Tame Volatility Through Paired Trading

• ByRich Masino,
• On 9:30 am EST, Friday December 19, 2008

Volatility is not a market attribute that I find particularly appealing. To tame it, I've been employing the equity market-neutral strategy of paired trading. I use no leverage, no derivatives, and it doesn't cost me 2 and 20.

So let's get to it. My theme today revolves around President-elect Obama and his energy plan. We know that he favors a cap-and-trade program to reduce greenhouse gas emissions.

Thus, electric utilities that rely heavily upon coal-fired plants may experience more margin pressure than those companies that do not. That pressure will come through either the purchase of carbon credits or increased capital expenditures to lower the emissions of their coal plants.

We also know that Obama has set a goal that 10% of the nation's electricity come from renewable sources by 2012. Utilities that already depend largely on renewable sources will be ahead of the game. In fact, they just may become desirable takeover candidates for the big CO2 emitters.

I've gone short a basket of what I call the coal-centric utilities and long a basket of the greener utilities. By doing so, I have largely mitigated market and sector risk. That leaves me with individual stock risk -- something that shouldn't be considered insignificant, but then again, there's no such thing as riskless arbitrage.

The Short Ideas

DTE Energy , DPL and Southern Co. on average generate about 70% of their electricity from coal. We can also weave a regional theme into our thesis: I would prefer to sell companies that have franchises in regions that are experiencing slower population growth and weakening economic conditions. DTE is focused on the Detroit and Michigan area, DPL's franchise is largely in Ohio and Southern is big in the Gulf region.

I'm going to throw one more name into my short group -- Wisconsin Energy . More than 50% of Wisconsin's power supply is generated from coal, and while that's not as substantial as the other three short ideas, it appears the most overvalued. It sports the lowest yield of all the stocks we're discussing today, and I see no compelling reason it should be valued at a premium.

The Long Ideas

Avista Corp. has a very nice mix of generation capabilities, with 55% hydro, 24% natural gas, 11% wind/biomass/other and just 10% coal. The company is based in Spokane, Wash., and also has operations in Idaho.

Idacorp is also blessed with having a franchise in the Northwestern region of the country, where renewable resources are more likely to be found through natural geography. It operates in Idaho and Oregon, with 51% hydro and 45% thermal.

As always do your homework; this company does have a wholly owned subsidiary -- Idacorp Financial Services -- that is a vehicle for investing unregulated capital in real estate.

Exelon Corporation has one of the better balance sheets in the business and lays claim to franchises in the Midwest and Middle Atlantic states. A whopping 70% of its power generation comes from nuclear.

With a $217 million market cap, Central Vermont Public Services is the smallest of the lot. As the name indicates, the company serves parts of Vermont and has a very clean portfolio of power generation: 48% nuclear, 39% hydro and 3.9% wood, with a smattering of oil, cow power and other.

As a group, the longs offer a slightly lower dividend yield -- about 4.2% vs. a 4.9% yield on the short group.

Next Catalyst

This is not a trade on the fundamentals; it's a thematic trade on the shift in political power. Though I may trade intermittent movements at any time, I've got my calendar marked for inauguration day -- let's see what happens.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider Central Vermont Public Services to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

Buzz up!