Shorting the market: Options or ETFs?

Since it looks like the market will be handing us lemons for the foreseeable future, perhaps we could parlay this sour state of affairs into some sweet profits. There are many ways to play a bear market. Popular techniques include shorting the indices, buying index put options, and going long the short and ultrashort index ETFs. This last strategy is especially popular in retirement accounts.

We've looked at these strategies before in previous blogs (see 6/18/08 and 7/15/08) and thought it's time to compare them again since the market is much more volatile than it was last summer.

Strategy comparison
Here are the following strategies that I selected:

Short the index tracking stocks: QQQQ, SPY, DIA
Buy their short counterparts: PSQ, SH, DOG
Buy their ultrashort (2x) counterparts: QID, SDS, DXD
Buy March 2009 at-the-money (ATM) puts on the above tracking stocks
Buy 2010 ATM puts on the tracking stocks
Buy 2011 ATM puts on the tracking stocks

I wanted to look at a recent downturn so I choose the (relative) high peak put in on January 6th of this year and used today's (March 5th) closing prices. The table below summarizes the results.


Options still rule
The table reveals several interesting observations. The first is that buying the short ETF did better than shorting the underlying. (I've written before on the dangers of the short and leveraged funds (see 2/10/09 blog) so be aware that they may not perform in the way you think they should.)

The second observation is that instruments based on the S&P 500 and the Dow Industrials generally outperformed those based on the Nasdaq 100 (the Qs). Most likely this is due to the constituent makeup of each index.

The last observation is that short-term options trounced the returns of their LEAP counterparts. Using my handy-dandy Black-Scholes options calculator applet on my Blackberry, I found that the implied volatilities of the short term options are higher than that of the LEAPs, confirming my suspicion.

The effect of volatility
Before you race out and buy short-term puts, you should be aware that volatility is a double-edged sword. If you purchase an option in times of higher volatility, it's very possible that you can lose money if the volatility decreases, even if the market goes in your direction. To illustrate this point, I looked at the 2010 Jan90 put on the SPY. On 11/20/08, the VIX (market volatility index) hit a high of 80. That day, the S&P 500 closed at 752 and the put option at $27.15. Three months later on 2/26/09, the S&P again closed at 752 but the VIX had dropped to 45. What was the put worth? It closed at $22.15, 18% lower! The drop in value is due almost entirely to volatility as time decay is minimal for this LEAP.

Does this mean that you shouldn't take the options plays? Of course not! You can mitigate the volatility effect by using options spreads. A long put can be replaced by a bear-put debit spread where you buy the higher strike put and sell a lower strike put against it. One nice feature of this strategy is that your cost basis is decreased but it comes at the price of capping potential profits.

Cost basis
It's worth noting that not only do options offer you more leverage but they're cheaper than buying the underlying instrument, giving you an extra bang for your buck. Plus, your risk is limited to the price of the option unlike shorting a stock which has potentially unlimited risk. However, if you've never traded options before I strongly urge you to learn about them and paper trade them first.

I hope this exercise has been instructive. That's the long and the short of it!

How low can we go?

I don't mean to throw a wet towel onto today's China Syndrome rally, but I believe that this is only a temporary breather before the next leg down. Now I'm not the only bear in the forest—not by a long shot—and it seems as if I and my other furry brethren are struggling to answer the burning question of the moment: “Where do you think we'll find a bottom?” The best answer I can give to that is: Try a restroom.

Nobody knows anything right now
I don't mean to be flippant but I do think that the right answer is: Nobody really knows. The fundamentalists for sure don't know. Today on CNBC, one reporter (Bob Pisani?) said that analysts can't even come up with a reasonable guesstimate as to where earnings will be in 2009 which makes predicting any sort of support level impossible.

The technicians don't know, either. My charting program only carries ten years worth of price and volume data for the Dow Industrials and nineteen years for the S&P 500. The Dow has already broken through major support at the 7800 level and I don't have enough data to discern the next stop. The S&P recently blew through its 800 major support level as well as minor support at 755. According to its monthly chart, the next points of minor support are down around 670 and then 450.

