Option Hedging Strategy

| December 7, 2008 | 0 Comments

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.

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!

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Category: Options Trading

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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