Chris Rowe

How to Profit Like a Hedge Fund

by Chris Rowe   07/13/09

Free Trading Guides

You make two bets -- a bullish bet on one stock or ETF and a bearish bet on another. If everything works perfectly, your bullish bet trades higher, and your bearish bet trades lower, so both parts of the trade win!

But since the stock market has a lot to do with the direction of your positions, it's likely that a strong up or strong down market will cause you to be right about one part of the position, and wrong about the other.

If the general stock market moves up by 20%, and your bullish trade advances 50% while your bearish trade advances 20% (which is essentially a 20% loss to you), your combined position is up 30%.

Pairs Trading With Stocks

Editor's note: This article was originally published on June 10, 2008.

Let's say you read my April 1, 2008 article titled "How to Make Sure YOU Don't Own the Next Bear Stearns," and my comments on Lehman Brothers prompted you to bet that the stock would trade lower. At the same time, you decided that, since energy stocks were doing well, you'd bet that Exxon Mobil (XOM) would trade higher.

Two weeks later, you bought $10,000 worth of Exxon and you sold short $10,000 worth of Lehman Brothers. You consider the two positions as one, so you essentially have a $20,000 position.

Lehman Brothers traded from $45 to $29.43 -- down 35% -- which is in your favor.
Exxon Mobil traded from $93.50 to $89.08 -- down 5% -- which is not in your favor.

You were right about your bet on Lehman Brothers trading lower, but you were wrong about Exxon Mobil trading higher. Together, the combined position shows a 15% gain: (35% gain - 5% loss = 30% gain)/2 = 15% average/combined return.

In this case, the general market basically traded flat. Below is a chart of the S&P 500 (SPX) compared to Lehman and Exxon. The strategy isn't really put to the test here because the market was flat. But it illustrates how we were wrong on XOM but profitable on the whole deal.

But here's the important takeaway: Since Exxon Mobil was a stronger stock than Lehman Brothers, we can assume that if the market pushed higher, Lehman would either still have declined, or it would have been pushed up by the market, but by a lesser percentage gain than Exxon. That would be a win.