Fibonacci levels
Technicians often resort to Fibonacci levels which are used in Elliot Wave Theory. Using the S&P 500 as an example with 1550 being the market top and 0 being the bottom, we get support levels around 960, 775, 590, and 365. The problem with Fibonacci levels is that they're not always accurate, and I especially have a problem using them over such a long time frame.

Aren't there any other places we can go to get some clues as to where a possible bottom might be?

How saving money will put us in the poor house
In his excellent column that appeared on MSN Money yesterday, Jon Markman used the Levy-Kalecki model of economic behavior to explain how high levels of saving and a decline in borrowing can lead to the devastation of corporate profits, a situation we could very well find ourselves in. Using this model, Markman came up with a couple of market scenarios--both rather grim tales. He said that if households save as little as 7% of their incomes, the S&P 500 could sink as low as 550 and the Dow as low as 5,300. If the wealthy are taxed per Obama's plan and savings rates go to 10%, the Levy-Kalecki model suggests that corporate profits will be slashed by 50% from their 2007 peak. Depending on whether investor confidence or fear prevails, the S&P could either end up around 755, a little higher than where it is today, or around 420, a lot lower.

I'm casting my vote for the fear camp and here's why.

The reason for another market downturn
The reason I think the market still has a ways to tumble is because of the VIX, the volatility index. The rule of thumb is that the more uncertain the market, the higher the volatility. Even though the volatility has been high lately, it's still nowhere near where it was last autumn. Below are daily charts of the S&P 500 and the VIX.





You can see that the VIX roughly inversely mirrors the movement of the S&P. When the S&P made new lows last October and November, the VIX made new highs (around 80). But the S&P has dropped well below those levels and what has the VIX done? It hasn't even come close to making any new highs. This divergence is a signal that the market has a lot more room to fall.

The answer to the question
So, where will we find the market bottom? The answer to this question is not where, but when. We'll find it when the VIX forms a new top, and it doesn't seem to be in a hurry to do that. So fasten your seatbelts 'cause it's going to be a bumpy ride!

Channel Breakout: Stock Candidates

Last week we looked at a recipe to profit from breakouts in channeling patterns. On Friday, I said that I'd rustle up some potential candidates for this strategy to add to your watch list. If you're playing recipe #3 on channeling stocks, you can also add these to that list as well.

I've divided the table below into four sections.

The first section deals with stocks that have just broken out of their consolidation pattern in the past day or so. You can still play them. (See Recipe #15 for strategy details.)

The second section is comprised of stocks that are on the verge of breaking out. Watch these closely.

The third section holds stocks that are currently channeling.

The last section is for illustration purposes to show you stocks that have broken out in the past couple of weeks.





















Points to Note:

1. Some of these stocks have major support levels below their channeling support (the lower level), so please make a note of them. You may wish to hold off on entering a trade until they either break through or bounce off those levels. This comment particularly applies to ANW, DTV, ROP, and BRCM.

2. The market is now in a downward spiral, and attempts to play breakouts to the long side may not work out as intended. The higher percentage play is to play those to the downside, which is where the majority are headed for anyway.

Good luck!

Channel Breakout Examples

Yesterday, we looked at a recipe for trading stocks (or futures) that have just broken out of their consolidation patterns. Today, we'll look at a couple of examples of this strategy--Goldman Sachs (GS) and Honeywell (HON).

Goldman-Sachs: Daily Chart

[Click on chart to enlarge.]



Here's a daily chart of Goldman-Sachs (GS). The stock began consolidating in March of last year, trading between $152 and $190-$200. On September 15th, the stock ended its consolidation pattern and gapped down through support, closing the day at $135.50 on heavier than normal volume. This was the day to enter a bearish position, either by shorting the stock or buying put options. It was also the day for you to either enter a sell-stop order or set an alert for your exit point.

