Energy Pair – BUY Woodside, SELL Oilsearch

The ASX lists two globally significant oil and gas producers – Woodside and Oilsearch. While their assets are in different parts of the Asia Pacific region they have a key common factor – extensive gas reserves. Over the last year, Woodside has underperformed as a new CEO “cleared the decks”, delaying projects. The underperformance is clearly illustrated by the snapshot from the Tracker platform’s portfolio mixer:

Traders who view this news as largely factored in to current prices may be expecting Woodside to regain lost ground against Oilsearch, especially as Oilsearch is years away from full production. A one month analysis suggests yesterday’s closing prices are at a recent extreme:

 

Traders entering a pairs trade are likely to lean towards a value neutral position – selling the same dollar amount of Oilsearch as purchased in Woodside. At yesterday’s closing prices, the ratio is:

$34.22 / $6.95 = 4.92

Many traders will round this ratio to 5:1, suggesting the following trade:

BUY 2,000 Woodside, SELL 10,000 Oilsearch at or near $34.22 and $6.95 respectively.

To read more on Pairs Trading methodology, click here:

http://blog.cmcmarkets.com.au/2012/04/12/pairs-trading-an-explanation/

 

 

About michaelmccarthycmc

Chief Market Strategist - CMC Markets and Stockbroking Regular on ABC, BBC, Bloomberg, Channel TEN, CNBC, SBS and SKY
This entry was posted in Market, Shares, Stocks, Trading and tagged , , , , , , . Bookmark the permalink.

14 Responses to Energy Pair – BUY Woodside, SELL Oilsearch

  1. John Greenwood says:

    Michael…I find the concept of pair Trading fascinating…and have taken your trades…one thing that I am curious about it the size of your recommendations…I mean $70-$80k per side is a lot…I know the risk is minimal…but is there a reason? and does it make a difference?

    • michaelmccarthycmc says:

      Hi John – thanks for the feedback. The lower overall market risks mean that I trade larger amounts in pairs, but the example given is just an illustration. In thinking about trade size, I generally start with the profit potential – a move of around 4% in the relationship between the two share prices equates to a $2,800 profit on a $70,000 trade size.

      Of course, its up to each trader to determine the right size for their circumstance – would be interested to hear how others do it.

      All the best in the markets, Michael

  2. xsor says:

    i will not go long as gas price may fall dramaticly in future [just look usa natural gas price]

    • michaelmccarthycmc says:

      Hi Xsor – that’s the beauty of pairs trading – a falling gas price will affect both the long and short positions, with gains largely offsetting losses. Profit and loss are dependent on how the two share prices trade relatively to each other, not what happens to the underlying commodity.

      Good trading, Michael

  3. Jason says:

    how do you locate your trading opportunities when it comes to pairs trading?
    Do you ever look for index pairs trades?

    • michaelmccarthycmc says:

      Hi Jason – you may want to check out the explanation here http://blog.cmcmarkets.com.au/2012/04/12/pairs-trading-an-explanation/

      Every trader does it their own way. I usually start with an idea or investment theme, think about the best way to express that, and then go to the portfolio mixer to see the performance. And yes, I also pair with indices, commodities and currencies. As an example, if I believed Australian bank margins were likely to be pressured by political concerns, I might sell a bank cfd (let’s pick on NAB) and buy an Australia 200 index cfd for the same dollar value.

      Hope this helps, Michael

  4. dv34 says:

    I have no idea what you are doing here with these inverse correlation trades… but I like it!!, don’t think I could trade them though – more of a directional trader. Very interesting perspective though

  5. Pingback: Profit from Pairs | CMC Markets Blog

  6. Grova says:

    I’m intrigued that it’s thought the risk is less. How is that possible for the whole trade? Market risk appears as though it is less but isn’t the worst case outcome still the same ie both stocks can move against you? If you double your exposure, you double the risk. Am I missing something?

    • michaelmccarthycmc says:

      Hi Grova – thanks for your thoughts. A couple of aspects of risk are relevant to this discussion. Yes, there is still risk in pairs trading – if there is no risk, there is no potential for reward. However, portfolio theory tells us that combining exposures can lower overall risk, especially where there is negative correlation – and broadly, long/short (pairs) trading gives negative correlation. In buying one and selling another, you are not doubling the exposure, you’re reducing it.

      • Grova says:

        thanks Michael. I think I understand what you’re saying but :
        Combining exposures will not, cannot lower risk *unless* there is a direct negative correlation. Has that been proven, mathematically or otherwise?
        Is it possible that with pairs trading, you could win on both sides? The remote probability of that does not make it impossible? A loss on bothsides would likely have the same improbability but its certainly possible isn’t it?
        What mathematics can you offer to support your last sentence?

      • michaelmccarthycmc says:

        Hi Grova –

        Two stocks that are negatively correlated have, by definition, moved in opposite directions. If that relationship continues, being exposed to both lowers the risk of being exposed to either one alone – this is one of the key axioms of portfolio theory and the CAPM. Negative correlations on share markets are rare – that is why we artificially create them by “going short” on one leg of the pair.

        Its possible to win or lose on both legs of a pairs trade (it happens fairly regularly), although it is the relative change that drives profit and loss. The mathematics supporting the last sentence is straightforward – if I win $3 on half my trades, and lose $1 on half my trades, I will be in profit.

        Hope this helps, Michael

      • Grova says:

        *IF* you win $3 … “if”: that’s the point. It comes down to a view, an opinion then that the 2 trades have indeed a negative (and it will stay negative) correlation over the required period. Opinion does not quantify risk. *”Artificially”* creating negative correlations ? Baloney ! Its either there to start with or it isn’t. The chart shows what may be a negative correlation since early March, about, but going further back you have both positive and negative – in other words there’s no correlation at all and certainly not mathematically. The risk has to be related to the size of the opening position.

      • michaelmccarthycmc says:

        Hmmm – not sure where you are coming from on this.

        You make a good point about the difference between intended profit to loss ratio and actual profit to loss ratio. If there is a large difference between the two, further work is required by the trader. This is an issue for all traders, not just pairs traders.

        MYR has a daily, one year correlation to DJS of 0.57. If you buy both, they are positively correlated positions. If you buy one and sell the other, they have a negative correlation.

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