By: Chris Rowe — February 22, 2016
How to Profit if The Market Advances... or Declines!
After seeing how quickly money poured out of the stock market and into the fixed income market, it makes sense to increase exposure to fixed income.
Why restrict yourself to profits in the stock market?
And as a rule, we like to overweight into the strongest asset classes.
But, at the same time, due to historically oversold stock market conditions, we remain bullish on most sectors of the U.S. stock market for the next 2 - 4 months.
We know that most investors are afraid of stocks at the moment. And that stress can really reduce a person's life span.
You don't have to take a directional stance on the stock market in order to make profits.
Today's article is about taking a "market neutral" position in the stock market.
Let me start at the end.
Today's "market neutral" move is to take a bullish position on a sector that's working and take a bearish position on a sector that looks horrible.
We'd want to take both positions at the same time.
That means buying one security and selling short another security using the same dollar amount.
Security A: Buy $10,000.00 worth (doesn't matter if it's an odd number of shares).
Security B: Sell short $10,000.00 worth (doesn't matter if it's an odd number of shares).
If the stock market gets clobbered then you’ll profit as long as the security you purchased declines by a lesser amount than the one you sold short.
Historic example #1:
If the stock market advances, you just want the security you bought to go up by more than the one you sold short.
Historic example #2:
This is called a “Pairs Trade”.
The greener investors tend to get hung up on the “short selling” part.
Brief explanation: You don’t need to completely understand the mechanics of how it all works.
Be sure to consult with your broker about the risks of short-selling. But basically, you can profit from a price decline in most stocks or ETFs.
All you have to do is enter the trade as a “short sale” instead of a “buy”.
If you sell short 1,000 shares of an ETF at $60 and it goes to $50, your profit is $10,000.00, minus transaction costs. This is done in a margin account, although you don’t have to actually borrow money to do the trade.
Of course, if the same stock were to advance to $70.00, it would be a $10,000 loss. (But this article discusses a hedged position that aims to mitigate or eliminate that loss.)
To close the trade out, simply buy it back. Many brokerage platforms will just know that you’re “covering your short” (buying the stock back). Again, consult with your brokerage firm the first time you do this.
You may have to enter a standard “buy” order but you may have to enter the trade as a short-cover. Your broker will know.
If your brokerage platform is good, then in a pairs trade, they’ll let you set up the order so that you can buy security A and sell short security B simultaneously.
This is absolutely the best way to run your pairs trade. You wouldn’t want to do one side of the trade and then suddenly have the stock market move sharply before you can enter the other side.
Don't worry if this sounds intimidating. You'll find it's very easy.
I’ll give you an example of when this worked perfectly and then I'll give you an example of a pairs trade that can be used today.
In 2007, massive building, most notably in China, created demand for commodities. Prices of commodities, like oil, were gunning higher. And so were the stocks of that sector, like oil stocks.
But the Financial sector started to drop as the credit crisis approached.
Meanwhile, exacerbating their advance, commodities got an even bigger boost from the Fed lowering interest rates in an attempt to stave off the coming market collapse.
In the chart, above, you can see that the Energy sector went up and the Financial sector went down... by a lot.
If someone had $10,000 invested into the energy sector ETF and $10,000 behind a short position in the financials ETF, it would have been a $20,000 pairs trade.
The trade would have gained $8,421 (+42%).
In this case, the trade worked out perfectly because both positions (both sides of the trade) were profitable. It was a double whammy of a win.
But the point of a pairs trade is to make an investment that is market neutral.
If you win on both trades, that's fantastic. But don't expect it.
You simply want your primary security (the one you bought) to go up by more or down by less than the secondary security (the one you shorted).
Even if we see half of that percentage gain, it would be about three times the average annual gains of the stock market.
Let's Create a Pairs Trade
The weakest sector has been the Financials sector. So that's where we'll take our bearish position.
The sector ETF we'll use is "Financial Select Sector SPDR Fund" (Symbol: XLF).
The strongest sector is currently the Utilities sector.
But instead of using it as our bullish sector, I’ll use "Consumer Staples" sector (also very strong) because Utilities vs. Financials can turn out to be more of a play on interest rate expectations.
(Utilities tend to do well with lower interest rates and Financials tend to do well with rising interest rates. So if expectations end up being that interest rates are going to rise then we could have a double whammy in the wrong direction. But if the opposite happens, then we could see a double whammy in the right direction. Let's not make this about interest rate direction.)
Consumer Staples has been a very strong sector. The sector ETF we'll use is "Consumer Staples Select Sector SPDR Fund" (Symbol: XLP).
If we invest $10,000 into Consumer Staples, we'll own 196 shares of XLP.
If we invest $10,000 into a short position in Financials, we'll be short 476 shares of XLF.
Long 196 shares of XLP at $50.84 = $10,000
Short 476 shares of XLF at $20.98 = $10,000
Total Position Size: $20,000
The above chart shows the 6-month performance of the position XLP (long) vs. XLF (short).
You can find this type of "relative strength chart" for yourself. What I did, was on stockcharts.com, I entered XLP:XLF and I changed the "type" (in the drop down menu) to "performance".
This will show you the spread between the two, on a percentage basis.
EXAMPLE #1: If XLP advances by 25% and XLF advances by 9%, the chart will show a gain of 16% (the difference between XLP's gain and XLF's gain) for the specified time frame.
The $20,000.00 position would gain a total of $1,600.00 (or 8% of $20,000).
** Remember: A short sale position means we profit from the decline of the security and lose money when it advances. So, in EXMPLE #1, we profited when XLP advanced but, since we sold short XLF, the fact that it went up means we gave back (lost) some of those profits.
EXAMPLE #2: If XLP declines by 12% and XLF declines by 32%, the chart will show a gain of 20% (the positive difference between XLP's loss and XLF's loss).
The $20,000.00 position would gain a total of $2,000.00 (or 10% of $20,000).
EXAMPLE #3: If XLP declines by 20% and XLF declines by 10%, the chart will show a loss of 10% (the negative difference between XLP's loss and XLF's loss).
The $20,000.00 position would lose a total of $1,000.00 (or 5% of $20,000).
Keep checking your weekly issues of True Market Insider for the updates and in a month or so we will see how this hypothetical position does.
See you next Monday!
CIO True Market Insider