A Safer Way To Speculate on High-Fliers like Groupon and Netflix
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you are like me and consider yourself an early adopter of new technology and follower of growth stocks in the sector such as Groupon (NASDAQ: GRPN) and Netflix (NASDAQ: NFLX), you may be intrigued by making stock market bets on these companies despite the heightened level of volatility and risk. You do not have to go far to find bearish commentary on either of those, for instance, as Groupon faces stagnation in its core daily deals email service and Netflix is pressured by soaring content costs and increased customer discontent. There is a way, however, to play these stocks without taking huge amounts of risk.
Making a single directional bet on an individual company can really hurt. For instance, if you rode Netflix down more than 75% from over $300 to under $70 over a few short months earlier this year. If you have strong opinions on the futures for these types of stocks, but are skittish based on the volatility of the markets, I would suggest putting on paired trades. Paired trades involve betting on two companies relative to each other rather than each on their own. What do I mean exactly?
Let's say you are bearish on both Netflix and Groupon but feel that it is very riskly to bet against both by going short each one individually (what if you are wrong on both?). Sometimes you can devise a plan to make a bet that fits your thesis but consists of one long paired with one short, thereby greatly reducing your market risk. Netflix, for instance, currently has 25 million paying customers and a $3.7 billion market value, which comes out to about $150 per subscriber. Groupon, with a market value of over $12 billion, has about 30 million paying subscribers (people who have actually bought a Groupon). That equates to $400 per customer. Do you see the disconnect here?
Netflix customers pay each and every month. Groupon customers don't. In fact, only half of those 30 million people have bought two or more Groupons. It is certainly true that Groupon is growing far faster than Netflix right now, but Wall Street is valuing a Netflix customer at less than half of a Groupon customer despite more revenue on a monthly basis. An investor could decide to go long Netlfix stock and short Groupon. That way they are making a bet on the two companies but have reduced their day-to-day volatility because they are hedging their market risk. Theoretically, if both stocks fall from here, Groupon has a strong possibility of falling further, which would make the trade profitable.
This strategy can work for any sector, not just high momentum stocks in technology. Maybe you think Lululemon (NASDAQ: LULU) is extremely overvalued at a market cap of $7 billion, but relatively speaking are positive on the growth prospects for UnderArmour (NYSE: UA) at a $4 billion market cap (UA has far more revenue than LULU as well as a larger addressable market). Why not go long UnderArmour and pair that trade with a Lululemon short?
All in all, for high growth stocks that carry above average risk and volatility, a paired trade is a way to reduce your market risk but still play your convictions.
At the time of writing, Chad Brand had no positions in any of the stocks mentioned in this post.