Have you ever wanted to short a share, but were worried that the markets could take off and you’d end up losing your shirt?
Well, here’s a strategy that allows you to hedge against this risk. What’s more, there’s an interesting opportunity available right now that could deliver a tasty profit.
Let me introduce you to ‘pairs trading’…
This strategy takes two shares from the same sector, like BP and Shell for instance. These two shares tend to move in tandem, as they’re affected by the same sorts of economic factors.
If we notice that BP has started to get cheaper than Shell, then that gives us an opportunity. If we buy the BP shares and short an equal value of Shell shares, we can profit as the shares move back to their historic relationship.
The beauty of this strategy is that it’s ‘market neutral’. If oil stocks crash, then both shares should go down, but the profit on the Shell short, should compensate for the loss on the BP long.
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Of course, if the market goes up, the opposite happens, so we don’t get the benefit of a market rise. What we’re trying to do is profit from the fact that one share is too expensive relative to the other.
We can take this ‘pairs’ strategy and apply it to markets too. Let’s take a look at an expensive market and a cheap one. Then see how to apply the strategy…
Sell FTSE 250 & buy FTSE 100
Here’s a pairs trade for two markets that I’ve been studying. The FTSE 250 looks expensive relative to the FTSE 100. Let’s have a look at the long-term relationship between the two indices and then look at the valuation figures to see why…
Both the FTSE 100 and FTSE 250 were created in 1984 and started at 1,000 points. Graham Sarjeant notes in the Times that until 2003, “the 100 and 250 indices tootled along near enough to each other to recall a motorway and the A road it replaced.” But then, after 2003, the two indices started to separate.
The 250 stormed ahead and right now, the 100 trades at 5,342 while the 250 is nearly double that, at 9,982. Is there any justification for why the 250 motored ahead? Let’s look at some valuation yardsticks…
Valuation
My old favourite valuation tool is the p/e ratio. That is, the ratio of a company’s share price to its profits. We can use it for the market as a whole and then look at the yield too. Here are the current figures for both the FTSE 100 and FTSE 250 Indices:
FTSE 100 5,342, p/e: 14.33, Yield: 3.52%
FTSE 250 9,982, p/e: 18.97, Yield: 2.47%
So, on a p/e of nearly 19 times, the 250 is about a third more expensive than the 100. It pays only 2.47% yield, again, about a third less than the 100. I know that interest rates are low, but a return of less than 2.5% is pretty stingy.
Is there any reason for this anomaly? Two things tell me that the answer is no…
1. International versus UK focus
The 100 companies are large multi-nationals with fingers in many pies all over the globe. This means they have exposure to growing emerging markets, as well as currency diversification.
The 250, on the other hand is more concentrated on the home market and is considered by many a barometer of UK plc. So, if the UK economy suffers, then the 250 suffers.
The 100, on the other hand is better shielded through its international diversification.
2. Quality brands and financial power
Normally, you expect to pay more for quality. By quality, I mean world famous brands, proven management and a global infrastructure. These are all in abundance in the 100.
Of course, the 250 has good companies too, but by definition, they haven’t grown into the massive global franchises found in the 100.
Consider the fact that the 100 is worth nearly ten times as much as the 250 and you’ll see that these really are two different leagues. The large caps have access to international financial markets. They can raise working capital through bond and stock markets. While smaller companies have less financial fire-power.
As an investor, the last thing you want is to put your money into a company that goes bust. And the chances of this are a higher in the 250 camp, especially if we hit financial turbulence again.
You want to make a bet?
There are two sides to a pairs bet.
First, the ‘long’ side, which can be traded through an Exchange Traded Fund (ETF), the i-shares FTSE 100 can be bought through your normal stockbroker (LSE:ISF) and tracks the 100 index.
Then secondly, there’s the ‘short’ side. Unfortunately, no short 250 ETF exists, so I use a spread bet.
If you’d like to open a spreadbetting account, see our Compare the top 20 spread betting accounts.
With the 250 trading at 9,982, you can sell a June contract around that level. At £1 per point, you’ll have a £9,982 short on the 250. For every point the index falls, you’ll profit a pound on your bet (and vice-versa).
To keep the market neutral balance, you buy the 100 for the same value. You place an order for £9,982 worth of FTSE 100 ETFs (ticker ISF) with your stockbroker.
The risks
There’s no doubt that the 250 has had a good run. Because the companies that comprise the index are so much smaller than the 100 companies, they are more susceptible to takeover activity. Any rumour of takeover tends to push a stock price upwards.
If we really are on course for a swift economic recovery in the UK, then this bet could lose. The 250 could continue its upward trajectory, creating a loss on the spread bet.
If the 100 doesn’t keep up, then gains from the 100 ETF won’t keep up with the losses on the 250 short.
What this bet is really about
To me, the 250 index has got too carried away with talk of recovery. The price on the 250 is too expensive relative to the solid 100 companies. It’s anticipating too many takeovers and ignoring the quality of the top firms.
For me, it’s likely that the next government will have to make drastic cuts in public expenditure. This is not going to be good for UK Plc. This is not going to be good for the 250. The 100 will be less affected as most of its business is international.
• This article was first published in the free investment email The Right Side on 3 May 2010.
Spread betting is not suitable for everyone – ensure you fully understand the risks involved and never risk more than you can afford to lose. Spread betting carries a high level of risk to your capital. Prices can move rapidly against you and resulting losses may be more than your original stake or deposit. Margin amounts vary between spread betting companies and the type of markets spread bet. Commissions, fees and other charges can reduce returns from investments. Tax treatment depends on individual circumstances and may be subject to change in the future. Please note that there will be no follow up to recommendations in The Right Side.
Managing Editor: Theo Casey. The Right Side is issued by MoneyWeek Ltd. MoneyWeek Ltd is authorised and regulated by the Financial Services Authority. FSA No 509798. https://www.fsa.gov.uk/register/home.do