This strategy solves the problem of being right about a stock and wrong about the sector, writes the staff at Investopedia.com, and best of all, it is cost-effective.
One of the more popular ways that hedge funds make money is to be long and short on any number of combinations of stocks and/or other securities. The principle is simple enough: buy, for instance, the bank with the best fundamentals and most secure lending and investing book, and sell short its competitor that is in the hottest water. The difference in their respective stocks' performance becomes the trader's profit.
There are a number of variations on this theme, and a number of instruments that can be employed to effect the trade, from stocks to futures to options. Here we highlight one of them: a trading strategy that requires neither capital nor a hedge fund’s leverage to put into play. It's called a zero-premium sector trade.
Why "Zero" Premium?
The trade is called zero-premium because it's essentially cost-free. An investor buys one call option and sells another of roughly equal value. The two trades offset one another, producing a net-zero total outlay for the investor.
How It Works
There's no getting around it; to employ this technique, an investor has to do his/her homework. Good research is the key to success with the zero-premium sector trade. Determining the best-run, most dominant company in a sector—the firm whose stock has the greatest probability of appreciating in value in the near term—is critical to creating the greatest return. That said, a profit can be had by finding a company that, at the very least, outperforms the sector.
When the research is done, one simply buys a call option on the stock, then simultaneously sells a call option of roughly equal value on the sector ETF. This shouldn't be a great challenge since most sector ETFs offer a great many option strikes to choose from. One also has to be sure that both options have the same expiry.
A Real-Life Example
Consider the following scenario: you believe that gold producer XYZ will significantly outperform its gold brethren over the next three months, so you purchase a six-month XYZ call option with strike price 45 (the stock now trades at $41.00) for $2.90.
At the same time, you sell one gold stock ETF (GDX) 44 call option for $2.90 (the ETF is trading at $38.50. The trade is executed virtually cost-free (before commissions).
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Tickers Mentioned: GDX