Editor's note: In today's Weekend Edition, we're sharing the details about a little-known strategy every investor should be familiar with. This essay – adapted from a brand-new research report for DailyWealth Trader subscribers – explains how this strategy could help you make money no matter what happens to the overall market...
If the S&P 500 falls 20% in the next year, how will your stock holdings perform?
If the S&P 500 climbs 20% in the next year, how will your stock holdings perform?
What if a strategy existed that would allow you to make good money in either of these scenarios? What if you could say, "Bull market, I win... Bear market, I also win"?
There is such a strategy...
Not many individual investors use this strategy. But professionals have used it for years to profit in both bull and bear markets.
Now, I don't claim to know when this bull market will end. But we're more than nine years in... making this the longest bull market in U.S. history. You don't have to be an analyst or an economist to know the next crash may not be far off.
That's why today, I'm going to explain the basics of this valuable strategy...
To take advantage, you only need to buy and sell stocks. Yet at this dangerous moment in stock-market history, your financial well-being may depend on your ability to use it properly.
Once you understand this strategy – and especially once you begin to use it – you may never invest in stocks the same way again...
The strategy is called "pairs trading." And to begin, I want you to understand why it is one of the best strategies for today's market. So let's start with a thought exercise...
First, imagine the world's strongest man pushing a big stone up a hill.
On gradual sections of the hill, he moves the stone along at a good clip. On parts where the hill steepens, he progresses slowly.
The stone is too big for the man to see around, so he just keeps pushing. Although he doesn't know it, he eventually reaches the hill's peak. And suddenly, the stone rushes away. It rolls downhill and settles in a valley.
Nearly all the man's uphill effort is lost.
This is how most people invest. They know they're on a hill. And as long as their accounts are moving higher, they're happy. But they're blind to what's ahead.
When stocks come crashing down, all they can do is watch in terror.
Now, imagine another scenario...
The same big stone is sitting in the middle of a field. Thousands of strongmen are gathered around. And you're in charge... You can call up any two competitors.
Their goal is to push the stone forward rather than letting their opponent push them backward. And your goal is to choose the winner ahead of time.
This is pairs trading. It's a totally different game...
As long as you choose the "stronger man," you win. In other words, of all the stocks out there, all you need to do is choose one that will outperform another.
If you're right, you make money.
Now... if you've been pushing uphill and sense that we're nearing the peak, wouldn't you prefer to change games... and start playing on the level field instead?
Pairs trading allows you to do just that. A pairs trade has two parts, or "legs"...
You buy one stock. And you sell another stock short. You put equal dollar amounts into each leg. And you treat the two legs as a single position.
The result is a pair of trades that is "market neutral." In other words, a pairs trade is equally likely to profit whether the stock market rises or falls.
This market-neutral pair of trades is your level playing field. The stock you buy is the strongman you pick to win. And the stock you sell short is the strongman you pick to lose.
As long as the stock you buy outperforms the stock you sell short, you make money. And the bigger the outperformance, the more money you make.
With pairs trades, you have three ways to win...
In the following charts, you can see them in action. We'll call the stock you buy "Stock A" and the stock you sell short "Stock B."
The first way to profit is if the stock you buy rises more than the stock you sell short...
The second way to profit is if the stock you buy rises and the stock you sell short falls...
And finally, even if the stock you buy falls, you can still profit... as long as the stock you sell short falls more. You can expect to see this third scenario when we enter a bear market...
As you can see, in all three scenarios, the stock you buy outperforms the stock you sell short. And as a result, you make money in all three scenarios.
You will only lose money if the stock you sell short outperforms the stock you buy.
Notice that it doesn't matter at all what the overall market is doing... This makes pairs trading a fantastic way to make money without taking any broad market risk.
Pairs trades are flexible tools. If you have an idea about the markets, you can usually build a pairs trade to express that idea... and profit as it plays out.
Now, if you're confident the bull market will continue for years to come – without any significant interruptions – you may not want to use pairs trades at all. But I'm not so sure. The bull market could continue for six months to two years... Or it could end a lot sooner.
That's why I'm planning to use pairs trades in my DailyWealth Trader service in the coming months to help protect my subscribers' wealth. I suggest you consider doing the same.
Editor's note: Ben recently put together a special presentation to explain how you can use this strategy to make thousands of dollars in profits no matter what happens next in the stock market. Watch it here.