After hours, JPM was
up nicely after passing the Fed stress test, declaring an increased dividend
and announcing a surprisingly large buyback in their stock. Unfortunately,
Citigroup did not pass the test and cannot get Fed approval for the dividend
and stock buy back. C went down in price after hours. The purpose of the hedge
is not to make money both on JPM going up and C going down, although that could
happen. Usually, there is a price to pay for the hedge, namely, you make less
on the long because the short does not pan out. But you are hedged with both a
short and a long just in case there is a very sudden selloff in the banking
industry. In which case you would make money on the short and probably lose on
the long.
If you play the current news, then you are making a
short-term, momentum bet that C will go down some more, and JPM will go up for
another day or two. Longer term, hedge
fund investors may want to wait for C to bottom on this news and JPM to blow
off higher. At that point, they may see the long-term opportunity is to buy C
and go short JPM. The thesis here would be that all the good news is out on
JPM, and price may be a little too frothy. Likewise, C will do everything
possible to pass the test down the road and, eventually, do the dividend and
buy back stock. Let's look at the fundamentals and charts to see what the
possibilities are both over the short term and long term for this pairs trade.
For the short-term
pairs trade, let's go right to the charts to see the possible targets for JPM
and C. The-point-and-figure chart for JPM ( click
here) shows Tuesday's jump up before the close to $43, up 7% on
the good news. On this chart you can see the long-term triple top at $47. There
is some resistance at $43 to $44, so no surprise the price stopped at $43 on
the close and remained there in the after market. It may be slow going from $43
to $47 but that looks to be the target on this chart. One possible strategy
would be to go long at $43, target $47, but settle for $44 to $45 to close the
pair.
On the short side, C
dropped below $34 after hours, down from $36, and ended up above $35. The
point-and-figure chart ( click
here ) shows support at $34, the last high before the current
one of $36. And the next support is the last runup in price that ended at $32.
Let's presume the short gets off on the open Wednesday at $35 and your target
is $34. Theoretically, you get long JPM on the open at $43 and short C at $35.
By Thursday or Friday, JPM hits your target of $45 and you close both positions.
You make 2 points if C
does nothing but provide you with hedge protection. If you are lucky, C dropped
to $34 and you make a total of 3 points instead of 2 on the trade. You
did not have to worry about holding the trade over night because you were hedged
against a market selloff, where your short position could make more than the
long position. In this unlikely scenario, you would close the position when C
hits $32, making 3 points while you may lose a point or more on your long
position in JPM.
Now let's take a
contrarian view, one more appealing to professionals, like hedge funds. They will be interested in
shorting the frothy high of JPM and going long the dog, C. A possible
thesis would be that all the good news is out on JPM and the price has run up
too much. And C, on the contrary, has all the good news still ahead of it.
Namely, C will eventually pass the stress test and, like JPM, will eventually
announce a dividend and a buyback of stock to boost price higher. C has the
worst news behind it, crowned by its reverse split.
For the long term, we need to look at the fundamentals. Just because C failed the stress test,
doesn't mean it will fail the earnings tests going forward. The current drop in
price reflects the discount the market places on no dividends and buybacks this
year. The analysts are 20 to 7 positive on C and the mean target is $41. That
is not going to change because C failed the stress test. Price just broke above
the 200-day downtrend and the 50-day is in an uptrend challenging the downtrend.
Price may go down to test the 50-day uptrend at $32. There is a classic double
bottom in place and price has moved up bullishly from that bottom. According to
StockpickerUSA.com ( click
here ) it is a buy and this will not change as a result of the
stress test. The thesis here is that C, at $32, with a mean target of $41, is
very attractive. "Buy
on weakness" makes it attractive to the professional.
JPM on the other hand,
has a mean target of only $48. That will move up as analysts upgrade targets
slightly for the increased dividend and perhaps more than slightly for the
buyback in stock.
StockpickerUSA.com ( click here )
also has JPM as a buy. Until we see the new targets for JPM, it looks as if
price is running ahead of itself. For the time being, this supports the trading
plan that JPM is overvalued and C is undervalued. It is a contrarian thesis to
buy C on the weakness created by the stress test failure, perhaps at $32; the
other half is to short JPM when price really is overbought, perhaps at $48. To
complete the trading plan for this long-term pairs hedge, let's slot in some
targets from the chart.
The next test of
support, after this run-up in JPM's price, could take it back to price support
at $41 or even lower to test the 50-day moving average. For C, let's plan on a
bounce up to retest $37 resistance where price has just fallen from. There are
two possible triggers to close the pair hedge, namely when JPM falls back to
$41 or when C retests the $37 resistance. Thus there is a possible 7-point gain
on JPM and a 5-point gain on C. Whichever comes first will close the pair. A
more likely scenario is that JPM never falls much below $48 and there is no
gain on the short, but C does eventually bounce back up to $37 for a 5-point
gain (or something less, depending on how low C goes for the entry price.)
The worst-case
scenario is that C keeps falling and JPM keeps moving up and you have to close
the position at a loss with stops at $50 for JPM and $30 for C to trigger a
close of the pair. The most probable scenario is that JPM will come back to
test $43 and C will retest $35 for the gain of a few points.
Conclusion: Short term
the opportunity is to play the quick trade, going short C and long JPM, riding
the wave of positive news and closing the trade before the wave crashes on the
beach. Longer term is the
professional, contrarian play of going long C to take advantage of the selloff,
bargain price and going short JPM to take advantage of the over-valuation
created by the positive news. The key to success is having targets for
the trade and stops to exit, if it goes badly. Stock pairs hedging lowers risk
and lowers profits on the trade, but sometimes you win both on the short and
long positions and optimize profits on the trade
Credits -marketwatch
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