How to Trade Volkswagen Now

Keith Fitz-Gerald Sep 23, 2015
41 

When I started Total Wealth I promised that I would give you a blend of tips, tactics, and specific trading ideas to help you maximize your wealth based on the events of the day.

Today I’m going to keep that promise with a look at how to trade beleaguered VW right now, using a brand new Total Wealth Tactic I think you’re going to love.

What I like about this trade is that it’s easy to understand and even easier to implement.

Best of all, the trade I’m going to share with you today has the potential to turn a profit no matter whether the broader markets go up, down, or simply nowhere.

Let’s get started!

VW’s Fall Highlights Tremendous Profit Potential

German auto giant Volkswagen AG (Equity OTC:VLKAY) has been clobbered on news that the company deliberately programmed more than 500,000 vehicles to emit lower levels of emissions during official testing than when they’re on the road.

As if that weren’t enough, the company admitted Tuesday morning that internal investigations appear to involve another 11 million VW vehicles around the world. It’s a betrayal of customers everywhere who thought they were buying greener, energy-efficient vehicles — including yours truly.

I believe the appropriate German expression is: “Ach du lieber!”

The company’s already set aside $7.3 billion in an effort to cover recalls, but the penalties could top $18 billion in the U.S. alone. Worldwide the number could be double or even triple that amount, if investigations in South Korea, Britain, France, Italy, and other countries find similar problems.

The reputational damage to the VW brand, though, may represent an extinction- level event. Nobody is talking about that yet, but you can bet your farfegnugen that they will.

A 2010 joint study by Lin Bai of the University of Cincinnati College of Law, James Cox of the Duke University School of Law and Randall Thomas of the Vanderbilt University Law School found that companies engaged in fraudulent behavior may suffer financial punishment at the hands of the financial markets averaging 7.5 times that of any legal penalties.

VW shares, as you might expect, have tanked. They’re down 29% in heavy trading over the past few days. Almost a third of the company’s value has simply vaporized.

Millions of investors, large and small alike are reeling, with shares of BMW and Daimler taking corresponding hits of 6% and 7% respectively, simply because they’re German-based and even though the issue does not affect their cars.

For most investors, this is the end of the road – pun absolutely intended. They can’t imagine a way out let alone how to profit from the situation.

But I can and that’s what I want to share with you today.

Introducing a New Total Wealth Tactic Perfectly Suited For “DieselGate”

Most investors have never heard of a “pairs trade.” That’s what you call a market-neutral strategy many pros use in situations like this one.

Technically speaking, a pairs trade is a form of statistical arbitrage. That’s a fancy way of saying that it has two parts and that the relationship between the parts is such that you can profit as the spread between them changes.

First pioneered in the 1980s at Morgan Stanley, a pairs trade typically involves two highly correlated securities. You buy one and short the other simultaneously, creating a “spread.” Then, as one weakens and the other strengthens, the spread changes. And that’s your profit mechanism.

Imagine, for example, Wal-Mart Stores Inc. (NYSE:WMT) and Target Corp. (NYSE:TGT).

Historically, the companies have tracked relatively closely, moving more or less in sync with market conditions. If Wal-Mart began looking too hot while Target stayed flat, a trader could buy Target stock while simultaneously selling Wal-Mart stock short.

If Target rose to “catch up” as is often the case in today’s highly computerized markets, the trader would make money on the Target stock. Or, if Wal-Mart stock began to slip, he’s set himself up for profits having shorted the Bentonville giant.

Whether the markets rise or fall is moot once this trade is in motion. It’s the relationship between the two stocks that matters.

Pairs trades have a number of key advantages.

First, they’re great in rocky markets because they help you control risk. It’s not uncommon, for example, to have both stocks in a pairs trade fall on a big down day. While that would clobber regular investors, pairs traders may remain completely neutral or even profit if the relationship changes in their favor.

Second, pairs trades are not market driven. They can potentially profit when the markets go up, when they go down or even when they go nowhere at all. Remember, it’s the relative performance that you’re after here.

Third, there’s no directional risk. Because a pairs trade always has one long and one short position, the first position is constantly hedging the second.

And fourth, because of the way they work, pairs trades can be very low cost or even no cost. It’s not uncommon for the short position, for example, to pay for the long. Margin requirements, as a related item, are typically much smaller, too because drawdowns are minimal by virtue of the fact that they’re always offset.

