How to Risk Less and Profit More
After 20 years of consistent trading and investing in the financial markets, if you were to ask me what the greatest investment is, I’d have the answer immediately.
It’s a strategy that’s incredibly easy to understand... It offers a significant reduction of risk but still has the potential for huge gains...
I’m constantly blown away that it isn’t incredibly popular among investors of all calibers.
This type of investment can be structured in an infinite number of ways, but the idea is to significantly reduce, or even eliminate, stock market directional risk.
I’m talking about a strategy called “pairs trading.”
What Is Pairs Trading?
It’s simple. You bet on one thing going higher and then take the exact same dollar amount and bet on a correlated asset going lower (two stocks, two ETFs, two options, etc.).
Let’s say you’re bullish on Investment A. You think it’s going to trend higher. So you invest $10,000 into the idea.
At the same time, you’re bearish on Investment B. You think it’s going to trend lower, so you invest $10,000 into a short position on that idea.
Now you have a $20,000 position that you will profit from as long as Investment A goes up more than Investment B does... or Investment B goes down more than Investment A does. (This doesn’t take margin or commission costs into consideration.)
If you try this with individual stocks, you’re more likely to get hurt than if you try it with exchange traded funds (ETFs). ETFs represent the weighted average value of a basket of stocks. I like sector ETFs the best because they tend to trend more.
By using ETFs as opposed to individual stocks, I don’t have to worry about Investment B getting acquired by another company and opening 50% higher the next day (thus causing me to take a big loss, since I’m bearish).
I also don’t have to worry about Investment A getting cut in half overnight because the SEC launched an investigation into its accounting.
No matter what happens, I’m all but guaranteed to come out on top. This is what I’m talking about when I say you can reduce your risk but still have the potential for huge gains.
As an example, let’s consider two sectors for a trade...
The Utilities sector was the strongest sector in 2013. I want to be bullish on Utilities as they continue to be among the strongest sectors.
Of course, Energy was the weakest sector. But it’s been hit so hard that I’d be concerned it may have a sharp rebound after betting against it.
I want to structure a pairs trade with two sectors that have a similar level of historic volatility. You don’t have to be a math wizard to find a good match. You can just compare the charts and eyeball it.
So let’s hypothetically take a bullish position in the Utilities sector and a bearish position in the Financials sector, because Financials was the second-worst performing sector after Energy.
Take a look at the performance chart above.
My four weak Financial ETFs are on the left, averaging a loss of 8.27% in January.
My four strong Utility ETFs are on the right, averaging a gain of 1.32% in January.
The S&P 500 is in the middle, down 3.07%.
After some checking, I found that the Fidelity MSCI Utilities ETF (NYSE: FUTY) historically had the most consistent dividend payments and the highest yield. So I want to invest my $10,000 in shares of FUTY. As I write this, it’s at $31.07.
$10,000 / $31.07 = 322 shares.
Now I want to sell short $10,000 worth of one of these financial ETFs. I’ll pick the worst-performing one, which is iShares US Financial Services (NYSE: IYG).
$10,000 / $86.48 = 115 shares.
So I want to buy 322 shares of FUTY and sell short 115 shares of IYG.
The combined position is worth $20,000.
In a perfect world, ITG would go down and FUTY would go up. But as long as FUTY goes up by more - or down by less - than IYG, I’m going to be profitable (less trading costs).
Let’s revisit this trade in three months and see where we stand. My feeling is it will have less than half the volatility of the S&P 500 and will end up with a significant profit.
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