Cisco's Upgrade Is Good -- for Extreme
By Don Luskin
Special to TheStreet.com
Originally posted at 12:28 PM ET 5/8/01 on RealMoney.com
My colleague Dave Nadig and I have received a tsunami of emails asking us
to explain the pairs trade we put on Tuesday: Short Cisco Systems
(CSCO:Nasdaq - news) and long Extreme Networks (EXTR:Nasdaq - news).
Dave mentioned the trade earlier on RealMoney.com's Trading Track. And I
mentioned the position, too, by way of disclosure in my earlier column on
Cisco.
The idea is to capitalize on a subtlety in Tuesday morning's upgrade of Cisco
by Morgan Stanley's superstar networking analyst Christopher Stix. First,
we're concerned that Stix's upgrade is a form of capitulation -- that he's too
late, and has missed the majority of the move in Cisco. Second, we note that
Cisco's growing business strengths cited by Stix in his upgrade may actually
indicate even better prospects for Extreme Networks than for Cisco.
Stix's upgrade of Cisco was based on Morgan's recent chief investment officer
survey that points to stabilization in the enterprise market, particularly the
Layer 3 switch market. After further channel checks, Stix believes that the
corporate spending slowdown is winding up, and that we will see a pickup in
enterprise demand in the next six months. Some 39% of the CIOs surveyed
today indicated that they expected 81% to 100% of their switches to be Layer
3 capable, up from 22% of CIOs in the last survey.
According to MetaMarkets.com networking analyst Chris Thiessen, "Layer 3
switching is Extreme Networks' strong suit. While it doesn't have a
stranglehold on the market -- it is the No. 2 player behind Cisco -- its
business is highly leveraged to Layer 3 switching. If there is a pickup in that
market, Extreme will benefit a lot more than Cisco."
Assuming you buy the Thiessen thesis, that leaves the question of how to
engineer the trade. How many shares of Extreme do you buy, and against
how many short shares of Cisco? The idea is to create a market-neutral
position, one that will capture the perceived value gap between Cisco and
Extreme whether the overall market, or the networking sector, is up or down.
If you buy and short the same number of shares, you won't have a position
that is neutral to overall market or sector risk. That's because Extreme (at
$33.99 as I write this) is much higher-priced than Cisco (at $20.14 at the
same moment). Buying the same number of shares that you short means
you'll have almost twice as many dollars long the market as you would have
short. That means if the overall market moves up, the position will be helped --
but if it moves down, it will be hurt.
You can eliminate this problem if you simply dollar-weight the positions. That
means you'd buy about 20 shares of Extreme for every 34 shares of Cisco
that you short. Now you've got the same number of dollars both long and short
in the market. That's a big improvement in risk control compared with just
trading the same number of shares of each stock.
But you can take it one step further. Remember that what you want to hedge
here isn't actually the dollar value invested on both sides of the trade now --
rather, you want to hedge the future changes in the dollar value of the trade.
That means you'll want to take into account the fact that Extreme -- a much
smaller and younger company -- has a much more volatile price than the
larger and better-established Cisco. So a given number of dollars at risk in
Extreme is effectively larger than the same number of dollars at risk in Cisco.
Our solution is to weight the trade by the two stocks' respective volatilities.
Volatility is a statistical measure of the distribution of a stock's price
changes. The higher the volatility, the higher the risk. According to Bridge
Information's BridgeStation, Extreme's volatility is rated at 165.8, while
Cisco's is 100.8. Both numbers are extraordinarily high by any normal
historical standard -- but what counts for this trade is just the difference
between them: a ratio of 1:65 to 1.
The difference between the volatilities means that you'd want to buy less
Extreme (the more volatile stock) and short more Cisco (the less volatile
stock). With simple dollar weighting, you'd have shorted 34 shares of Cisco --
so now multiply that by 1.65 to scale it up to match the volatility of Extreme.
That will give you 56 shares of Cisco short, to 20 shares of Extreme long. To
round it into convenient trading lots, you'd short 5,000 shares of Cisco for
every 1,800 shares of Extreme.
I'm sure I needn't warn you of the risks in such a trade. While on the one hand
you are -- at least theoretically -- neutralized against market and sector risk,
the reality is that you have separate positions that may end up not hedging
each other at all. You might say you now have two ways to be wrong. But
then again, if you thought you were going to be wrong, you wouldn't make the
trade.
We debated whether to put this trade on ahead of Cisco's earnings Tuesday
night, and decided to at least establish a pilot position. Whatever Cisco says,
it will rock the whole sector -- and probably the whole market. We're betting
that the more information investors have, the more they'll see the strength
developing right in Extreme Networks' sweet spot.
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