Chris Rowe

How to Profit Like a Hedge Fund

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Today I'll show you how to make money, whether the market trades up or down, with a simple-yet-effective strategy that the hedge funds use: pairs trading.

Many of you might already be familiar with this strategy. But even if you are, keep reading to check out the spin that you can put on it to make it even more effective than most professionals do.

Profit Regardless of the Market's Direction

Pairs trading allows you to position yourself to make money, even when you're wrong about the direction of the stock market. It involves considering two separate positions as one position.

First, you find the stock or exchange-traded fund (ETF) that you think has the greatest chance of advancing, and you bet on it doing just that. Then you find another one that you think has the greatest chance of declining, and you bet on it doing so. Again, the combined trades should be considered as a single position.

As you probably know, you can profit from a downward move in a stock or ETF by selling short that security. You sell it at one price, and then try to buy it back cheaper, profiting on the difference. There are many other ways to profit from a downward move, but short selling is the most popular. (Learn how to Play it Safer With Put Options.)

Now, you've probably heard the old saying: "A rising tide lifts all boats," meaning when the general stock market advances, even crummy stocks trade up. On the flip side, when the general market gets slammed, even great stocks move lower.

However, in down markets, strong stocks and ETFs tend to trade down by a lesser amount than weak stocks and ETFs. And, in up markets, strong stocks and ETFs tend to trade up by a larger amount than weak stocks and ETFs.

Everyone understands the concept of diversifying their portfolio for safety. The traditional way of diversifying assumes the market only trades up. When some of your stocks inevitably go down, you have others that go up, and hopefully the advancing positions outweigh the declining ones. Either way, you are playing it safe. That is, unless the market tanks.

Well, pairs trading is one way of diversifying, but it shields you from having to guess the direction of the stock market.