Hedge this stock against CVS

This technique could protect you in the case of a market decline.

By Stock Traders Daily Dec 16, 2013 9:39AM

A woman carries a bag as she leaves a CVS store in Houston, Texas, U.S., on Tuesday, Dec. 8, 2009. A Texas pension fund will decide this week whether to award CVS Caremark Corp. a new pharmacy-benefits contract valued at almost $1 billion after the state's attorney general sued the company for alleged Medicaid fraud. Photographer: Aaron M. Sprecher/Bloomberg via Getty ImagesBy Thomas H. Kee Jr., Stock Traders Daily 


Are you interested in making money from the stock market by taking advantage of price fluctuations while remaining market neutral?  Hedging techniques may be something that you should consider.

 

Using a hedged trade is very popular in institutional circles; the concept is to initiate a long position against a short position. Sometimes this is done using two different stocks within the same sector, but sometimes it involves stocks that are not related at all.

 

In the trading example below, the stocks are not related at all. In fact, I would consider them at virtually opposite ends of the spectrum. Not only is this true based on the markets they serve, but the same can be said for stock performance recently. 

 

The stocks being considered here are CVS Caremark (CVS) and KLA Tencor (KLAC). Both have performed well this year, but recently one has surged while the other has languished. One of these stocks is also at major resistance, where the other is at support.

 

When trading stocks, the rules that govern successful trading strategies tell us to buy near support and sell near resistance, so that is exactly what this proposed hedge aims to do. KLAC is trading close to a level of longer term support, while CVS is trading close to a level of longer-term resistance, and the hedge is based partly on that.

 

The hedge is also designed to protect investors against the risk of a market decline, or market increase for that matter. If the market turns down, for example, a stock that is already a little beaten up could find stability (the sellers have already sold), while the other stock pulls back. 


So this trade is to short the stock that is testing resistance (CVS), and buy the stock that is testing support (KLAC), with the intention of taking advantage of the oscillations that might happen in the natural cycles of these companies while remaining market neutral.

 

Traders who are interested in this trade should, as always, pay careful attention to both the fundamentals of the companies themselves and the macroeconomic environment too, but you should also expect, as is typical in almost all cases where opposite side hedging techniques are implemented, the company being bought might have had bad news recently, and the company being shorted against it may have had a series of positive events instead. That's normal, and goes with the territory.


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