By David Sterman
Whew! The markets have put investors through the wringer since April, and as the volatility continues into autumn and with no clear end in sight, investors increasingly are looking for ways to mitigate risk.
One "market neutral" approach involves paired trades. This entails finding the best stock in an industry and simultaneously shorting the weakest player in the group. Since stocks within an industry group tend to be highly correlated, gains come solely from the relative performance of the paired trade in play.
Yet for many investors, finding the right stock to short can be challenging. Simply put, it's easier to find stocks with clear positive catalysts than it is to find stocks on the cusp of a major downward move. A different twist to the paired trading strategy involves using ETFs to swap in for the short side of the trade. You're still removing market risk from the equation, but need only worry about analyzing just one individual stock, not two.
The mechanics of this paired trade strategy are pretty straightforward. Let's use oil giant ConocoPhillips (NYSE: COP) as an example. The Houston, Texas-based energy company has been making a series of shareholder-friendly moves by selling off assets that fetch top dollar. The company's rising cash hoard is being deployed for ever-larger stock buybacks: ConocoPhillips bought back 150 million shares between 2007 and 2010, and announced plans in early 2011 to buy back another $10 billion worth of stock over the next three years. An upcoming move to spin-off a low-margin refining business is also expected to help the company generate higher returns on its capital.
But a sharp pullback in oil prices would surely imperil shares, so you also need to prepare for potential downside. You could look to place a corresponding short position in a rival such as ExxonMobil (NYSE: XOM) or Chevron (NYSE: CVX). But you'd want to have a high conviction that those firms are less likely to deliver share price gains than the peer group.
Instead, you could commit a corresponding dollar amount to the iShares S&P North America Natural Resources fund (NYSE: IGE), which holds a basket of natural resource stocks. (Oil firms and oil service firms make up the top five holdings, though the ETF also owns other non-oil related resource stocks).
Broadening The Scope
This ETF-based paired trade strategy doesn't need to simply focus on a corresponding industry-specific ETF. Some investors use currency-based ETFs to ensure their foreign investments aren't subject to the whims of the forex market.
Others use this strategy to offset the risk of specific asset classes. A portfolio heavily weighted towards small cap stocks can be easily hedged with a short position in the iShares Russell 2000 Index (NYSE: IWM). That way, you're focusing on the potential outperformance of the specific stocks you've selected and reducing the risk associated with broader underperformance of small caps in general.
As with any ETF, liquidity is crucial. A thinly-traded fund is likely to carry higher expenses and wider bid/ask spreads. The Russell 2000 ETF, for example, trades roughly 80 million shares a day, and typically carries a bid/ask spread of just one cent. Unfortunately, many ETFs are not quite as liquid. It may be best to stick with ETFs that trade at least 100,000 shares daily, and carry bid/ask spreads of two cents or less.