HIGH RETURN PAIRS TRADING USING ENERGY ETFs

No one knows when the stock market will enter a sustained bull phase again. I like generating income with a hedged investment style, while waiting for the markets to turn. I am buying XEG.TO, iShares S&P/TSX Energy ETF, and selling XOP, SPDR Oil & Gas Exploration & Production ETF. XEG has a yield of 5%, whereas XOP's yield is 1.4%. Our studies show that the correlation between these two securities is about 95% and a hedge ratio of 42% is appropriate (e.g. buy 100 shares of XEG and short 42 shares of XOP). The economics of the trade would be as follows, if the trade is held for a year (all prices are as of March 10, 2009; no commissions):

Buy 100 shares of XEG and pay $(985.85) {$(1,267) Cdn.}
Sell 42 shares of XOP and receive $ 1,050.42
Borrow/Interest Costs @2% are $21.05
Net Investment $ (43.53) {positive cash flow}
Net Dividends Received $ 37.73

WE ARE PRINTING MONEY; BUT......

In trading this pair, one has to keep in mind that one is exposed to basis risk and he will have to monitor the position for a change in the relationship between the two ETFs. The price ratio of XOP to XEG averages around 2.3. However, it has been as high as 3 and as low as 1.9 in the last 3 years. In the same period, the difference in the two prices have been as high as 44 and as low as 12, with a mean of 24. That metric stands at 14, currently. In a bullish and speculative environment, XOP is likely to outperform XEG. The US market is much larger and XEG is not known to most individual US investors. Also, XEG contains lower beta income trusts and pipelines.

Other factors to watch would be the additions and deletions to each ETF and the dividend rates over time.