Highlights in this issue:

*** The essential strategy for profiting NO matter what…
*** Not sure what sector share to buy… this is the answer…
*** Is spread trading for you…?

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From the pen of Tim Bennet…

Dear Investment Academy Reader,

Which is easier to predict: How far the share price of Pick ‘n Pay will rise over the next few days, or whether you think Woolworths will do better than Mr Price? Both may sound like tough questions.

But what if you find out a key executive is defecting from Pick ‘n Pay to Woolworths? Suddenly you have a clear trading opportunity. Odds are that the Woolworths share price will surge while Pick ‘n Pay’s will slump.

You could respond by just buying Woolworths shares or shorting (that’s when you sell movement in  a share) Pick ‘n Pay. But that leaves you open to swings in the broader market.

What if, having bought Woolworths, all retailers suffer a bad few days? Or having shorted Pick ‘n Pay, the wider  market rises unexpectedly? This is where you need a pairs trade, which is designed to profit whichever way the broader market turns.

How to do it?

A pairs trade involves simultaneously placing an up bet on one asset (this could be a share, currency, commodity – indeed, almost anything these days) and a down bet on another. The easiest and quickest way to do this for a private investor is by using spread trading. The strategy actually involves four trades. In the example above you would initially place an up bet on Woolworths (you ‘buy the spread’) at, say, R3.80, and a down bet on Pick ‘n Pay (‘sell the spread’) at, say, R2.90. Let’s say the Woolworths share price then jumps 20c to R4, while Pick ‘n Pay sags to R2.60. You now close out both trades.

At first glance the overall profit looks pretty meagre – 20c on the Woolworths leg and 30c on Pick ‘n Pay. However, the beauty of spread trading is that you can gear up. The amount you choose to risk on each trade is negotiable. But let’s say your original bets were at R10 a point (one point being a 1c movement in the share price). Now our profit on the Woolworths up bet is R200 (20 point x R10) and the profit on the Pick ‘n Pay trade is R300. That’s R500 in total minus perhaps R40 to reflect the fact that the opening prices above didn’t reflect the typical bid-to-offer spread (say 2 points, or R20 on each stock). In practice you may also want to weight your trades so you’re equally financially exposed to each share. That would mean betting nearer R13 a point on Pick ‘n Pay (since R3.80/2.90 = 1.3 times).

What can go wrong?

There’s one big flaw with a pairs trade. Had Woolworths fallen and Pick ‘n Pay risen – the opposite of what you expected – you could have lost pretty fast too (around R400 in the above example). However, as with all spread trades, there’s a solution. It’s called a guaranteed-stop.

The idea is that you specify a price at which you want each leg of the pairs trade closed. So on your Woolworths up bet it might be set a few cents below your opening price of R3.80. That way should Woolworths subsequently dive you won’t get wiped out. Some brokers charge for guaranteed stops – typically the spread on your chosen share is slightly wider.

So, where should budding pairs traders be looking to make money?

Single stocks

The trick is to find pairs of share prices that have diverged. Charts are one way to spot this happening. Or you can track the relationship using a simple multiple. For example, say two firms, A and B, have share prices of R10 and R5, so the relationship is two (R10/R5). What’s more, that ratio has held more or less constant over the past two years. If it suddenly moves to three, you know that either company A has shot up or company B has dropped. A good trade would be to short A and buy B, assuming the relationship will re-establish itself. Failing that you need a good reason why it has suddenly changed permanently.

Sectors

Another option is to trade whole sectors against each other. At IGindex, for example, you can buy or sell UK and US sectors using spreadbets (this is what they call spread trading over there).

Given how far cyclical stocks have surged this year, and how far defensive shares have lagged, one good bet looks to be to sell a cyclical sector, such as miners (which depend on economic growth for their profits), and buy a defensive one, such as utilities (which are less sensitive to tough economic conditions).

Currencies

All currencies automatically trade in pairs – if you are betting that sterling will rise, it must be against another currency that is set to fall. So, for example, you could buy the GBP/USD pair as a sterling bull or sell it as a sterling bear. At the moment, notes Jim Mellon, the battered dollar looks set to stage a recovery while the euro is now facing headwinds as more trouble wafts out of eurozone members such as Greece and Spain. So you could try a short EUR/USD trade via your broker.

Regards,

Tim Bennet
For the Investment Academy