So let’s return to VW.

There is no doubt in my mind that VW is in serious trouble. I think the company’s stock is going to take a real pounding and that the financial penalties potentially at hand here will eviscerate earnings for years to come. Customer trust has been shattered, especially among those green-minded drivers who thought they were buying eco-friendly cars.

If the markets take off, VW is probably going to get left behind. If the markets fall, VW will probably fall faster. Nobody wants to be associated with a liar, let alone a company that may have deliberately engineered its products to gain an edge at the expense of the investing public.

Here’s one way to play that Total Wealth style using your newly gained knowledge.

Simultaneously buy the S&P 500 using an ETF like the SPDR S&P 500 ETF (SPY) and sell short an equivalent dollar amount of VW stock. An equivalent number of shares won’t work, so don’t mistakenly assume that 100 shares of SPY will offset 100 shares of VW.

As I write this, SPY is trading at $193.60, so that means 100 shares will set you back $19,360, excluding commissions. Volkswagen AG (Equity OTC:VLKAY) is trading at $25.58. Consequently, you’d sell short roughly 756 shares of VW ($19,360 divided by $25.58 equals 756.84 shares).

If you wanted to follow along with much smaller amounts, the math is the same. For example, let’s say you wanted to risk $1,000 on this trade. You could buy 5 shares of SPY and sell short 39 shares of VLKAY, again not including commissions that vary from broker to broker.

As long as VW does, in fact, lag the broader markets and the S&P 500 itself in the months ahead, the trade will make money.

As an aside, you can use a trade like this for any company you expect to underperform the broader markets. We’ve talked about Shake Shack Inc. (NYSE:SHAK), Zoe’s Kitchen (NYSE:ZOES), Twitter Inc. (NYSE:TWTR) and GoPro Inc. (NasdaqGS:GPRO) as being terrible investments, for example. They’re all great candidates for this kind of trade at the moment.

Now, are there some gotchas?

Yep.

The biggest is that the spread could narrow instead of widen. That means one or more of the positions go against a trader taking the bet I’ve described. VW, for example, could appreciate faster than the S&P 500 on nothing more than bottom fishing. A positive news story would do it, too and that could conceivably range from the current CEO resigning or the board ousting him. Even a decent apology would change things.

Pairs traders typically have higher commissions because a single trade involves commissions on both sides. Remember, you’re buying and selling at the same time.

Then there’s slippage, meaning that a trader may not get exactly the fill he or she is looking for. Pairs trading can involve odd lots that are by their very nature more thinly traded, for example. Or, partial fills.

In closing, pairs trades, like our lowball orders, are a professional grade tactic you can use very effectively as an individual investor. Moreover, they’re tailor-made for the kind of situation VW faces now.

Until next time,

Keith

41 Responses to How to Trade Volkswagen Now

  1. hank Erbes says:

    I would have thought some specific stock, such as Daimler or BMW, would have been a better pairs trade than the SPY.

    • Keith says:

      Hi Hank. Those are both good choices; I was after a broader market play here because I think the entire German auto industry will be painted with a very dark brush so to speak.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  2. Charles Barron says:

    Keith,
    Is there an options strategy for this trade idea or a way to do it in an IRA? Sell VW puts and buy SPY calls, perhaps for lnger duration options? I don’t think I can sell short in an IRA.

    • AL Martinoski says:

      Would a Roth IRA work?

    • DAN says:

      I have the same issue… not allowed to directly sell a stock short in my IRA acct. Would have to put put options which lose time value. What if VW becomes a take-over target by another company to effectively bail them out? That would add more volatility to the stock price. I think I’ll pass…

    • Celeste Flynn says:

      Mr. Barron, you wouldn’t *sell* VW puts to implement your suggestion. Selling puts is a form of selling short (although you are only selling the puts), and obligates you to buy the underlying security. Which is in fact, a bullish trade, although you might do it because you’d only be happy to buy the underlying at a lower price.

      The simplest way to do this trade with options would be to *buy* VW puts (if you could) and *buy* SPY or SPX calls, or even SSO calls. SSO is the ProShares UItra S&P which is designed to trade at double the SPX.

