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By: Chris Rowe — June 15, 2009

How to Profit Like a Hedge Fund

Editor's Note:  Chris Rowe is in his final week of filming for his new options education course, Options GPS.  For today's issue, I selected one of my favorite articles Chris has written.  This article was originally published on June 10, 2008 under the title "Profit Like a Hedge Fund from this Article."
 
Today I'll show you how to make money, whether the market trades up or down, using a simple yet effective strategy that the hedge funds use.  This one won't be like the very basic hedging strategy that I gave you last week.

In that particular article, I suggested hedging a bullish portfolio with in-the-money put options on the S&P 500.  I even recommended to you the exact S&P 500 put option to use. Typically, I don't go that far in The Tycoon Report because I want to be fair to Trend Rider members who pay me for specific option recommendations.  But I think it's important to give Tycoon readers actionable ideas and balance that with fairness to paying members of The Trend Rider.

Today, however, I will give you the strategy alone, and you can apply it in any way you think is appropriate.  And just remember: by reading The Tycoon Report, you can definitely gather ideas from each of our 5 editors over time.  I'll give you examples of what I mean, but let's get on with the article...

Many of you might already be familiar with today's strategy.  But even if you are, keep reading to check out the spin that you can put on it to make it even more effective than most professionals do.

Ladies and Gentlemen and, um, otherwise, introducing "Pairs Trading"!


WHY I STARTED USING THIS STRATEGY

One day, about 12 years ago, my clumsy cousin came into my office on the corner of Wall and Water Streets.  Although his breath stunk of alcohol from a 3 martini lunch, I pretended I hadn't noticed as I offered him a seat and some water.  As he turned to pick up the water, he knocked over my crystal ball, and from that point on, no matter how many reliable indicators I studied, I never knew for sure in which direction the general stock market was going to move next.

It was at that point I decided that no matter how confident or smart I thought I was in my predictions, I had to plan for failure, and position myself to make money, even when I was wrong about the direction of the stock market.

THE STRATEGY

This really isn't rocket science, but just like many aspects of trading and investing, although it seems so obvious and easy, most people still don't do it.  Here's how simple it is...

This involves considering two separate positions as one position.

First you find the stock or ETF that you think has the greatest chance of advancing and you bet on it doing just that.  Then you find another one that you think has the greatest chance of declining and you bet on it doing just that.  Again, the combined trades should be considered as one single position.

As you probably know, you can profit from a downwards move in a stock or ETF by selling-short that security.  You sell it at one price first, and you try to buy it back more cheaply, profiting on the difference.  (If you're not familiar, Google it later).  There are many other ways to profit from a downwards move, but short-selling is the most popular.

Now, you've probably heard the old saying: "A rising tide lifts all boats," meaning when the general stock market advances, even crummy stocks trade up.  On the flip side, when the general market gets slammed, even great stocks move lower.

But what many people surprisingly still don't understand is that, in down markets, strong stocks and ETFs tend to trade down by a lesser amount than weak stocks and ETFs.  In up markets, strong stocks and ETFs tend to trade up by a larger amount than weak stocks and ETFs.

Everyone understands the concept of diversifying your portfolio for safety.  The traditional way of diversifying assumes the market only trades up.  When some of your stocks inevitably go down, you have others that go up, and hopefully the advancing positions outweigh the declining ones.  Either way, you are playing it safe.  That is, unless the market tanks.

Well, "pairs trading" is one way of diversifying, but it shields you from having to guess the direction of the general tide (stock market).

You make two bets -- a bullish bet on one stock or ETF and a bearish bet on another.  If everything works perfectly, your bullish bet trades higher, and your bearish bet trades lower, so both parts of the trade win!

But since the stock market has a lot to do with the direction of your stock and ETF positions, it's likely that a strong up or strong down market will cause you to be right about one part of the position, and wrong about the other. 

If the general stock market moves up by 20%, and your bullish trade advanced 50% while your bearish trade advanced 20% (which is essentially a 20% loss to you) your combined position is up 30%.

I'm giving you a strategy you should use to profit for the rest of your life.  I hope this means more to you than a specific recommendation.

Some Examples ...

First, an example using stock, and then an example using ETFs and options...

Let's say you read my April 1 article titled "How to make sure YOU don't own the next Bear Stearns", and my comments on Lehman Brothers prompted you to bet that the stock would trade lower.  At the same time you decided that, since energy stocks are doing well, you'll bet that Exxon Mobil will trade higher.

