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How to Profit in a Down Stock Market

Friday, October 2, 2009

How to Profit in a Down Stock Market

 There are many ways to profit in a declining stock market, but I want to discuss a method where your downside risk is limited while upside potential profit remains huge.
 The stock market has been in a mid-term up trend for many months now and these stock increases have been fuelled by speculation and greed. There are many reasons why there is potential for a stock market pull back and these have been discussed in previous articles on Investing in Canada: How to Protect Yourself From a Red October, Double Dip Recovery or V Shaped Recovery.

The most effective way to profit from a pull back in the stock market is to implement a very basic options strategy: The Long Put.

Now, this is not your regular old Long Put. I am not suggesting simply buying puts on a stock like (Nasdaq:GOOG) and hoping it tracks the market or drops more than the market; what I am suggesting is a Long Put on steroids. Basically, ETFs have made going long and short the market very affective because many have options capabilities with large volume. Further, leveraged ETFs that are long or short the market allow you to gain an added incentive since there are rebalancing cost for the fund that chip away at the total value.

Some issues that you need to consider before undertaking such a strategy are:

• The duration of time you expect the pull back to occur over

• The size of the pull back

A rule of thumb with options trading is that the longer the duration to option expiry the more you pay; the closer the strike price is to the current price, the more you pay; and the lower the volume in the options traded, the more you will pay.

Now that we have some basic rules I will provide my interpretation of what these rules mean to me today and how I will be executing.

• First, it is a difficult feat to pick the absolute top or bottom of a market cycle so a very short term options contract will not work for me.

• Second, I do not want to pay a tonne of option time premium

• Third, once a pull back begins I do not expect to be able to pick the bottom.

• Forth, when investing in Canada you will notice that options do not get the volume necessary for a tight bid/ask spread so I will look to NYSE, AMEX, or Nasdaq options.

Given this and the fact that I want to be well diversified in my strategy I will buy puts on a market ETF. There are so many different ETFs out there now, but these guidelines narrow it down very quickly.

Although there are not currently any leveraged ETFs that track the S&P 500 my selection is to track this market as it is a good gauge for the overall market in North America.

My selection is to buy puts on (NYSE:SPY), which is an ETF that tracks the S&P 500 and has the seconded highest volume out of all North American ETFs.

The next step is to determine the time duration I am comfortable with. Since the erosion of the option time premium increases exponentially as you get closer to the expiry date and I want a slightly lower priced option I will go for a December 2009 expiry.

Now you go to look for the cost of the various puts for your time frame. The closing price of (NYSE:SPY) was $103 so if I pick a price very near to $103 I will be paying more for being at or near the money and the further down in price I pick the strike price the cheaper the contract will be. You need to balance out your price expectations here against the time frame.

I could conceive of a 15% pull back at this point so something around $87-90 suites me. When scrolling through the DEC put option contracts on SPY I noticed that the $90 strike has large volume and many open contracts. As a result this is the contract I will purchase.

The contract symbol I am referring to is FYSXL.X; the bid is $1.40, and the ask is $1.46. Let’s assume I have to buy on the ask at $1.46 to calculate the break even point per contract that I buy at expiration.

B/E = Strike Price – Premium Paid

B/E = $90 - $1.46 = $88.54

This means that SPY must trade below $88.54 at expiry to make a profit. This is effectively a 14% drop in the S&P500.

Now, that is assuming that I hold onto the contracts until expiry, which I would not recommend. If I sell the contracts at the end of October I will still be able to recuperate a substantial amount of time and risk premium from the contracts.

The great thing about options is that when you buy puts or calls the most money you can lose is the amount you put in and you get to be leveraged 100 to 1 against the stock or ETF index.


The Rat said...

Interesting. I have absolutely zero experience in dealing with puts or calls...sounds you feel comfortable with this investment vehicle and buy puts quite often?

Smac20 said...

Yes, I buy options and sell options from time to time. Buying options is a relatively low risk strategy when you think about it from an exposure stance. For example buying 1 contract of the SPY DEC $90 Puts cost me $1.44 per share. Options trade in lots of 100 so 1 contract represents 100 shares. That is a total cost of $144 for exposure to 100 shares. The most I could lose per contract is $144, while the upside is huge with a large move in the stock. The payoff is pretty much the same as shorting SPY, but that would require risking over $10,300 (100 shares x $103 share price).
Basically, as long as you think the stock market will make a move in one direction or the other than options are a great way to capitalize. If you think the stock market will just move sideways then selling options a good strategy, but that is another discussion.
Think of it this way, if you think the market will increase by calls; if you think the market will decrease buy puts.

Financial Samurai said...

Just short everything in October!

Financial Samurai