Sector Spread
A thought crossed my mind, “How great would it have been to short Ford a go long on Toyota.” By betting Ford is going to go down, and Toyota is going to go up, what I am really doing is saying Ford is that Toyota is going to outperform Ford.
Lets say I thought of this last January, and I bought an equal dollar value of long Toyota and short Ford.
- January 2, 2008, sell 1,515 shares of F (Ford) at $6.60/share and buy 93 shares of TM (Toyota) at $106.46/share.
- December 30, 2008, sell 93 shares of TM at $65.44/share and buy 1515 shares of F at $2.29/share.
Uh oh, those numbers don’t look good. Both Toyota and Ford devalued.
I bought about $10,000 of Toyota stock and sold $10,000 worth of Ford stock, which I borrowed from my broker and have to return at some point. When I sold my Toyota, I made $6,085.92 (Ouch!). I bought 1515 shares of Ford for $3469.35.
So how much money did I lose on my virtual trade?
| Starting Balance | $10,000 | |
| Buy Toyota | -9,900.78 | 93 shares * $106.46/share |
| Sell Ford (Short) | 9,999.00 | 1,515 shares * $6.60/share |
| Sell Toyota | 6,085.92 | 93 shares * $65.44/share |
| Buy Ford (Cover) | -3,469.35 | 1,515 shares * $2.29/share |
| Ending Balance | $12,714.79 | 27% Profit |
I made $2,714.79, or 27% return on the $10,000. The return on investment is not really correct, because this strategy actually carries unlimited risk since Ford could have gone up infinitely, while Toyota stayed the same or went down. The odds of that happening seem acceptable to me.
Now, after I thought of these little scenario, I also realized that I picked Ford, which is the healthiest of all the American car companies. I should I picked GM, since it is on the verge of bankruptcy and Chrysler is privately held.
If I would have picked a worse American car company, how would I have faired?
| Starting Balance | $10,000 | |
| Buy Toyota | -9,900.78 | 93 shares * $106.46/share |
| Sell GM (Short) | 9,983.69 | 409 shares * $24.41/share |
| Sell Toyota | 6,085.92 | 93 shares * $65.44/share |
| Buy GM (Cover) | -1,308.80 | 409 shares * $3.20/share |
| Ending Balance | $14,860.03 | 48.6% Profit |
If I would have picked the GM over Ford, I would have made 48.6% return on my $10k.
This makes a lot of assumptions. One, that there are no costs associated with a short sale (there are and they are about 10% APR for me). Two, that I could have picked this scenario last year, but all i picked was that Toyota would out perform Ford, not exactly genius.
What wasn’t an assumption but is necessary for these kind of returns is a catastrophic event for the short company in a bear market or a outstanding return for the long company in a bull market. Without the best company significantly out performing the worst company, the cost of the short sale will likely create a losing trade in real life.
What I don’t know is if I could structure the same approach with options, providing a fixed risk and eliminate the costs associated with the short sale. I am pretty sure I can, and I imagine that the sector spread is not uncommon or original.