Trading Made Easy (kind of)
***Written By: Dann Mcnulty Stock Forum ID: WallStGolfer31***
Ever think of a stock, and say to yourself “Company XYZ sure looks good compared to its peers, I think that’s a buy†only to buy it and it sinks like a rock because of market conditions?
Market neutral trading is the answer. With this strategy, you are picking winners, but relative to an industry or the overall market. Here’s how it works.
You find a company that has fundamentals that you feel is above and beyond its peers. This stock should go up more and down less on good and bad market days respectively. This does not have to do with Beta, which usually tells this story, which is something completely different. Once you have found this company, you should buy it.
After this, you find what industry it is in, find the ETF that represents that industry, and short the ETF. When shorting the ETF you want the dollar amount of the short to be equal to the dollar amount of what you bought. You, theoretically, have effectively no market exposure by doing this. By doing this you have eliminated overall market risk, called systematic risk, and have isolated company specific risk, called idiosyncratic risk.
Overall market movements from data like the CPI, job numbers, and other such systematic news will now be eliminated from this trade and so will industry news. Your only risk is specific to the company.
As long as the company you have bought is outperforming the industry, you will make money from the divergence of prices. For example, if the market goes down, and the industry does as well, but your company does not go down as much, you have made money. Inversely, if the market and the industry go up, your company (if it does outperform) will go up more.
This is not without its risks though. Companies still have risk, the idiosyncratic risk discussed earlier.
The bottom line here is you’re not trying to pick the direction of the market, or a single stock, you’re picking how it will perform relative to an industry. I find this to be much easier, and I think you will to.
