Relative Value Trading Idea: Short Homeowners Choice, Long Universal Insurance

One of the most frequently employed strategies in trading is pairs trading, or relative value trading, where the investor is long one stock while short another. The idea is that this strategy can hedge out some of the market risk inherent to individual securities. Many hedge funds employ a long/short equity strategy which seeks to be long undervalued stocks and short overvalued stocks. An interesting opportunity that may be compelling in the small-cap insurance space is a pairs trade in Universal Insurance Holdings

and Homeowners Choice

. Both of these companies operate in the Florida insurance market. Homeowners Choice has a market capitalization of roughly $175 million while Universal Insurance has a market cap of just under $134 million. There are a number of differences between the stocks, however, that could suggest a profitable pair trading opportunity. On a valuation basis, Universal Insurance is somewhat less expensive than Homeowners Choice. On a trailing basis, Universal Insurance trades at 8.49 times earnings. Homeowners Choice, on the other hand, has a trailing P/E of 10.19. There is also a substantial difference between these two stocks' dividend yields. Universal Insurance is yielding a whopping 9.64 percent whereas Homeowners Choice is yielding around 4.05 percent. All things being equal, holding Universal Insurance shares provides a substantial payout premium to its competitor while being exposed to similar market trends. Even more compelling, potentially, is the massive divergence in these two stocks' recent returns. Homeowners Choice has soared in 2012, rising over 146%. Universal Insurance, on the other hand, has actually lost over 7%. If the current trends in these two stocks were to revert even modestly, being long Universal Insurance against a short position in Homeowners Choice could be quite profitable. This trend could begin on Tuesday, as Universal Insurance shares are trading up on the session and Homeowners Choice has lost over 6%. Look for this pattern to continue in the coming days. It should be noted, however, that this is a very risky trade. Not only are both stocks thinly-traded small-caps, but Homeowners Choice has been incredibly strong. Any trader attempting this trade would need to use tight stop losses and realize that shorting the company could be very risky. Nevertheless, a look at Homeowners Choice's chart reveals that the stock had made a parabolic move prior to today's sell-off. Frequently, a day such as Tuesday, where volume is very heavy, marks the beginning of a steep correction in stocks that have seen their charts go parabolic. More than 720 thousand shares of the company have already traded on the session compared to a daily average of under 200 thousand. F For traders looking to take on some short-term risk, a potential idea would be to go long Universal Insurance and short Homeowners Choice with a stop in the latter above its 52-week high of $22.00 - which was touched on Tuesday morning.