Understandably enough, buying a stock, or anything traded for that matter, below the price at which it is trading is the dream of just about every trader and investor. Imagine buying something, knowing that you are already making a profit and that you can set a stop loss that makes your worst possible result break even, or even a small profit on the trade overall. The thing is, if you understand a strategy that is pretty common in dealing rooms around the world and are prepared to take on a bit of risk for the opportunity to do it, owning a stock, or ETF, or futures contract, or just about any other traded instrument below its market price when you buy it is actually quite simple.
It is a trade that I usually refer to as going short to go long or selling to buy.
The basic idea is to sell something short that is going down, then reverse the position to a long at a certain point. The net effect of that is to leave you long, with an average below the price at which you reversed. That sounds easy enough, but of course there is a catch…It needs a quite rare, perfect setup in order to work. You need to find a situation where your short-term and long-term views of something differ. One of those situations arose yesterday in crude that created a setup that I sent out to Energy Income Trader subscribers and it is a good example of the tactic.
The EIA inventory numbers were expected out at around 10:30 and, while I usually don’t trade through data of any kind, I saw an opportunity here that I thought would play out. Markets in all risk assets have been nervous lately, with oil no exception. The sustained gains have taken us to a point where new 52-week highs are a regular occurrence and, no matter how justifiable that is based on fundamental conditions, it still puts traders a bit on edge. That made it likely that there would be some selling before the numbers came out, but great economic data, in things like GDP and Personal Income, hinted at a bullish EIA number as demand was presumably recovering rapidly.
That set up this trade, that played out well, at least initially…
If you did as suggested and sold at around 66.60, then bought double the amount of that short position at 66.20, you would be long CL at an average of 65.80, forty points below the market level. As you can see, the bounce back off of the 20 level and the rapid, if short-lived, spike immediately after the numbers gave plenty of opportunity to make a nice profit. If you didn’t take that opportunity and looked for more, you were disappointed as oil headed lower from there, but the point of this kind of trade is that even if that were the case, you could have set a stop forty points below where you established the long position and still got out flat at 65.80.
This all sounds easy and logical but, as I said, it demands a near perfect setup. That is rare, and the trade is also not without risk. Actually, I probably don’t need to say that because all trading and investing involves risk. The key is to minimize risk while maximizing potential, and this type of trade does that well. If your entry point for the original short position is close to a proven point of resistance, as it was here, your stop on that initial position can be quite tight, say twenty points away from your entry level. On the other hand, if things work out and you get a drop and a bounce back to your entry point, the potential profit is eighty points. That gives a 1:4 risk/reward ratio, with a chance for much more should the originally identified resistance level fail to hold on the bounce back and the stock, contract, or whatever, continue on higher.
My own trade on this move didn’t make the most possible profit, but it is still a good example of one way of playing out a trade like this that locks in some profit, while still giving you the chance of making more. I sold 2 contracts of CL at 66.60, then bought 4 at 66.20 to establish a 2-contract average long position at 65.80. Then, on the bounce, I sold one of those contracts when we got back to the original 66.60 entry point and ran the other one, hoping that the EIA data would spark some serious buying and maybe even a break above the 67.98 high achieved in March.
That didn’t happen, but a move lower looked likely when we turned tail so quickly after the numbers, so I got out of the 1 contract long position, which by then was at an average of 65.00, at 66.40 after a second attempt higher around ten minutes after the data release failed. There is quite a bit of math and averaging in the above, but the net outcome is a 140-point profit on 1 contract which, at $10 per point per contract, works out to a profit of $1400 in a few minutes on a position that was never bigger than 2 contracts.
If you are a longer-term investor or swing trader and all of this sounds a bit too day trading oriented to you, you should understand that it works on a longer timescale as well. You are looking for a short-term bearish influence that may disrupt a long-term upward trend, and that can play out over days or weeks just as well as it can play out over minutes. The important thing is to understand that when a dip can be anticipated, selling into it before buying may be a better tactic than trying to catch the proverbial falling knife on the way down. Providing you have a margin or trading account that allows you to short sell, it is something you should consider.
As counterintuitive as it is to sell something that you want to buy, in the right circumstances doing so reduces risk and increases potential reward, and that should be your goal in every trade you do.