Right now, the market environment breeds uncertainty. Risks to the upside and downside remain elevated for bears and bulls as any breaking news, whether that’s a vaccine development or a financial institution collapsing, could move markets 10% either way in minutes.
Nonexistent price discovery adds further uncertainty. Stock markets used to be about finding the right price for a company, but now it’s about how much liquidity central banks pump into the system. Their actions create stark irregularities: pensions funds buy risky assets only to chase high yields, retail buy stocks on hope or F.O.M.O, distorting financial markets to no end.
Still, when it comes to trading, there is a way to bypass irrationality and uncertainty: market-neutral trading or pairs trading for short.
Pairs trading is where you buy (go long) a stock and short (short-sell or go short) another stock against it, eliminating your exposure to the market’s direction. If the market plunges 10%, your “long” falls 10%, but your “short” also falls 10%. Voila! You break even.
You make money from a pairs trade when your “long” outperforms your “short”: If your “long” rises more than your “short” or if your “long” falls less than your “short”.
To demonstrate, let’s look at a trade I executed right before the COVID-19 crash: “long” Domino’s Pizza and “short” McDonald’s: $DPZ/$MCD.
Note: Pairs trades are commonly noted as LONG/SHORT: LONG meaning the stock you buy and SHORT meaning the stock you short. It’s also called a spread. (DPZ/MCD) is the result.
A Real Example: Long Domino’s $DPZ / Short McDonald’s $MCD*
At the start of 2020, I was working on some potential COVID19-themed pair trade ideas, one of which was the consumer’s increased demand for takeout and their decreased demand for restaurant food.
After two hours of painstaking work, I decided to buy Domino’s Pizza $DPZ (everyone’s indoors and they love pizza) and short McDonald’s $MCD against it (retail is in lockdown, franchisees are going bust, and commercial real estate is on the verge of collapse).
Before I open any position, I consider how both stocks move relative to the market. Beta-adjusting helps me to calculate how many shares I need to buy or short to adjust for the stock’s volatility. For example, if McDonald’s stock has a beta of 1.2, it’s 20% more volatile than the market, so, on an average day, when the market moves 1%, $MCD moves 1.2%.
To work out the beta-adjusted amount, I divided the total cash amount by each stock’s beta.
DPZ $10,000 / 1.1 = Long $9,000 McD $10,000 / 1.2 = Short $8,000(You will find a stock’s beta on most finance websites like Yahoo Finance, CNBC, and Bloomberg.)
On February 12th, I took the plunge, buying X shares of Domino’s and shorting X shares of McDonald’s.
After a month, the market had plunged roughly -32%, but the “long $DPZ, short $MCD” trade was up 69% outperforming the market significantly. Alpha! Domino’s stock price rose 3% and McDonald’s stock price fell 34%.
Our pairs trade didn’t care about the virus, the market, or the restaurant industry as a whole, only that Domino’s outperformed McDonald’s. We isolated a “theme” within the market, ignoring everything else.
Learn to Trade “Themes” Not “Direction”
Building an entire portfolio based on outperformance is a strategy many hedge funds employ to generate alpha, achieving true diversification by avoiding the market and trading many themes within it.
At any one time, you could be “long” tech and “short” real estate, “long” Walmart and “short” Target, “long” Nvidia and “short” AMD. You could be trading 5, 10, 20 different themes simultaneously. The possibilities are endless. The more ideas you generate, the more diversification you add to your portfolio — and the greater your market knowledge becomes.
The problem with the standard “long-only” portfolio — all “longs” and no “shorts “— is you have 100% exposure to the market. If the market falls 35%, you could lose 35% or more.
But with a “long-short portfolio”, in theory, you lose nothing as — if you remember from earlier — your “longs” fall the same as your “shorts” — providing they are beta-adjusted.
Most of the “smart money” employs the long-short strategy as it preserves their capital over time. Crashes of 10% or more, like in February 2018, December 2018, and February 2020, happen over a few days but wipe out years of gains in a long-only portfolio, while long-short portfolios have their best month on record.
Eliminate Big Risks in Pairs Trading
Although pairs trading excludes the broader market risk, you expose yourself to two new ones: takeover risk and industry risk.
Still, there are ways to get around them.
Takeover risk arises from shorting stocks. The stock you short could move violently against you, in some cases, 100% to 200%. In 2019, if you shorted Red Hat the night before IBM announced its takeover bid, you would have lost 55% at the open.
There are two ways to remove takeover risk.
First, instead of shorting a stock, short an index fund as a hedge. If you think Domino’s Pizza will outperform the entire retail industry, you could go “long” $DPZ and then “short” the retail index: $XRT.* Since the $XRT index holds many components, each with a small weighting, when a company gets taken over, you will barely notice.
The second is to buy put options on the stock you want to short.
With this strategy, you limit your downside to the option’s premium you pay. Let’s say you think Wells Fargo will fall to $20 from $25 in the next six months so you “short” $2,500 worth of WFC stock. But the next morning, Goldman Sachs announces a takeover bid, and the stock gaps up 100% overnight. You lose $2,500. Whoops!
But if you had bought one 25 strike put option for $1.14 per contract*, you would have only lost the premium you paid for the option: $114 (100x$0.82) — that’s a nice $2,386 saving.
Industry risk has less disastrous consequences, but still, be wary of it. If your “long” and “short” lie in different sectors, say, “long” Walmart and “short” Apple, you expose yourself to industry-specific hazards. If Apple’s competitor announces a revolutionary new handheld device that wows critics, say goodbye to those gains.
But if you stick to stocks within the same industry, you avoid this risk. With the “long” $MCD and “short” $DPZ trade, they operate in the same industry, so any industry-related news will not affect your profit and loss. Both stocks will fall the same amount — beta adjusted — and you’ll break even — unless, of course, the news is positive or negative for just one stock.
Ultimately, no matter what you do, there will always be risks when trading stocks, but these tips will help you reduce your losses going forward.
As the latest disconnect between economic fundamentals and stock prices shows, trying to time this market has become a futile endeavor. But what you have learned today is how the “smart money” bypasses this issue.
They have realized modern-day price action is impossible to predict— fifty years ago, maybe, but today, no dice — so they have adapted: avoiding directional bets and embracing market-neutral trades.
Of course, anyone can do the same as the pros. To have a better chance of making money, you must dig deep within this insane market and find tradable themes. Themes you can use to create market-neutral trade ideas.
Whether those ideas then turn into profit, however, is down to you.