band range. This indicates that there is still some work to be done to get higher.

So XLE may be ready to fall or it may not be. And XLF might be getting ready to rise, but it has some work to do. This is best played by a pairs trade.

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The chart above shows the ratio of XLE to XLF over the past year. The technical analysis on this chart reflects many of the same points of uncertainty. There was just a big pullback, but it held at the gap-up level from about two weeks ago at 4.58 with a bullish hammer candle that just touched the 20-day SMA. There is also support underneath at the Fibonacci level at 4.49.

There are three ways to play this pair depending on how it moves:

  1. Buy XLE and sell XLF in the ratio of 4.6:1 (long 500 XLE and short 2300 XLF) and keep it on until it tests the high again at 4.83. The stop for the trade would be a ratio of 4.58
  2. If it moves lower, then stay in cash
  3. If the ratio falls below the 4.49 Fibonacci level, then reverse the above trade, selling XLE and buying XLF in a ratio of 4.5:1 (short 200 XLE and long 900 XLF) and hold it until the ratio tests support at 4.40 or the 4.29 Fibonacci level lower. The stop on this trade is a ratio of 4.50

So it turns out that it does not matter if there is a flow from energy to financials or not. As long as both do not stay where they are right now, then there is a low-risk opportunity to play the pair.

By Greg Harmon of