Though Wall Street isn’t known as a sympathetic place, many traders are quite fond of the sympathy trade. These are trades in which a trader reacts to news occurring in one security by trading another security that is making a move as a result.
Sympathy trading can be very profitable when executed correctly. Below is a look at what sympathy trading is, the different types of sympathy trades and how sympathy traders take advantage of opportunities in the market.
Market sectors and subsectors often trade in tandem on a given day, depending on news items that impact the entire sector.
Even news about a single company can have a major impact on the share prices of its competitors. An earnings miss from Macy’s Inc (NYSE: M), for example, may suggest to traders that J C Penney Company Inc (NYSE: JCP) had a weak quarter as well. If shoppers weren’t buying at Macy’s, traders might conclude they probably weren’t buying at J C Penney either.
As a result, a bad earnings report at any major retailer can drive shares of other retailers down.
Sometimes, however, bad news for one company has no bearing whatsoever on certain competitors.
Back on December 8, 2016, Macau casino stocks Melco Resorts & Entertainment Ltd (ADR) (NASDAQ: MLCO), Wynn Resorts, Limited (NASDAQ: WYNN) and Las Vegas Sands Corp. (NYSE: LVS) shares all plummeted more than 10 percent after reports surfaced that the Chinese government might restrict ATM withdrawals in Macau.
That same day, U.S. casino operator Caesars Entertainment Corp (NASDAQ: CZR) shares traded down by 1.2 percent as well. Caesars has no properties in Macau and was not materially impacted by the China news at all. Assuming there was no other news out about Caesars that day on an otherwise strong day for U.S. stocks, that 1.2 percent decline likely came in sympathy for the rest of the casino industry.
Sometimes these sympathy trades come from investors not fully understanding the implications (or lack thereof) of a particular news item. Sometimes they’re just the result of trading algorithms set to automatically sell one stock if a related stock dips below a certain price. Whatever the reason for the dip, traders that bought Caesars that day were treated to a 1.8 percent bounce the following day as the market adjusted for the sympathy sell-off.
To recognize a potential sympathy trading opportunity, traders must be able to identify when market-moving news impacts only a specific company and when it has broader implications.
They also need to know the sectors and industries that are most susceptible to sympathy moves. We mentioned retail above, but biotech, airline, and cybersecurity stocks also frequently move in sympathy with each other. On a similar note, gold and oil stocks are very tied to the prices of their underlying commodities.
Once a potentially tradable sympathy sell-off has been identified, traders can take an additional step to limit their risk by using a pair trade. Simply buy the stock that sold off in sympathy and short the stock that is directly impacted by the bad news. That way, even if the sector-wide selloff continues, you can still potentially profit from the differences in relative performance between the two stocks.
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