Two weeks later, you bought $10,000.00 worth of Exxon and you sold-short $10,000.00 shares of Lehman Brothers.  You consider the two positions as one so you have a $20,000.00 position.

Lehman Brothers traded from $45.00 to $29.43 -- down 35% -- which is in your favor.

Exxon Mobil traded from $93.50 to $89.08 -- down 5% -- which is not in your favor.

In this case, the general market basically traded flat.  You were right about your bet on Lehman Brothers trading lower, but you were wrong about Exxon Mobil trading higher.  Together, the combined position shows a 15% gain.  (35% gain - 5% loss = 30% gain)/ 2 = 15% average/combined return.

Below is a chart of the S&P 500 compared to Lehman and Exxon.  The strategy isn't really put to the test here because the market was flat.  But it illustrates how we were wrong on XOM but profitable on the whole deal.  But here's the important takeaway:  Since Exxon Mobil is a stronger stock than Lehman Brothers, we can assume that if the market pushed higher, Lehman would either still have declined, or it would have been pushed up by the market, but by a lesser percentage gain than Exxon.  That would be a win.
 

Now let's make it interesting.  Let's say you read my January 3rd article titled "Crude Oil Hits $100.00! 3 Ways To Profit From It!" and you gathered from that read that you could profit from an advance in the energy sector, and a decline in the airline sector. 

So you took my advice and took a bullish position on the ETF representing energy stocks (XLE) and a bearish position on the airline index (XAL).  If you used "pairs trading" and committed the same dollar amount to each of the positions, you would have made a killing, and you would have been hedged. 

By the stock market's March low, the Energy ETF that we were bullish on (XLE) was down 10% and the Airline Index that we were bearish on was down 30% (which means a 30% gain).  The combined positions show a net gain of 10%. 

$10,000.00 bullish in XLE was down $1,000.00 (10%)
$10,000.00 bearish in XAL was up $3,000.00 (30%)
Net gain on $20,000.00 is $2,000.00 (10%)

At the same time the, S&P 500 had declined by 12%.

Currently, XLE is up 11% and XAL is down 45% (which is a gain for bears).  So the combined position would be up 17% (while the S&P 500 is down 8%).
 
The fact of the matter is that you would have made MUCH, MUCH more than that for two reasons:

1. Since XAL is an index (not an ETF) I suggested buying put options on it, because you can' t buy the index itself.  Since XLE is an ETF, I didn't say to buy call options, but I did suggest call options on the Oil Service Index (OSX), which traded up 13% -- 2 percentage points above XLE. 

2. If you read the article, I suggested buying XLE when it pulled back (declined) to its 20-week moving average.  I also suggested getting bearish on XAL when it hit its down trend line.  Both of these events happened, so you would have gotten better prices than when I wrote the article and in the above examples.  Click here to read it.

This isn't an advertisement for The Trend Rider, but I want to illustrate my point once more.  Below is my track record as of the July top, and as of the October top, along with a chart showing what the market has done since then.
 

This is done by playing both the bullish and bearish side of the market at the same time.  I have been doing it for ages, and I've been making the recommendations public since September of 2005. 

I'm not telling you that you have to sign up with my service.  But if you're not doing it yet, for crying out loud -- at least start hedging!

Finally ...

I told you I would show you my spin on Pairs Trading.  This is simple.  Trading deep in-the-money options (high delta options) in replacement of stock gives you an even better reward to risk ratio.

Here's a hypothetical example:

If XYZ stock trades up 10 points, the deep in-the-money (high delta) call option may trade up 9 points.

If XYZ stock trades DOWN 10 points, the deep in-the-money (high delta) call option may only trade down 7 points.

What does that tell you?

First, consider what happens in pairs trading when the bullish stock gains 10% and the bearish position loses 10%.  You would be flat, right?

Well, if you replaced your bullish stock position with high delta calls, and your bearish position with high delta puts, here's what happens in the hypothetical example above:

Your call option (assuming it's on a $100.00 stock) gains 9 points.
your put option (assuming it's on a $100.00 stock) loses 7 points.

That's a net gain.  It's only 1% in this simple example, but that is MAGNIFIED in many circumstances.  But my fingers hurt too much to explain.  I'll see ya next Tuesday!

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