I picked up an article on Seeking Alpha yesterday suggesting a "pairs" trade. This type of trade typically looks at two securities within the same sector and takes a view on the expected performance of the two stocks relative to each other. "Relative" is the important watchword as one of the attractive features of this kind of trade is that the effect of exogenous factors are in theory neutralised as they effect both securities equally. For example a spike or a drop in oil prices should affect two airlines equally. Clearly, it's not that simple as each company might have different fuel price hedging strategies, but that's not the point here.
In the article (you can read it here) the author looks at the relative trading between Continental Airlines and United Airlines. He draws the conclusion that the relative value and recent trends between the two stock prices suggest a narrowing of the spread from the current approx 215% towards the 180% historical level. The author's recommendation (not mine - I don't have a view) is to go long UAL and short Continental.
If the author is correct, it doesn't matter whether the stocks move up or down, the key factor in profitability is the relative price movement. This isn't the most obvious example I have ever seen, but as a blogger, I have to take the bones thrown to me. I have created a Bloomberg chart below and made some annotations showing movements for the past four months and the relative prices. It also shows why stock loan trades need to be open trades as the trader doesn't know when the convergence will happen, if it all. As an example, if you were expecting the relative movement to go to 180 and you put the trade on at 4 June, you might have closed out a month later at a loss. The same trade put on a month later would continue to yield a profit even though it hasn't hit the target level yet.
As a side note, DataExplorers has issued a couple of research reports on airlines stock, and Continental has featured in the document you can read here. It concludes that short interest in Continental has declined recently, which has coincided with a rise in the stock price.
