Looking for Good Trades? What about the 2nd Derivative?
The whole concept of the second derivative trade is to benefit from specific news or asset moves that could impact one company’s activity (positively or negatively) and where we think it as not been priced by the market yet.
Already we have the (1rst) beauty of the 2nd derivative trade: it will generate long and short ideas, depending if the news should be taken as positive or negative.
Over the mentoring programme and the 4×4 Video Series, I very often push the concept of the second derivative. Here I would like to discuss a bit more about this idea and I will try in the next few months to come with different practical examples.
In these days of growing Artificial Intelligence and algos, you would think that any significant news will be spotted immediately and machines will be quicker to react. That means that any news should be priced in very quickly.
For the underlying asset, that is most of the time true. For example, if you have a specific news hitting the tape for one stock on Reuters or Bloomberg, algos would react very quickly and the price action would be immediate. That is why trading the tape for M&A news or reading the tape only is almost impossible for retail traders.
But as we will develop later, for the 2nd derivative trades, that is most of the time untrue.
It is fair to say that trading those news is much harder than 10 years ago. It means one thing mostly: change your timeframe and look at other edges. If you do your homework properly, you have good chances of making money. For example, that implies doing a proper fundamental analysis when you look at a company. When looking at commodities, analyze supply and demand.
The (2nd) beauty of the 2nd derivative trade is it can be done on any sector or industry. What I especially like in those trades is the risk reward or the very favorable risk management: You want to identify stocks that have barely move or slightly move on something that should normally impact their businesses. The whole idea here is to have a free option where if you are completely wrong on the interpretation of the news, the stock will only come back to its initial price and you will suffer a small loss. On top of that, you have a clear stop loss which is where the stock started to move. On the other hand, the upside could be quite significant. So from the moment you enter the trade, you can already set the stop loss to where the initial move started.
The (3rd) beauty of the 2nd derivative trade is it can be done on different timeframes, from very short term to very long term.
To give you an example, each time we cover a company during the mentoring, we look at how many customers a company has and its diversification. Why? Because if one of its big clients is releasing a significant news that might impact its activity. Here we will be looking mostly at 1 to 3 months timeframe.
As one of my mentees asked me recently, for U.S. companies you should find the consumer concentration in their 10-K reports. If you still can not find the relevant information, look at their investor presentations or ask them directly. For example, AMS, an Austrian sensor specialist, would be massively impacted by any news from its major customer: Apple. Here you would be looking at the whole Apple value chain and who could be impacted. And the timeframe could be from 1 day if Apple is updating about its latest iphone sales to 3-6 months or more if they are pushing for new technologies or new distributors.
The whole idea here is to get your own database of supply chain, supply and demand… to understand what the implications could be and more importantly be ready to pull the trigger if a significant news comes out.
Now let me give you an example on something where even if you missed the move on the underlying move, you could still be making money.
At the start of this year, one of my mentees came with the idea of shorting the Palladium. My first reaction was to tell him to not go against the trend but still trying to benefit from it.
In other words, do not go for the contrarian trade at shorting Palladium at 1320 but look at companies that could be impacted by the move: negatively if that is a big part of their costs and positively if they are somewhere along the palladium value chain.
Yes he missed the initial move but so be it. You will be missing many moves but do not go for the revenge trade by getting against the momentum unless you have a strong fundamental case to do so, overlaid with a favorable price action.
Instead what we tried to do was to identify companies that would be impacted by the palladium move. That sounds obvious here when we look at a commodity and supply and demand. Still I am pretty sure that 90%+ people look at palladium only and how to trade it without even understanding the supply-demand story behind it and completely missed the opportunities along the value chain.
The 2nd derivative trade mentioned above was to look at this Palladium producer: Sibanye, ticker SBGL in the U.S..
A nice move up on a dual listing (South Africa + U.S.) Gold + Platinum producer. And this was done in less than 2 months. In a longer timeframe, the company benefited in 2019 of two positive trends: Gold and Platinum as ~50% of its revenues come from Gold and ~39% from Platinum.
If you are looking at a shortage of Platinum, you have to be looking at the different producers and when you do your research, you will find out that there are not that many.
Now let’s look at the Palladium move and how Sibanye did afterwise, in 2019.
This is for the Palladium in 2019:
and for Sibanye Gold:
The move in Gold was the cherry on the cake but was not the initial idea back in January 2019. Then Gold move was another positive catalyst.
If you are still looking at Palladium only, you are making something wrong as too many people were looking at it. But if you look at Sibanye, you were right.
In other words, what we covered here is supply chain, supply and demand, price maker, price taker, concentration… In that sense, the 2nd derivative is almost infinite and offers great opportunity short term and long term. So you could be diversifying across timeframes, asset classes, regions. What you want to achieve is identifying stories that have barely move on a news or price action that should impact one company’s operations. By doing so, you will limit your downside to the small initial move and benefit from upside when investors will later react.
Again, I will try to come with specific examples in the next few months on different asset classes and timeframes. What I really like here is even if I could move the initial move on the underlying asset that should be impacted first by the news, I do not want to miss the 2nd derivative move. In other words, to benefit from this 2nd derivative move, you only have to do your homework. If you miss it, this is your fault.
I hope it helps,