      As I write, SPY last traded at $193.60, and VLKAY last traded at $27.10. Sadly, however, VLKAY is not optionable. So the only way to do this specific pairs trade is with the SPY and VLKAY shares. You could use SPY calls for that half of the trade, but you’d have to use about twice as many at-the-money SPY calls as you might think in order for that side of the trade to be a counterbalance to the shares of VLKAY. I know it’s complex, but at-the-money options only move at about half the velocity of the stock.

      Therefore, if you bought one SPY $194 call representing 100 shares, you’d have to sell short about 358 shares of VLKAY in order to be somewhat balanced. And to be fair, this is not the idea that Keith is proposing.

      • Regina says:

        Great response Celeste, very clear. Thanks. Regina

      • Lawrence says:

        Actually, just to be clear, selling puts is a form of going long, rather than a form of selling short as stated above. If you sell puts you’re collecting a premium that you hope to keep as your profit because you believe that the underlying security *will not drop* below your strike price, in which case you’d be obligated to buy the underlying security if you get assigned. Hence, selling puts is form of going long.

        • Keith says:

          WOW!

          Great discussion here guys and fabulous suggestions for each other. Way to go and thank you to everybody who put in their two cents.

          Options are certainly doable but you’ve got a few more variables to get right ranging from time decay to deltas and even volatility as part of the equation to pull it off. It can be far more complicated than I’ve got space for here today.

          But I’ll chew on it and see if I can come up with a simple example in the weeks ahead.

          Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

      • R. J. says:

        Interestingly, Money Morning published an article: This Week’s “Unloved” Stock to Buy: Volkswagen AG (VLKAY).

        Reading this current post, however, it appeared to suggest that one would write a put on VLKAY, which confused me.

        If it’s not optionable, then one would have to own the stock and write a put?

        Thanks for explaining that an option’s price will not necessarily change for a corresponding one-unit (point/dollar) change in the price of the underlying security.

  3. Sara says:

    Thank you for describing the pairs trade. As an aside, every day seems to disclose a new level of corruption in both business and politics. Nothing surprises me any more.

    • Keith says:

      Sadly, me neither Sara. But don’t lose faith. The Total Wealth Tactics and Unstoppable Trends can put the odds in your favor and give you a defense against Wall Street’s nonsense.

      Thanks for being part of the Total Wealth Family and best regards, Keith 🙂

  4. raul aljanati says:

    Existe a la fecha una diferencia de precio de la accion que equivale casi al 50% del valor de mercado.

    El tema es de mucha importancia pero no creo que los clientes salieron corriendo a que le solucionen los problemas .
    Por lo tanto VW va ha solucionar los temas en la medida que se vayan presentando, por lo que ,creo que es una buena oportunidad de compra.El pueblo Aleman lo va ha solucionar.

    • Keith says:

      Buenas dias Raul.

      For those of you who don’t speak Spanish, Raul has pointed out that there is a difference in share price that’s now approaching 50% of market value and, under the circumstances, that VW will solve this. He’s making the suggestion that it could be a good buy at these levels.

      My response…albeit in rusty Spanish of my own… Ha sido un large tiempo desde que he escrito en espanol. perdoname. Estoy de acruerdo con sus puntos. Si usted tiene la paciencia, VW puede ser una buena especulacion.

      I noted…it’s been a long time since I have written in Spanish so please excuse {my errors}. I agree with his points. If you have the patience, VW can be a good speculation at these levels.

      Saludos y gracias por ser parte de la familia. Keith 🙂

  5. Max R. says:

    As I understand If I´d like to use the tactic with TWTR or ZOES today investing $1,000, I´d buy 5 SPY shares and sell short respectively 36 shares of TWTR and 26 shares of ZOES.

    a) Could we use the system through options instead of stock?
    b) What If someone already has let´s say Dec 15, $20 Puts on TWTR or Dec 15 $30 Puts on ZOES?, Thanks

    • Celeste Flynn says:

      The first problem with using options for the pairs trade is that you are buying on both sides (buying calls for your bullish side and buying puts for your bearish side) so it’s more expensive than going long stock versus short stock. On the other hand, you’re not borrowing stock to short and incurring margin interest for that part of the exercise.

