Exploring CAT vs DE potential Pair Trade

Not sure if the market will continue up?

Nervous about the risks presented by this rising market?

Let’s talk Pair Trading...

by Rob Friesen

Caterpillar Inc: CAT (NYSE) vs. Deere & Company: DE (NYSE)

We can see that they are tracking together well, but both charts are plotted on a linear price scale rather than logarithmic. CAT has risen from roughly $100 to $200 while DE has risen from $120 to $300 so DE has certainly outperformed over the same period.

But what about comparing the characteristics? 

Even though they are $100 a part, the Average True Range (ATR-14day) as a percentage of price is the same for both: 2.37% for CAT and 2.39% for DE. Weekly and Monthly Volatilities are also very close.

We see that they track together, they should both respond similar to market moves and even industry related news.

But what about the Non-Correlated Risk?

And why has DE outperformed CAT in all recent timeframes?

Before we can address the reasons for DE performing, we need to view a ratio chart:

 This is DE / CAT weekly line chart from the year 1993 until Friday, January 8, 2021

We observe mean-reverting behavior overall, but now is stretched out to a ratio not previously seen.

What insights can StockOdds Data provide in terms of the probabilities of the spread relationship expanding or contracting?

On Wednesday, January 6^th after the market closed and data was updated, I ran this screen for Momentum Signals using the StockOdds Database. Thursday, January 7^th would be the first of 10 days of subsequent behavior for these two stocks.

We observe that CAT has better Odds of an up event with a better average performance and Sharpe ratio than DE. Additionally, its Maximum Favorable Excursion (MFE) during the 39 events of our lookback period is better than twice its Maximum Adverse Excursion (MAE).

How do we set up a trade?

The first thing is converting the Spread Ratio into something that you can trade, resembling the price action of a stock. The current ratio is showing that DE is 1.5 X the price of CAT…so we have to turn that around to make it 150 shares of CAT to 100 share of DE. We will name the pair: CatDe150
The formula: Spread Number = 1.5 * (Last price) CAT – (Last price) DE

Here is that “Factor-Adjusted Differential” Spread Chart: CatDe150

And below is what happened on the 1-minute chart for Thursday, Jan 7 and Friday, Jan 8:

Thursday presented an opportunity mid-to-late day to participate.
Friday was follow through of that move.

When traders are looking for mean reversion from a pair, it is best to design a plan on what you need to see in order to participate. Either one is going to get involved while it is still trending out, stable, or coming back in (retracing or mean-reverting).

So StockOdds can give you a potential trade, but it is up to each trader to apply the timing, entry and exit criteria. My own plans revolve around IF-THEN rules that ask each symbol and each pair to show me something…to meet me on my terms.

There is plenty of upside or retracement potential in the pair, and it is good to think about what could possibly drive each of the stocks. Why does CAT have potential to out perform DE going forward?

I highlighted the ETFs that are common to both, and CAT has a bit more weight in those except for ARKQ. Notice how CAT has been utilized in many Leveraged ETFs, both bullish and inverse.

Since there tends to be a bit of a cancelling effect with the overlap, we must play the game of what is not like the other?… What ETFs can really impact either of the symbols?

Weighting and Volume are going to have a more pronounced influence, so for CAT, the DIA would be important as CAT will perform more in line with other DOW components.
For DE, maybe the ARKQ… which is weighted 13.05% in TSLA, so that certainly has an effect and ARKQ is up 122.46% over the last year. I can see it pulling DE along with it.

Segments:

• CAT: Construction, Resources (Mining), Energy & Transportation, Financial Products, Fluids, Parts, Logistics/Distribution
• DE: Agriculture & Turf, Construction & Forestry, Financial Services

CAT overall is more industrial, while DE is more agricultural and consumer orientated. There is significant overlap which makes them competitors and a pair that can be traded, but their differences, or the non-correlated risks can cause the stocks to perform at different paces, converge or diverge.

The pandemic caused a slowing of commercial endeavors, but consumers forced to stay at home spent money on their homes, yards, tools and more. I believe these factors have benefited DE more than CAT.

Looking into the future, as economies rebuild and once again focus on infrastructure globally and domestically, we could see CAT perform better.

The ETFs listed above could be trading instruments against either CAT or DE or could be used to hedge if there is a need to offset some drift. Additionally, there are other stocks in the industry that you may wish to get familiar with. Here are the top 8 stocks by Market Cap in “Farm & Heavy Construction Machinery”.

I highlighted CNHI which is domiciled in the United Kingdom and NAV which has merger related problems so should not be paired with any of the others.

The key for pair trading is to be able to get some production, or “earnings” from the pair, as if it were a machine or a good employee. In a perfect world, it would be great to get some production as well as some Return on Investment (ROI), so the concept is “trade some, hold some”. Of course, you could be flat overnight and take the pair trade each day if and when it is warranted.

One other option is to crutch trade by watching the market and the symbols and take one side of the pair first, using the other side only if needed as a hedge.

Once you have researched and flagged an opportunity, set some alerts to assist you to get in on your own terms. Don’t speculated that a pair is going to go up or down, but rather think about premium or discount to a central theme… as in where does it spend most of its time, the distribution area?

Think of outliers to those areas and plan for that mean reversion. There are multiple time frames to look at, not only the day session.

Overall, the current trend of CAT relative to DE is down, meaning that quite possibly CAT could still underperform DE. We are discussing this pair as it has potential to climb back up from this discount.

The benefit of a pair is that whether you get the direction right or wrong for the pair itself, you are somewhat insulated to the noise of the market, the violent moves you have no control over, and the macro forces of the market. This is helpful from a psychological perspective, as well as buying you time for planning, further research and running the scenarios.

CAT vs DE has shown sympathetic moves overall, but there is still enough difference in operations to increase risk, and opportunity. This pair can move many many dollars. This makes it very different than two classes of stock in the same company such as NWS and NWSA. 

The Spread Change in CatDe150 may be greater than $40-$50 per year versus $1.50 - $2.00 with a pair like NwsNwsa100

Separate your pairs into various categories, like those that tend to trend and those that live in tighter ranges. Position size is determined not only by dollars, but by risk.

The opportunities presented by various types of pairs are almost unlimited. Finding and trading these relationships can be fun and profitable but operate first as a risk manager. Personally, I would rather focus 80% of my trades on the boring and predictable relationships and 20% into those that are “movers and shakers”. This reduces the risk of ruin, while focusing on earning money, not “winning money”.

There are many signals in StockOdds to view subsequent performance for CAT & DE and many other global stocks and ETFs. Acquire our education on how to trade them as well as the data to be informed while you do.

Trade Profitably! 

~Rob

For those interested in seeing an example of trades taken on CAT / DE with results, check out this post in the StockOdds Community. If you don't have access to the Community, you can sign up below.