they are suppose to hedge out not only losses but also market volatility. Meaning Hedge Funds are obsessed with risk and controlling risk. One of the only ways you can control or minimize risk is to trade a Market Neutral Strategy.
A Market Neutral strategy means that for every $1 in long positions you have $1 in short positions on your book. Basically your betting on your stock picking ability while taking out the risk of the overall market. But as we have learned over the past 5 years this is very hard to do as Macro events have made the markets swing wildly up and down and this is why the majority of market neutral funds have failed or have had poor performance. So what can you do today, if you want to trade a low volatility market neutral strategy? Well the best way I have found is to use ETFs. ETFs are great because they are extremely liquid, easy to short and they represent an entire market, country, sector or asset class.
So if I were back at a Billion Dollar hedge fund, I would implement a market neutral trade today by buying $100 million dollars worth of US stocks while at the same time shorting $100 million dollars worth of emerging market stocks. As a retail investor you can execute this same trade but since you don’t have to worry about controlling volatility you can use Leveraged ETFs to implement this market neutral trade which will really juice your returns as well.
So here is my aggressive Billionaire’s market neutral ETF trade : I would be long the ProShares UltraPro S&P 500 ETF (NYSEARCA:UPRO) this ETF is leveraged 3X or 300% and I would be buy an equal dollar amount of the Direxion Daily Emerging Markets Bear 3X Shares ETF (NYSEARCA:EDZ). Therefore you are betting that US stocks will continue to go up and that emerging market stocks will drop. I think this is a great trade both from a fundamental and monetary policy perspective but also technically as well.
Now if you want to get even more aggressive, I would put on a ETF market neutral options bet. This is a great strategy that even investors with a small account can use . Due to the recent unprecedented move in long term interest rates, I am very bullish on Financial Stocks (Financial stocks become more profitable as the yield curve steepens, as it is doing now) but because of this I am very bearish on homebuilders now (as higher mortgage rates will hurt future new home purchases). Also the chart on the Financial Sector ETF (NYSEARCA:XLF) looks very strong, while the chart on XHB, the Homebuilders ETF looks like it is starting to break down, confirming this fundamental trend.
So here is the real secret by combing the market neutral strategy that Billionaire Hedge Fund’s use with options you now have the perfect strategy, a strategy that will profit regardless of where the stock market goes in the next 3 months, but you have the potential to make triple digit returns because of the leverage you now have with options.
So here it is, the Billionaire’s Hedge Fund Market Neutral Options Trade:
I would purchase an equal dollar amount of XLF, the Financial Sector ETF September Call Options and at the same time purchase an equal dollar amount of the SPDR S&P Homebuilders (NYSEARCA:XHB) September Put Options (So I am betting that the ETF, XHB will drop).
This is a very exciting profitable and low risk way to trade ETFs and ETF options.
William Meade is the President of Pure Alpha Research, a hedge fund consulting and investment research firm. He is the former Director of Research at Zacks Investment Research in Chicago. Before that, he was the lead analyst at a top performing $1.2 Billion dollar institutional investment firm and hedge fund. Mr. Meade has a Masters in Applied Economics from The Johns Hopkins University. Learn more about William Meade and how he follows Billionaire Investors into stocks by visiting the Billionaires Portfolio.