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Good Things Come in Pairs (Trades, That is!)

April 05, 2006

Dear Fellow Options Trader,

Sometimes, the best way to play the market is to position yourself in the right sector with two parallel trades that enable you to hedge your risk and take advantage of the momentum within that particular industry.

Options traders can do this through a two-sided (pairs) trade that lets you leverage one company against another (i.e., one of its competitors in that space). I know this is a little bit new to you, but I'll walk you through it and pretty soon you'll see that pairs trading is another powerful tool to have in your arsenal when you want to improve your odds of winning when you're trading options.

Today, let's give that a try with some familiar restaurant names that will make your mouth water almost as much as the potential profits should!

CATCHING THE CHANGEWAVE -- HAVE YOUR STEAK AND PROFIT FROM IT, TOO!

During the week of March 14-17, 2006, the ChangeWave Alliance conducted a consumer survey on restaurant spending habits, with a close-up look at spending plans for the next 90 days. The Alliance came up with the following results:

• 23% of respondents say they'll increase spending during the next 90 days.



• 24% saying they'll decrease spending.

Big whoop, Doc -- what does that tell me? Well, when compared to the same question we put to the Alliance back in September, only 18% said they would increase their restaurant spending and a whopping 29% said spending would decrease! That, my friend, is a change in sentiment, and we're looking to cash in on our findings. Here's how:

The Outback Steakhouse (OSI) chain clearly showed the most momentum among all restaurant chains surveyed. Moreover, OSI showed strong momentum among consumers both for the past 90 days and for the next 90 as well. OSI is the parent company of the Outback Steakhouse, Carrabba's and Bonefish Grill restaurant chains.

On the contrarian side of these results, we found Ruth's Chris Steak House (RUTH) showing signs of a slowdown in the current survey.

Here is one way you could position your portfolio to take advantage of our Alliance findings in a pairs trade:

I recommend going long in OSI (through buying calls) and shorting RUTH (through buying puts).

Now, before your eyes glaze over, this isn't as tough as you might think.

We don't care about the market capitalization of either company -- just share price. What we do, then, is divide the smaller share price (which is RUTH, trading for $23.71) by the larger share price (which is OSI, trading for $41.05).

Thus, the ratio of shares of RUTH to OSI would be 0.58 (23.77 / 41.05 = 0.577). That means that for every share of RUTH we sell, we'd buy 0.58 shares of OSI.

Here's how you can put these together into a pairs option trade. One with limited risk, but great potential:

THE TRADE

• I recommend telling your broker to buy six of the OSI May 45 Calls (OSIEI) for 45 cents. Because each option represents 100 shares of stock, that means you will have invested $270 on this side of the trade and as always, the premium you pay is your entire risk.



• Next, have your broker buy 10 of the RUTH May 22.50 Puts (UUKQX) for 65 cents. Because each option represents 100 shares of stock, that means you will have invested $650 on this side of the trade and as always, the premium you pay is your entire risk.

Once completed, you have a trade on that makes money if OSI goes up and RUTH goes down, which is what our recent survey has projected. If this scenario doesn't play out by May expiration, you could lose $920. But if RUTH falls and OSI rallies, there is nearly unlimited profit potential.

Tell your broker to buy six of the OSI May 45 Calls (OSIEI) for up to 45 cents and to also buy 10 of the RUTH May 22.50 Puts (UUKQX) for 65 cents. You can ramp up the strategy as big, or make it as small, as you'd like, just as long as you maintain the 0.58 ratio between the two trades.

Good luck trading and remember -- pigs get fat, but hogs get slaughtered, so don't be a hog!


Jon "Dr. J." Najarian
Editor
ChangeWave Options Trader