The colder weather leads people to crave hot drinks and warm baked goods, and it's in this space that I found this week's pairs trading idea.
First, a word about pairs trading. It is a market-neutral strategy that takes advantage of a certain imbalance in the stocks, ETFs, bonds, commodities or currencies in focus. In other words, it does not depend on the broader market making a directional move.
Pairs trading involves a long position and a short position in a pair of highly correlated assets, and the strategy is believed to lower risk because it creates a natural hedge.
Traditionally, investors would look for two stocks in the same sector, preferably in the same subsector, that showed good positive correlation. Therefore, if the two stocks were to diverge, a pairs trader would buy the stock of the underperforming company and sell short the stock of the outperforming company. The trade would be profitable if the spread between the two stocks narrowed, i.e., the stocks' prices again moved closer together. Looked at this way, pairs trades are simply market bets on a mean-reversion move.
Another pairs trading strategy is to bet on the continued outperformance of one stock versus another.
Dunkin' Brands operates and franchises quick service restaurants under the Dunkin Donuts name. The company hasn't been publicly traded for long, but it has performed exceedingly well since its July 2011 IPO.
DNKN has rallied a little less than 100% from its $25 IPO opening price. And after pushing past lateral resistance in the spring of this year, has moved steadily higher. The stock has good support at its 100-day simple moving average (blue line), as well as its November 2012 uptrend line.
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On the daily chart below, DNKN has been trading mostly in a consolidation phase since mid-October, which most recently found support at its rising 50-day simple moving average (blue line) on Nov. 20.
On Nov. 27, the stock broke to a fresh all-time high on a daily closing basis and now looks to have enough momentum to break higher still in coming weeks.
The positive technical picture of DNKN stands in contrast to that of another popular beverage and baked goods chain, Krispy Kreme Doughnuts.
The company reported fiscal third-quarter results on Dec. 2, announcing earnings per share rose 34% year over year to $0.16, which was in line with analyst estimates. However, on the revenue side, while the top line was up 7% on a year-over-year basis, it missed expectations, coming in at $114 million versus an estimated $115 million.
KKD plummeted 20% on the day after the earnings release, causing damage on its charts.
First and most obviously, on the two-year logarithmic chart above, the post-earnings sell-off snapped the stock's November 2012 uptrend in a big way. From this point of view, the stock's medium-term chart is simply broken, and risk/reward does not favor buying the stock.
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Big downward gaps, like we saw on Dec. 3, often bring plenty of momentum that continues for several days or even weeks, which is to say that KKD likely has more downside before a bounce attempt occurs.
Depending on investors' time frames, the Dec. 3 price action more or less dictates their action. At the very least, it should cause investors to sell a portion of any long positions, while traders looking to buy the stock are better off in a wait-and-see mode until the stock can slow its downside momentum.
On the daily chart below, we see that the stock's plunge sliced right through its 100-day simple moving average (blue line) and took KKD down toward its first better area of support, which is marked by the red line. This support area is made up of the September bottoming process and supported at the lower end by the stock's rising 200-day simple moving average, around the $18.50 area.
This recent earnings-driven sell-off in KKD and the relative strength in DNKN led to a pop in the ratio between the two stocks. The ratio of DNKN divided by KKD spiked last week and broke out of an 18-month downtrend, which is significant and supports a further rise in the ratio, i.e., the continued relative outperformance of DNKN and underperformance of KKD.
Recommended Trade Setup:
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-- Buy DNKN on a daily close above $48.90 while shorting an equal dollar amount of KKD on a daily close above $20 (only enter the trade when both criteria are met and if the spread between the two is $28.90 or greater)
-- Exit if the combined position is down by 3.5%
-- Take a profit when the combined position is up by 6%
-- Time frame: 3-5 weeks