Spread Trading Tips

SPREAD TRADING TIPS 

          If you decide to take advantage of a spread trade, you should realize that it is a risky business. You could be on the wrong side of both markets. Since spreading involves selling short one stock and simultaneously buying another stock, if the price goes in the opposite direction of both trades, you can lose on both sides of the trade. Selling short is a hard concept for many traders, both novice and experienced, to grasp. Believe it or not, there are some folks who are not aware that you can sell first without owning the security. Short selling means you are betting that the price of a given product will decline; therefore, you would be selling first without owning the underlying product with the hopes of buying back later at a lower price. Selling short is considered highly speculative for stock traders; the process involves “borrowing” the stock from the brokerage firm, if the firm has that security in inventory. Shorting stock is very similar and should not scare investors. It is a very simple concept; in fact, it is just the opposite for longs. You want to buy low and then sell out later at a higher price. With shorting, you are selling first and buying back later, hopefully at a lower price to generate a profit.

There are certain restrictions; for one, you need to set up a margin account with your brokerage firm. Another restriction carries potential execution risks: Due to Securities and Exchange Commission (SEC) regulations, there is what is known as the “uptick” rule. The uptick rule was established in the 1930s to prevent a bear market raid on a stock. In order to execute a trade, the stock needs to trade at a price higher than the preceding transaction price in the same security. For example, if you wanted to enter a spread by selling Dell Inc. and buying Apple, you would have been anticipating or looking for Apple to outperform Dell’s price gains. Or if both stock prices decline, you would want Dell to decline more than Apple. But in order to effectively execute that strategy, you would want to enter the sell side of the spread first because there are no restrictions on entering the long side, just on the short side of the transaction. Let’s say you enter the long side first without confirmation that you were filled on the short side; if the market on the position you hold—the long side—goes down and if both markets moved in tandem, you would need an uptick on the short side in order to be in the spread. Imagine if you went long first and the stock dropped. Then when you are finally able to execute the short side, the market has plunged. That would translate into an actual loss. So if you do not get filled first on the short side, the worst that can happen is that you lose a trading opportunity. This is a great example of why traders have the obligation of knowing all there is about the market they trade in. As you can see in Figure 1.6, Dell has moved in the same direction as Apple, but Apple has outperformed as a price leader. The spread opportunity between these two computer manufacturers, long Apple and short Dell, would have generated a tidy profit.

Another example of a spread opportunity within competitors of the same industry or sector would be Best Buy versus Circuit City, as shown in Figure 1.7.

As consumers flocked to retail malls before the holidays to purchase gifts such as Apple’s iPods, if you want long Best Buy as the sector leader and short Circuit City, Best Buy stock outperformed Circuit City stock. As you can see from the chart, after the stock market bubble burst in 2000, Best Buy managed to maintain a positive trend higher. It is the leadership of the company and the consumer loyalty that really have helped to support this company’s growth and profitability. One reason is Best Buy continued to sell appliances versus one of their rival competitors and as a result they saw sales rise 7.7 percent from 2004 through 2005. They also had aggressive gains in web sales, and online revenue jumped 40 percent as more customers shopped and redeemed gift cards online for the same time period.

Best Buy’s main competitor, Circuit City, decided or needed to cut back and close stores and then discontinued selling appliances to stay afloat. It depended on increasing DVD and CD sales and on electronic products. As the housing boom materialized soon after that decision, Circuit City gave up market share to Best Buy; and no doubt companies such as Home Depot and Sears picked up increased revenues in appliance sales. Therefore, it was hard for Circuit City to re-enter selling that product line.

As you can see in Figure 1.8, Circuit City’s stock just had not been a great performer in that sector. The company was founded in 1949, so it has a long history and may survive the competition. However, if consumers start to spend less on home electronic products in 2006 and 2007, this company may have trouble getting its stock price back up to the 2000 high near 65 per share. Circuit City will need consumers to continue to buy and upgrade new televisions, camcorders, and digital cameras to boost revenues. I personally have no intentions of buying another camcorder; I barely use the one I have. As for game software, game hardware, and personal computer software, those are competitive products; so I believe Circuit City will have to do more to survive the next few years of what is being forecast as a consumer electronic sales recession. Therefore, one would need to look closer at these two companies and decide which one has more to gain or which one has more to lose; once a decision is made, this would be a good pairs market for a spreading strategy.

Investors have many trading opportunities with stocks, as you can see from the preceding few pages. There are many ways to analyze a company, from taking a simple look at the P/E ratio to using technical analysis studies. Investors can see which company is the leader in a specific sector and invest with that leader. As you can see in the cases of Apple versus Dell and Best Buy versus Circuit City, holding a diversified portfolio of stocks may help investors see profits or a positive cash flow. Realistically, you can’t own shares in every stock. Longer-term investing—you know, the buy-and- hold mentality, sometimes referred to as the Warren Buffett method—helps toward generating big gains in solid companies. But remember that WorldCom and even Lucent Technologies were solid companies at one point. So the message here is that investors need not only to be selective in which markets they buy and hold but also to monitor their positions. There is the idea that you can buy stock in a company to which you relate or from which you purchase products . . . companies like Starbucks, as shown in Figure 1.9. This company has solid growth, great coffee; it carries with each 20- ounce cup, named a Vente, a solid jolt of caffeine. That is what keeps me going back, day after day, dropping two dollars per cup for the Starbucks “experience.”

Starbucks has made stellar gains and is a great moneymaking stock. It has solid industry leadership, textbook marketing concepts, and, more important, customer loyalty. These are all the qualities to look for when selecting a long-term purchase.