From the August 01, 2007 issue of Futures Magazine • Subscribe!

Taking stock of opportunities abroad

The pieces are in place for U.S. discount brokerages to begin allowing direct investment in stocks listed on overseas exchanges through online trading accounts. Ultimately, the fallout for the U.S. equity markets could be huge. Most important, this could make available new strategies that traders can employ to trade new and existing markets.

In fact, this trend is so significant that its influence could transcend stocks, and the U.S. dollar, bonds and commodities markets also could feel the impact.

One of the first of the online brokerage companies to offer this is E-Trade Financial, which is allowing access to stocks from Japan, Britain, Hong Kong, France, Germany and Canada. The company says two-thirds of traders are interested in trading stocks on non-U.S. exchanges, and 70% of those interested would trade overseas stocks if accessible.

There are several ways to formulate successful trading strategies. One is to correctly assess how industry trends and developments could affect how the markets move and then position your account accordingly. This is one of those times. Let’s consider some possible results of the easy availability of non-U.S. equities to U.S. equity traders and the strategies that can be employed to take advantage of this trend.

NATION ROTATION

Despite overseas markets being at the heart of this move, U.S. stocks may be the most affected. Consider that for online stock traders to free up funds to invest in overseas stocks, U.S. stock holdings must be converted into cash.

Of course there’s no way of knowing how much money online stock investors may rotate out of U.S. stocks and into overseas issues, but with many investment experts recommending investing at least 25% of a portfolio in non-U.S. stocks, the amount could be enormous. This immediately suggests a strategy of selling U.S.-based indexes like the S&P 500, the Dow 30 and the Russell 2000 and buying non-U.S. indexes like the like the STOXX 50, the DAX or the Nikkei 225.

It’s natural to expect this shift to be tempered by the amount of money already invested in non-U.S. mutual funds and by overseas firms listing their stock on U.S. exchanges. But consider E-Trade’s claim that nearly half of customers indicated they would trade these markets if accessible. That implies additional active investment, not apathy.

Results of this will be felt on U.S. shores. Although investment in non-U.S. stocks may have a reserved, if measurable, negative effect on U.S. stocks across-the-board, there are certain sectors that may be particularly hard-hit:

1. High-yielding stocks. With many stocks on overseas exchanges paying dividends of 5% to 10%, U.S. high-dividend stocks now will have new competition (see “Poised for a breakout?” below). High-yielding stocks in utilities, financials and real-estate investment trusts (REITs) especially would face increased competition.

2. Litigation-threatened stocks. U.S. corporations have to deal with an increasing risk of litigation. Investors who want exposure to U.S. stock sectors most affected by this risk may opt out of their U.S. holdings and move into those companies’ non-U.S. counterparts. (See “Litigation stagnation,” below.) Consider stocks in these sectors: tobacco, pharmaceuticals and health care.

3. Regulation-threatened stocks. U.S. corporations also face substantial regulatory risks. Investors may choose to rotate funds out of U.S. stock holdings most vulnerable to regulatory risk and, again, into non-U.S. counterparts. Affected sectors include health care, pharmaceuticals and airlines.

There are many specific strategies available to protect yourself in the advent of potential weakness in these U.S. equity sectors. The most basic technique is simply to reduce exposure. Another is to establish hard and fast risk controls that will liquidate the positions in the case of a quick fall in the market (stop-loss orders or put option purchases, for example).

However, exploiting major trends is more than just risk control. It’s also about opportunity, and one of the greatest exists in the exchange-traded funds (ETF) market. For example, the American Stock Exchange (Amex) lists options on a number of ETFs that represent the potentially-affected sectors. These options allow equity traders to establish bearish positions.

One example is the Select Sector SPDR-Health Care ETF (XLV), which is designed to generally correspond to the performance of the benchmark Standard & Poor’s Health Care Index.

In addition to an outright short, a potentially profitable position would be a bear put spread in the options on XLV. A bear put spread involves the purchase of a put, while simultaneously selling a put at a lower strike price. The put you purchase costs more than the put you sell, creating an initial cost, but the put with the higher strike (the one you bought) will ultimately be worth more if the sector suffers weakness. This method enjoys better downside protection than an outright short trade because the lower-strike put offsets some of the pain if the market doesn’t drop.

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