Last week I talked about the grim outlook for the British High Street. How the likes of HMV are facing a bleak year as they try to pass escalating costs onto already reluctant consumers.
Over the next few months I’m sure plenty of investors will sell out of the likes of HMV and Next. But while many of these investors will nurse losses on their investments, many in the City will be profiting massively from the demise of these stocks.
They’ll do this by shorting the retailers. And there is no reason why you shouldn’t do the same. It might sound dangerous. But in fact there is a simple way for a private investor to control the risk of going short on a stock.
It’s called a “pairs trade”. And today I want to show you two examples – and how you could use it to make a nice profit during the financial turmoil ahead.
A simple, but deadly strategy
Pairs trades sound daunting. But they really aren’t. Ultimately you are looking to buy a stock that you think is undervalued, and then sell a related asset you think is overvalued.
Take the retail stocks I discussed last Friday. HMV is in a bad way – sales are down 10%. And they are being killed off by competition from online vendors and illegal piracy.
Sainsbury’s on the other hand has just reported a 3.6% jump in sales. And has the clout to pass on higher food prices over the next year. So we short HMV and go long on Sainsbury.
The trick is to pick two stocks that are highly correlated. That means that the shares you pitch against each other should normally move together as the market moves up and down.
By pairs trading, you are also reducing your market risk. That means that if the retail market crashes, your short HMV position should help offset the losses on the long Sainsbury position. By being both long and short these stocks, it shouldn’t matter if the retail market rises or falls.
In fact you don’t just have to pit a share against another share. You could short a share against almost anything – a sector, a commodity, a country.
Let’s take another example…
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How to profit from turmoil in emerging markets
Let’s say you think that emerging markets (EM) look a bit overpriced. You reckon we’re about to see a replay of the 2008 financial crisis which hit EM pretty bad. So you want to put on a short.
But then again, you think Brazil is still a good bet…so here’s what you do: You buy your Brazil fund. Whether it’s a unit trust, ETF, or Investment trust, that’s your choice. Let’s say you go long £12k on Brazil.
The next thing is to short an equal amount of the EM index. To achieve the short I would suggest you use a spread-betting account. If you haven’t got an account, I’ll point you in the right direction in a minute.
We can short EM by selling the MSCI Emerging Markets ETF. I’ve just taken a quote from the IG and that shows a price of 2942 to sell the September 2011 contract. Now, for every point that price moves down, we can profit. And the size of the profit depends on how much money we bet per point (£pp)…
So that’s what we need to work out. We need to know how many £pp will balance our long position on Brazil. Here’s how I work it out…
Let’s say your Brazil fund goes down 1%, then you’ll lose £120 (£12k x 1%). So we want to get an equal exposure on the short-side.
If our short moves 1% in our favour and we bet £1pp, we’d pocket £29 (1% of the quote 2942 rounded down). But we’re looking for an exposure of £120… that means we need to bet £4pp (4 x £29 =116).
As you can see, this is just an approximation. The point is we’re looking for a hedge, you’re never going to get an exact offset.
Now let’s see what happens if the emerging markets do take a tumble. Let’s say that we were right and Brazil outperforms EM as a whole. Say EM fall 5%, but Brazil only falls 3%.
We’d lose £360 on our Brazil fund (3% of £12k), but we’d win £588 on the EM bet. That’s because the index would come off 147 points (5% of 2942) and we’ve bet £4 per point. i.e. 147 x 4 = £588.
Some warnings
My example assumes that we were right (and we made a profit). Of course the whole thing runs in reverse if our long bet does worse than the short, and it’s still possible to make a loss. In this case if Brazil fares worse than the emerging markets as a whole.
The idea also assumes that past correlations will continue. But, there’s no guarantee that this holds in the future. So, for instance if Brazil’s performance de-couples from EM as a whole, you may not be able to remove the market risk.
For simplicity, I haven’t stated all the transaction costs. These include broker fees and the ‘spread’ on the spread bet. There are various other costs involved with spread-bets (roll-over, controlled risk stops, implied interest) and you’d be wise to find out exactly what they are before you put your money down.
There’s some great information available on the spread-betting providers websites. You’ll be able to work through some tutorials and really get a feel for trading before you go live with your hard-earned cash.
Don’t be frightened of spread-betting and shorting stocks, but do be cautious – get wise and use these great new tools to your advantage.
If you are looking for a guide, then there is no better man than John Burford. John is a spreadbetting veteran – he spent years working as a trading advisor with the US Commodity Futures Trading Commission. And he writes a very useful spreadbetting email called MoneyWeek Trader.
I’ve been reading John for some time and I think if you are interested in spreadbetting at all, then you need to sign up to this letter. Click here to find out more.
MoneyWeek Trader is an unregulated product published by MoneyWeek Ltd.
PS. Next week I’ll be showing you my first foray into what I think will be the industry of the next decade – pharmaceuticals. And there will also be an update on my favourite commodities fund, which is beginning to look really interesting just now. Until then, have a great weekend.
• This article was first published in the free investment email The Right side. Sign up to The Right Side here.
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. Your capital is at risk when you invest in shares – you can lose some or all of your money, so never risk more than you can afford to lose. Always seek personal advice if you are unsure about the suitability of any investment. Please note that there will be no follow up to recommendations in The Right Side.
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