When I started Total Wealth, I promised you a blend of analysis, tips, and specific trading tactics to play today’s financial markets for big profits.
There are a variety of ways to trade what’s happened but I’ve got something special lined up – a trade that has the potential to turn a profit no matter whether the markets go up, down, or simply sideways.
Here’s what you need to know.
Big Profit Potential in a Tiny Trade
Depending on your perspective, the end of net neutrality is either the greatest thing since canned beer or like having legendary movie bad guy Darth Vader use the “force” against you.
I’m not going to wade into that – my job is to help you make money.
Right now, the best way to do that is via a “pairs trade.”
The setup is straightforward.
The end of net neutrality means that corporate players – thinking carriers here – have every incentive in the book to “throttle” content and to carve up the Internet based on a “who wants to pay how much for what degree of service” model.
At the same time, the end of net neutrality means that content delivery companies like Netflix Inc. (NasdaqGS:NFLX), Amazon.com Inc. (NasdaqGS:AMZN), Alphabet Inc. (NasdaqGS:GOOGL), and others – will have their content buffered by companies that they can’t control. It also means that smaller service providers like Frontier Communications Corp. (NasdaqGS:FTR), who often absorb excess network capacity as a means of playing around the edges, will get clobbered as margins thin about and user growth flatlines.
You and me, of course, are caught in the middle. High speed delivery and reliability are going to go right out the proverbial window.
In fact, I’m already experiencing that and you may be, too. My network latency, for example, has doubled even though I use a very high speed, custom fiber connection here in the office. At the same time, T-Mobile US Inc. (NasdaqGS:TMUS), which I use for our cell phones, has a Binge On “feature” that’s supposedly for “optimization” but which really is a content restrictor by any other name. And, not surprisingly, my Comcast TV package – a high value delivery with both English and Japanese content – went on the fritz.
All three companies claim that nothing of the sort is going on but, if that’s the case, why can I pay extra “not” to be subjected to throttling and why do I suddenly have to spend five hours waiting for a technician to grace me with his or her presence and try to upsell me another “package?”
I was born in the middle of the night, but it was not last night. The whole thing makes me madder than a hornet – but that’s a story for another time.
How You Can Profit…
Let’s shift our attention to how to play the situation profitably.
Many investors have never heard of a “pairs trade” – it’s what you call a market neutral strategy that pros often use in situations like this one.
Technically speaking, a pairs trade is a form of statistical arbitrage. That’s a fancy way of saying that it has two parts, and that the relationship between the parts is such that you can profit as the spread between them changes.
First pioneered in the 1980s at Morgan Stanley, a pairs trade typically involves two highly correlated securities. You buy one and short the other simultaneously, creating a “spread.” Then, as one weakens and the other strengthens, the spread changes. And that’s your profit mechanism.
Imagine, for example, Wal-Mart Stores Inc. (NYSE:WMT) and Target Corp. (NYSE:TGT). Historically, the companies have tracked relatively closely, moving more or less in sync with market conditions. If Wal-Mart began looking too hot while Target stayed flat, a trader could buy Target stock while simultaneously selling Wal-Mart stock short.
If Target rose to “catch up,” as is often the case in today’s highly computerized markets, the trader would make money on the Target stock. Or, if Wal-Mart stock began to slip, he’s set himself up for profits having shorted the Bentonville behemoth.
Whether the markets rise or fall is moot once this trade is in motion. It’s the relationship between the two stocks that matters.
Big Advantages and Big Profit Potential In One Easy Move
Pairs trades have a number of key advantages.
First, they’re great in rocky markets because they help you control risk. It’s not uncommon, for example, to have both stocks in a pairs trade fall on a big down day. While that would wallop regular investors, pairs traders may remain completely neutral or even profit if the relationship changes in their favor.
Second, pairs trades are not market driven. They can potentially profit when the markets go up, when they go down, or even when they go nowhere at all. Remember, it’s the relative performance that you’re after here.
Third, there’s no directional risk. Because a pairs trade always has one long and one short position, the first position is constantly hedging the second.
And fourth, because of the way they work, pairs trades can be very low cost or even no cost. It’s not uncommon for the short position, for example, to pay for the long. Margin requirements, as a related item, are typically much smaller as well because drawdowns are minimal by virtue of the fact that they’re always offset.
Here’s how you’d set up the trade using your new-found knowledge.
Buy Citrix Systems Inc. (NasdaqGS:CTXS) and simultaneously sell a corresponding dollar amount of Netflix, shares short. An equivalent amount of shares will not work so don’t assume that 100 shares of Citrix will offset 100 shares of Netflix.
I picked Citrix because it’s a strong enterprise level player in three critical areas related to content delivery – cybersecurity, cloud computing and network delivery. Customers like Microsoft Corp. (NasdaqGS:MSFT) , Apple Inc. (NasdaqGS:AAPL), and Hewlett Packard Enterprise Co. (NYSE:HPE) pay gobs of money to use Citrix servers to balance their loads instead of paying for more expensive capacity development.
I chose Netflix because the company is highly dependent on internet service providers that have every incentive to throttle the content it delivers. The company’s cash position is terrible and the much-ballyhooed original content it produces won’t mean beans if customers can’t watch it quickly, easily, and without buffering.
As I write, Citrix trades at $87.52 so 100 shares will set you back $8,752.00, excluding commissions. Netflix trades at $186.64. Consequently, you’d sell short roughly 47 shares of Netflix ($8,520 divided by $186.64 equals 46.94 shares).
The math is similar if you want to use smaller amounts of cash. For example, let’s say you wanted to risk $1,000 on this trade. You could buy 11 shares of CTXS and sell short 5 shares of NFLX, again not including commissions that vary from broker to broker.
As an aside, you can use a trade like this for any company you expect to underperform the broader markets. In past years we’ve talked about Shake Shack Inc. (NYSE:SHAK), Zoe’s Kitchen (NYSE:ZOES), Twitter Inc. (NYSE:TWTR), and GoPro Inc. (NasdaqGS:GPRO) as being terrible investments, for example. They’re all still great candidates for this kind of trade at the moment.
To be fair, there are some gotchas.
The biggest is that the spread could narrow instead of widen. That means one or more of the positions go against a trader taking the bet I’ve described. Netflix, for example, could appreciate faster than Citrix on nothing more than bottom-fishing. A positive news story would do it, too and that could conceivably range from a management change to some extremely popular “original content” that grabs the imagination despite the fact that it does bupkis for profits.
Pairs traders typically have higher commissions because a single trade involves commissions on both sides. Remember, you’re buying and selling at the same time.
Then there’s slippage, meaning that a trader may not get exactly the fill they are looking for. Pairs trading can involve odd lots that are by their very nature more thinly traded, for example. Or, partial fills.
In closing, pairs trades, like our lowball orders, are a professional grade tactic you can use very effectively as an individual investor. Moreover, they’re tailor-made for the kind of situation created by the end of net neutrality.
Until next time,
Keith
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Source: Total Wealth Research