Option Hedging Strategy
The Dynamic Wealth Report
December 17, 2008
How To Hedge This Market For Big Profits
Early in my banking career I spent a good deal of time on the phone. No,
I wasn’t talking to friends or flirting with girls. I spent hours on the
phone developing contacts at institutional investment firms. You’d be
surprised how difficult it is to talk with a money manager running
billions of dollars.
I learned early on financing a company wasn’t always about a great
story. The key was knowing who wanted to buy a particular type of stock.
Some firms focused only on technology. Others specialized in medical
devices and drugs. One group liked the big market cap firms, and others
believed in ‘smaller is better’.
Present the wrong type of idea to the wrong money manager, and you’d
quickly lose credibility.
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As a banker having a well-developed institutional rolodex was important.
I spent hours discussing investment strategies with firms, asking
questions, leaning what worked for their strategy and what didn’t.
I remember talking to one fund based in New York that had a really
interesting strategy. It was very simple in concept, but could be made
as complex as an investor wanted.
What they did was “matched pair” trading. At least that’s what they
called it. I know it sounds a little out there. But give me a minute and
I’ll show you how it works.
Very simply, matched pair trading is when an investor buys one stock and
at the same time sells another. Your capital commitments are very low
because when you buy something (money out) you also short something
(money in). The low initial capital outlay can really lead to some
mind-blowing results.
But here’s the exciting part… because you’re both long and short the
market, a big market move in either direction makes you lots of money.
Now, there’s a secret to this trading style.
You must go about your stock selection in an intelligent way. Some of
these big money managers pair trades by industry. For example they might
go long Wal-Mart (WMT) and short Saks (SKS), as a play on the retail
industry.
Other investors focus on commodity interactions. When oil prices are
high, they might short American Airlines (AMR) and buy
Exxon (XOM). If
oil prices are falling, they’ll do the opposite.
This is a type of hedge that can be very powerful in just about all
market conditions.
To further enhance the strategy, I like to use two stocks that aren’t
linked in any noticeable way. Simply buy good companies and short bad
companies. In my mind, this is one of the best ways to do matched pair
trading. You’re not limited by industry.
You can really focus your long positions on good companies in hot
sectors- and focus your short positions on poor companies in out of
favor sectors. It’s the best of both worlds… and can be extremely
profitable while minimizing risk.
Now I know what you’re thinking. How does an average investor do this?
What if you can’t short stocks?
The simple answer is through options. With options you can set up trades
to profit when a stock falls (puts) or climbs (calls) in value. It’s
easy to do and you don’t need thousands of dollars to get started.
Let me give you an example of how it might work…
Back in September real estate numbers were horrible. However commercial
real estate was still holding on. It just didn’t make any sense. ProLogis (PLD) is a REIT who owns a great deal of commercial real
estate. They were bound to fall. Anyone could have bought put options on
the company for about $150 a piece.
Over the next few months the stock collapsed from over $40 a share to
under $3 a share. Those put options increased in value by 1,687%.
At the same time we knew the medical sector would do better than others
in a recession. Thoratec (THOR) manufactures medical devices for use by
patients with heart failure. Anyone needing these products is buying,
recession or not. The company had recently announced impressive results. We thought the stock was bound to head higher, and you could buy call
options on the company for about $190 each.
At the time, the stock was trading at around $27 per share. Despite the
horrible market volatility, the stock now trades for over $30 a share.
While the stock was up just 11%, the options jumped over 39%.
So in this case, we were right on both sides of the trade. But even if
we weren’t, you can see how this type of trading can really put the odds
in your favor. Even if we were completely wrong on the Thoratec calls,
the most we could have lost was the small premium paid. But the amount we could make is
truly unlimited.
Had you put just $1,000 into each of these trades, you’d be sitting on
$17,260 in profits!
By taking both sides of the market, you don’t really have to worry about
which way it moves. You only have to be concerned with finding good
stocks in good sectors for your longs, and the opposite for your shorts.
If you’re even half way decent at that, the sky’s the limit with this
approach!
If you’d like to explore this strategy in more detail, we encourage you
to read this report. It discusses not only how this strategy works, but
also how you can start trading this way for maximum profits…
• Corn ($3.99 per bushel)
Corn rallied moving higher from its lows of $3.05 set just a few weeks
back. The price jumped 30% because of the weakening dollar and large
buying from end users. The commodity closed above its 50-day moving
average… a big technical sign the move should continue for some time.
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