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When the stock market falls, it's hard to find winners even among good stocks. If you're confident that you've found the top dog that can stand out from the pack, then there's a simple strategy that makes it completely irrelevant which way the market goes.

Have a pair
Most of the time, when you buy a stock, you need it to go up in order to profit. But if you use what's known as a paired trade, the most important thing isn't whether your stock goes up or down -- it's whether it outperforms the other investment you include in the pair.

Mechanically, here's how a paired trade works. As you'd expect, it involves two steps. The first part of the strategy is simple: buy the stock you've picked to outperform, just as you would normally. But the second step is the key: sell short a similar amount of another investment that you expect your stock to beat.

The concept behind the paired trade is pretty simple. In a down market, even great stocks will sometimes lose ground. But with the paired trade, you're hoping that the investment you sell short will fall more than the stock you picked to outperform. If you succeed, then you'll earn a net profit, even when most stock investors are suffering big losses.

The trade-off, of course, is that if both parts of the paired trade go up, you'll make less money than you would have if you had just bought your favorite stock alone. The lower risk involved, however, arguably outweighs that lost profit opportunity. Moreover, if you picked a great stock, then you'll still make money from its outperforming the investment you sold short.

Make the trade
So once you have a promising stock, how do you decide what to pair it with? You have several choices:

  • If you want to make a broad bet that a stock will beat the market, then short-sell broad-market ETF SPDR Trust (NYSE: SPY  ) for large-cap stocks or iShares Russell 2000 (NYSE: IWM  ) for small-caps. For international stocks, consider using the iShares MSCI EAFE ETF (NYSE: EFA  ) .
  • To narrow down your focus further, you could use a sector-specific ETF as the other half of your paired trade.
  • If you've also identified an individual stock that you believe will do worse than the industry average or the market in general, then you can use that stock as your short-sale candidate.

Let's look at an example. Say you agree with my fellow Fool Alex Dumortier that IBM (NYSE: IBM  ) is ridiculously underpriced, and you believe that its higher earnings, steadily increasing dividends, and cheap valuation will help it be a long-term outperformer. But you also think that with the economy still on the ropes, the stock market could drop sharply in the near future, and you don't want to take on that risk.

Going through your options, pairing IBM shares with a short position in SPDRs would give you a profit if IBM beats the broad market. If you think IBM will be the industry leader in technology going forward, then pairing it with SPDR Select Technology (NYSE: XLK  ) or even the Nasdaq 100 Trust (Nasdaq: QQQQ  ) would give you gains if IBM tops the tech-focused indexes these ETFs track. Finally, if you think Microsoft (Nasdaq: MSFT  ) can't keep up with the competition, pairing a long IBM position with a short position in the Windows giant could increase your profits, as you could gain doubly if Microsoft stock continues to do worse than average while IBM beats the rest.

How much to invest
Another variable is how big you make your long and short positions. While a perfect hedge would have both positions start off in equal value, you could vary those proportions depending on your views for the overall market. Buying more of your favorite stock, for instance, would give you some market exposure while giving you a partial hedge. Making your short position bigger would build a bet against the overall market into your paired trade.

Volatile markets call for different strategies than you'd use in a bull market. Paired trades let you make money from your smart stock calls while removing some of the risk of simply buying shares. If the stock market falls or goes nowhere in the months to come, then you'll be glad to have the added protection that paired trades give you.

As companies start announcing results, which sectors will do best? Read more from Alex Dumortier about the winners and losers for this earnings season.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger often hedges his bets. He doesn't own shares of the companies or ETFs mentioned. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy makes you a winner.

Read/Post Comments (5) | Recommend This Article (3)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 14, 2010, at 2:00 PM, CPACAPitalist wrote:

    At first I thought people were just being silly, but I think the Fool is ligitimately anti-MSFT.

  • Report this Comment On July 14, 2010, at 8:38 PM, neamakri wrote:

    Okay, I get it. You buy $5000 worth of IBM and also short-sell $5000 worth of MSFT. What you just did is cut your IBM profits way down. You violated the KISS principle.

    If you are so scared of IBM, just invest $3000 to begin with and skip the rest of the headaches.

    I personally have the testicular fortitude to invest in good companies, without complicated "safety schemes". I follow analysts' earnings predictions and if an investment turns sour, sell it. I learn from my mistakes and successes.

  • Report this Comment On July 14, 2010, at 9:48 PM, Pr0metheus wrote:

    I think you're missing the point of a hedge, neamakri. It's designed more to protect/insure profit, rather than generate it.

    If you want to maximize profit potential, then yes, go all in on IBM. On the other hand, if you want to make sure you come out of the trade with money to show for it, then a paired trade would be preferable to the "all in" method, or "one-third in" method you suggested. Both methods would lose money if you are wrong, whereas the paired trade gives you some upside even if you are wrong.

  • Report this Comment On July 15, 2010, at 7:43 AM, rousseauhk wrote:

    "If you are so scared of IBM, just invest $3000 to begin with and skip the rest of the headaches."

    "If you want to maximize profit potential, then yes, go all in on IBM."

    Er.. no. You're both wrong.

    Buying $3000 IBM and Buying $5000/Short-sell $5000 MSFT are two very different trades.

    Buying $3000 IBM is simply a bet that IBM will go up, regardless of how the rest of the market performs.

    Buying $5000 vs. short $5000 MSFT is effectively a bet that IBM will outperform MSFT.

    If you don't think MSFT is going to go down, dont short it! The pair trade is only worthwhile if you want to trade performance in one company against another and you aren't sure of the overall market direction.

  • Report this Comment On July 16, 2010, at 10:49 PM, Pr0metheus wrote:

    @rousseauhk: Could you please explain how I am wrong in my assessment? As the article clearly states:

    "The trade-off, of course, is that if both parts of the paired trade go up, you'll make less money than you would have if you had just bought your favorite stock alone"

    Furthermore, the profit potential of going short is capped at 100% return. Whereas going long has infinite return potential.

    So again, if one only seeks the maximum potential, how does going $5000 long and $5000 short have more potential than going $10000 long?

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