Thursday, October 23, 2008

Trading In A Tough Market

With the volatile moves in the market lately it isn't easy to get a gauge on where things are headed. Every day there is a parade of "experts" saying this is the new market bottom. It can make for some confusing times.

The idea of spread trading is something to consider in this crazy market. Suppose you decided it was time to own a coal stock. One way to do this is to buy the one you determine to be the healthiest strongest company, and then decide who is the weak stock in the group and short that one. This is just an example, but in the chart below compares two coal companies, Peabody Energy BTU and Massey Energy MEE. The bottom pane is the spread of these two stock, BTU divided by MEE. When the moving average is sloping upward, Peabody Energy BTU is outperforming Massey Energy MEE.

Peabody Energy BTU / Massey Energy MEE (click to enlarge)

In this example Peabody could have been purchased on September 5th for 51.43 and Massey Energy could have been short sold at 50.95. It is important to use equal dollar amounts on each side of the trade. These two companies are similar in price, but in most cases the prices are very different. The idea is to benefit from the percentage out-performance of what was determined to be the stronger company. The advantage to this system is that if you are wrong, and the market continues to experience strong selling, the short side of the trade will allow you profit or limit your loss and market exposure.

This is another example of a potential trade. It involves BNI-Burlington Northern Sante Fe and CSX-CSX Corp, both railroad companies.

Burlington Northern / CSX Corp. (click to enlarge)

BTU/MEE Spread current position +9.8%
BNI/CSX Spread current position +6.7%

The key concept to remember is to employ equal dollar amounts on each side of the trade. Options can also used instead of outright positions, but they can be more complicated.

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