Getting in This Trade Now Makes Sense

When I started Total Wealth, I promised you that I would cover the best trading tips, tactics, and techniques for today’s markets, including specific trading methods when headlines make the case for doing so.

Today, I’m going to keep that promise with a trade based on a recent story in Fortune that caught my attention: “Black Friday Weekend Will Deepen the Divide Between Retail’s Winners and Losers.”

We’ve talked about the retail “divide” in great depth many times both here in Total Wealth and in our paid sister-service, the Money Map Report, and I’ve characterized the ongoing battle as “Amazon versus everybody else.”

We also invested accordingly (and very successfully if you’re following along as directed, I might add).

Today’s trade, though, is about the “everybody else” in that phraseology.

Not Amazon.

This is important stuff because the retail “divide” that makes this trade work is going to create fortunes for savvy investors who understand the dynamic and – sadly – wreck more than a few portfolios for those who don’t.

Obviously, I want you to be amongst the fortune-builders.

Here’s how to line up big profit potential even if the markets turn.

According to the National Retail Foundation, something on the order of 165 million to 170 million people will have hit the stores and/or shopped online between Thanksgiving Day and Cyber Monday.

Retail sales are expected to jump by 4%, but I think 5% might even be in the cards based on a strong economy and even stronger consumers. Shopify estimated prior to Thanksgiving that the average American shopper may spend $550, but I’ve seen estimates topping $1,000 as I type, late Cyber Monday evening.

Fortune’s Phil Wahba makes the case quite clearly and eloquently in his story that not all this money will get spread around evenly. Wahba also notes specifically and, I think very accurately, that, “many big chains, particularly department stores coming off a string of weak quarters this year, can’t afford to lose ground.”

My sentiments exactly.

Retail stocks tend to be driven by long-cycle trends that do not change despite intense short-term interest, especially where holiday sales are concerned. It’s simply unrealistic to expect strong retailers to fail any more than it is to expect weak retailers to turn around terrible results from the balance of the year when holiday shopping season rolls around.

Bluntly, if you’re a retailer like JC Penney Company Inc. (NYSE: JCP) and your results suck coming into Christmas, they’re not suddenly going to become a thing of beauty. In fact, they’ll still probably suck.

That puts tremendous downward pressure on a company’s stock price even in a rising market. Kohl’s Corp. (NYSE: KSS), for instance, squeezed out a gain last quarter but is hanging on by a thread because the store is discounting everything heavily. JC Penney’s transaction volume, a key measure of retail activity fell 19% last quarter according to Edison Trends over the same time frame, Wahba reported.

Meanwhile, the strong get stronger.

We’ve talked about that in terms of “tiers” with Amazon.com Inc. (NASDAQ: AMZN) at the top, followed closely by Walmart Inc. (NYSE: WMT) and Target Corp. (NYSE: TGT), both of which are keen to challenge Team Bezos on one-day shipping. That’s no small feat considering that Amazon could well account for nearly 50% of all e-commerce this year.

That’s also your entry.

We’ve got the “core” covered with Amazon itself, so it’s time to selectively play the fringes using what’s called a “pairs” trade.

We’ve talked about pairs trading in the past, using examples like Volkswagen AG (OTC: VWAGY) and Harley Davidson Inc. (NYSE: HOG), so I won’t rehash the details today. Instead, I encourage you to take a quick spin through the Total Wealth Archives by clicking on each of those links to see how and why pairs trades can generate significant profits over time.

If your attention span is as challenged as mine is or you’re otherwise disinclined to click, here’s what you need to know:

  1. Pairs trades involve buying and selling two stocks in such a way that you can profit from virtually any market condition (up, down, or even sideways – it doesn’t matter).
  2. Pairs traders usually buy the stronger stock and sell short the weaker stock (of the two) because the path to profits in a pairs trade is via the “spread,” which is a $5 word used to describe the gap between their respective share prices.
  3. Pairs traders normally use this trade whenever the statistical correlation between stocks that will be used in the trade to resume after having been broken; however, in this case, I’m looking for the opposite – meaning for the statistical relationship to break between stronger retailers and their weaker cousins. I think that’s going to happen in the next 30 to 45 days as more holiday shopping data emerges.

My guts and instincts – which I’ve honed with nearly 37 years of active market participation – tell me that Walmart Inc. (NYSE: WMT) has a bigger potential upside move ahead of it than other retailers chasing Amazon.

At the same time, Macy’s Inc. (NYSE: M), J.C. Penney Company Inc. (NYSE: JCP), and Kohl’s Corp. (NYSE: KSS) are struggling, which means the stock prices of all three are likely to fall or at least rise less in the next 12 months as they get left in the proverbial dust.

A quick scan of the headline news for each stock mentioned in the Fortune article – and those instincts I mentioned above – suggest that Walmart and Macy’s could be just the “pair” we’re looking for.

An interested investor or trader would buy 100 shares of Walmart stock (which is trading at $118) while selling-short an equal dollar amount of Macy’s (which would at current price be about 787 shares). That’ll set you back a net spread of $2.87 per equally-valued pair – or $11,800 for 100 shares of Walmart while at the same time receiving a $11,797.13 credit for the 787 Macy’s shares, in this example.

What you’re looking for and hoping to see is that the spread of $2.87 widens – meaning increases – over time as the stronger stock – WMT – pulls away from the weaker one – M.

In contrast to normal directional investing or trading where you’re after a specific stock for specific reasons and are highly dependent on market direction and timing to make it pay off, what you want to focus on here is the relationship between the two stocks – the “spread.”

Whether the markets go up or down from here doesn’t really matter. What you want to focus on is whether the spread widens, which means you’re making money, or if it narrows, which means you’re losing.

Most people think managing a trade like this is daunting, but in reality, it’s actually quite simple and elegant.

What’s more, you can treat this trade like you would any other transaction with appropriate risk management and profit targets. For example, I’d urge you to take profits on half of the overall position if the spread doubles. I’d also encourage you to use a protective stop if the value of the spread decreases by 25%.

You could also use a “time-based” stop as an alternative, meaning that you’ll give it until a certain day to play out assuming it doesn’t hit either your profit target or your stop in the interim. I believe that holiday data will further highlight the divide in Q1/2020 which is why getting in now makes sense before that happens.

As always, I suggest the 25% trailing stop as a starting point. Feel free to use different profit targets and protective stops in accordance with your personal risk management and risk tolerance. You can also pursue a pairs trade like this one with options instead of shares if you have the appropriate skills.

Are there risks?

Yes, every investment or trade involves the risk of loss, and pairs trading is no different.

This trade will likely lose money when the spread narrows, which means the stronger stock you’ve purchased, for example, is actually losing ground against the weaker stock you’ve sold short. Or, the weaker stock could simply be gaining unexpectedly against the stronger one.

Either way, what’s happening in that instance is that the correlation between the two stocks is returning to normal. It’s the abnormal potentially widening of the spread we’re after as the retail divide itself widens.

In closing, I hope you’ve enjoyed reading today’s column as much as I enjoyed writing it.

The financial markets are constantly creating new opportunities, and in that sense, every new trading tactic at your disposal means more profit potential. Ergo, the more you learn, the more you could earn!

— Keith Fitz-Gerald

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Source: Money Morning