      The idea of a pairs trade is to be equivalent on both sides. So your TWTR Dec $20 puts could be balanced versus SPY Dec $200 calls at a 10-to-1 ratio. Not a precise match, because your TWTR $20 puts are far enough out of the money that they currently only have a delta of -13. A better match would be TWTR Dec $27 puts with SPY Dec 195 calls, so that deltas are equivalent and you’d only need to balance number of contracts, at a ratio of 7.2-to-1.

      Similar problem with ZOES being out of the money, but it’s also a much thinner options chain. So, since ZOES closed at $37.04, your $30 puts only have a delta of -21. But there aren’t any Dec $37 puts, only $35 or $40 puts. With a delta of -37, the Dec $35 puts could balance versus SPY Dec $199 calls, at a ratio of 5.7-to-1. Or with a delta of -54, the Dec $40 puts could balance versus half SPY Dec $191 calls and half Dec $192 calls, at a ratio of 4.8-to-one half plus one half.

      I really hope that answer was not confusing!

      • Keith says:

        Really excellent commentary Celeste. You clearly have a great grounding in options! Thank you for helping out here.

        Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

      • Max R. says:

        Thank you so much for your flawless technical answer Celeste. As a begginer I´ll have to personally analyze it further, to really grasp it.

  6. FABIO says:

    KEITH,
    WOULD APPRECIATE IT IF YOU COULD DETAIL “SELL SHORT”

  7. Jim Tebay says:

    Hi, Liked your comments on VW.

    Would it work just as well to buy a call/put option pair contracts (market neutral or straddle)? These would have the same expiration date with the strike prices both at/in-the-money. For example, the stock price is $25.44. Considering a strike price of $25 and buying an October 17 call and put option pair would only cost a trader about $3.28 per contract. If the price continues to fall for VLKAY (as is likely), the breakeven occurs at $21.72, while if an acquisition rumor occurs which would drive the price up, the breakeven would occur at $28.28. This bet seem likely to be profitable. Any comments? Jim Tebay

    • Keith says:

      Thanks for the kind words, Jim.

      There’s no reason you couldn’t play this with options but, as I noted above, you’re fighting time decay and a whole host of other variables to really do it right and capture the nuances that are otherwise already implicit in the spread between the stock positions.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  8. Lloyd says:

    Barron: Your proposed Option trade is backwards.
    It should be:
    Buy SPY Calls &
    Buy VW Puts

    To replicate the Stock equivalents strategy.
    Probably using LEAPS to give the position time to work without losing much time value.

    This strategy is also used in Commodity Futures and named a straddle.
    Example Buy a Corn Future contract
    & Sell a Soybean Future contract
    assuming that the difference between Corn & Soy prices will increase.

    • R. J. says:

      So if I buy the SPY calls and the S&P rises, good.

      If I buy VW puts and the stock tanks, my option premium increases in value, and I can sell the option (or exercise), so good.

      In this case the spread widens. In any case, the option premium is all that I have at risk.

      Why is the article then suggesting that we buy the SPY ETF index?

      See my questions below.

      • Keith says:

        Hello RJ. It’s a play on the company versus the broader markets rather than versus another industry player as is more common, hence the SPY. Good question.

        Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  9. Niall Chin says:

    As I right this, I am seeing on the news the CEO stepped Down. Thank you for giving such a detailed explanation of Pairs trading.

    • Keith says:

      You’re welcome Niall!

      The situation is obviously changing very rapidly and that’s, in part, what makes this such an interesting trade.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  10. Charlie Harris says:

    Jim Tebay’s straddle trade appears more desirable and simpler to me. One would expect VW to volatile , both up and down. Either way we win.
    Certainly not an expert. Appreciate replies. Charlie Harris

  11. Friedl Mey says:

    The appropiate German Expression is “Ach du Sch…….” (my mother told me not to say such words). I’m afraid, this is only the tip of the proverbial iceberg. There is probably more cheating going on in the car industry including other brands, not just German. The flipside of this scandal will hopefully be cleaner cars. The damage for the car industry should be moderate, though. The avarage customer still doesn’t give a damn what comes out of his or her exhaust pipe …

    • Keith says:

      Danke sehr, Friedl. Mein Deutsch ist nicht sehr gut leider.

      Thank you for being part of the Total Wealth Family and best regards, Keith 🙂

      PS: We’ll see…we own a 2012 TDI Wagon and I hope they clean it up but there’s nothing from VW yet so we’ll see.

  12. RJ says:

    Keith,

    You mention a margin call, so I assume that I’m writing a put. And if I don’t own the stock, a naked put.

    Suppose someone who owned VW shares sold them early on after the bad news, doing so because they thought the overall, long-term outlook would improve for VW. And suppose the put is 90 days out, VW stock tanks, and this investor exercises the option. Moreover, what if the S&P (SPY) simultaneously flat-lines or drops.

    I then have to deliver the shares.

    In this scenario, how does this benefit me?

    Can some one please answer?

    • Keith says:

      Hi RJ.

      You’re on the right track but may have some wired crossed with the options. Actually, the simplest way to do this would be to buy a put because puts appreciate as the price of the underlying drops. In this case, that’s VW.

      In my example, I recommended selling VW stock short so there would be margin attached to that position by your broker. However, that would be offset by the corresponding position in the SPY depending on how your broker marks to market, which country you are in, etc. The rules vary widely.

      Crossing options against equity introduces an entirely different set of wrinkles.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  13. K.B. says:

    VW may have a justification: during highway travel, the diesel engine burns a lot less fuel than a corresponding gasoline engine. So, in the end there may well be less emissions generated than by a corresponding “clean” gasoline engine. In addition, by allowing a somewhat greater amount of emissions to be disgorged, there is less need to burn off deposits from the exhaust gas filter, which further reduces fuel consumption. I would love to have one of those “dirty” diesel VW Passats which makes 50 or even 60 miles by burning only 1 gallon of fuel – whereas corresponding gasoline cars generate a 2 gallon fuel pollution while travelling the same distance.

    • Keith says:

      That’s a really super point, KB and not one that’s being talked about at the moment. It’s kind of like the enviros here in the Northwest who automatically assume that buying local is greener than buying big farm products. In fact, there’s an economy of scale, more efficient equipment, etc.. that many times, means mass produced crops can be far more efficient than the local farmer using a 40 year old tractor, hand water lines, combines, etc. But they don’t want to look at the data because it disturbs their carefully constructed reality.

      It will certainly be interesting to see how the data comes out here when all is said and done. I just hope the “fix” doesn’t drop my TDI from the nearly 40 mpg we get now to something far less.

      Best regards and thanks for being part of the Total Wealth Family, Keith 🙂

  14. C Varner says:

    During my surfing the web and reading your great emails, (obviously very new to the stock market) I saw that the Nasdaq Composite has produced a “death cross” chart pattern today. Do you have an opinion on that? And, I guess, long story short, if it affects the stocks you have in your Watch List? Thanks!

  15. Robert Jewett says:

    Neither Schwab nor TDAmeritrade would allow me to short VLKAY…and yes, I have shorted before in these accounts.

    • Houyhnhnm says:

      Robert,

      Shorting pink sheets stocks can be dicey. Maybe Interactive Brokers (interactivebrokers.com) would allow it, but I’ve never tried, Even though Interactive Brokers caters to wild speculators, they will limit shorting on any stock that gets extremely volatile,

      Houyhnhnm

  16. eli d zdunich says:

    I DONT HAVE A COMMENT ON STOCK BECAUSE IM NEW AT THE GAME. BUT I DO ON VW. I HAVE A 2006 TDI JETTA AND GET 50 MPG, MY X HAS A 2000 TDI JETTA AND GETS 50MPG, MY DAUGHTER JUST BOUGHT A 2015 TDI JETTA MY POINT IS I WOULD PUT MONEY ON THE REBOUND OF VW BECAUSE I BELIEVE THE EMISSION TESTING BY CALIFS CARB AND EPA IS A VERY POOR EXCUSE OF POWER.I GUESS THEY WOULD RATHER FORCE VW OUT OF BUSINESS THAN TO ADMIT THEY MIGHT HAVE A PROBLEM WITH THEIR TESTING.WOULD I BUY ANOTHER VW,TDI YOU BET I WOULD AND HOPEFULLY I CAN. KEEP THE INFO COMING. MY REGARDS ELI ZDUNICH.

  17. Houyhnhnm says:

    Does anybody know a broker that will allow shorting odd lots? I thought shorting had to be in round lots.

    Thanks,
    Houyhnhnm

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