Where is your exit? From yesterday, we saw that we can expect the stock to drop at least the same magnitude as the breadth of the consolidation ON A LOG SCALE and we gave formulas so that we can calculate it directly instead of measuring it on a chart. For Goldman, it's pretty clear where the bottom support level is—about $152, but the upper resistance level isn't quite as obvious. One technician might determine that $190 is the proper level thereby ignoring the data point at $200, while another technician might include it. You can choose which ever one you want, but I'd err on the conservative side and select the one at $190.

Using the $190 level, our exit point will be $122; using the $200 level, the exit point is at $116. You can see from the chart that the stock had no trouble sliding by either one. Exiting according to this plan would have netted at least $13 for an ROI (return on investment) of almost 10%. Not bad for two days!

But what would have been your return had you instead purchased a put? The only data I have at my fingertips is the price history of the 2009 April 135 put. On Sept. 15, it closed at a price of $21.40. Two days later, it closed at $36.20. That gives a profit of $14.80 per contract for a return of almost 70%--yowza! You can see why options can be so alluring and why they are used in come-on ads to inflate potential returns. What they don't tell you is that trading options is not a piece of cake--you really need to know what you're doing! (Please see my sidebar for options education info.)

Honeywell: Weekly Chart



Sometimes consolidation patterns that have long cycle periods (aka wavelengths to you tech-heads) aren't obvious on daily charts and you'll have to go to the weekly or even monthly charts to discern them. The chart of Honeywell (HON) above is one such example. A well-defined channeling pattern began in mid-2006. It enjoyed a successful two year run, bouncing between $52 and $62 (you could have made some money playing the channel—see recipe #3) before it finally broke down on 6/26/08. (You have to go to the daily chart to see this.)

Actually, it broke support the day before, closing under $52 for the first time in two years. The stock gapped down the next day which would have been your signal to enter a short position. If you had shorted near the open, you could have gotten in at $51. Your exit point for this trade would have been $43.60 (or you could have made it an even $44—this science isn't that exact). Several weeks later, the stock finally hit the $44 mark and had you exited then, you would have netted $7 for an ROI of almost 14%.

Had you instead bought the 2010 January 50 put on 6/26 at the closing price of $6.40, you could have sold it on 9/17 for $10.40. That's a gain of $4/contract for an ROI of over 60%!

Summary
You can see the power of channel breakouts, especially when the stock is moving in the same direction as the market. Of course, any monkey's uncle in recent months could have thrown a dart at the stock market and done well shorting virtually anything out there, but most of the time the market is not nearly this volatile. You should note this because in the case of the above two stocks, had you held at least a portion of your position past the exit point, you could have profited even further. This certainly would have been true had you shorted the stocks, but be aware that because of changes in implied volatility, your option positions may not have fared so well. Also be aware of the fact that the above options returns were based on the assumption that the options were liquid enough for me to buy and sell at those prices. In a real-life situation, that might not have been the case.

Later this weekend or Monday, I'll try to rustle up some stocks that are consolidating right now so that you can add them to your watch list.

MANDA Updated Table

This table incorporates today's additions of NCX and HIFN.



Click on table to enlarge.

MANDA Portfolio Additions: NCX & HIFN

It looks as if M&A activity isn't completely dead. Yesterday, Abu Dhabi state-owned International Petroleum Investment Co (IPIC) launched a $500 million takeover of Nova Chemicals on Monday in an effort to rescue the Canadian-based plastics maker from drowning in debt. Note that Nova trades both on the Toronto exchange and on the NYSE under ticker symbol NCX. Under the proposed terms of this friendly deal, IPIC will pay NCX shareholders (US) $6 per share in cash with the caveat that at least two-thirds of the shares are tendered.

Looking at the chart of NCX yesterday (shown below), my first thought was that too many people already owned the shares at higher prices and would be loathe to part with them at a loss. But last night I looked at the chart again and noticed the substantial rise in trading volume in recent weeks. Adding up the daily volumes, I found that more shares than the float (approximately 85.6million versus a float of 82.6 million shares) had been traded since 1/21/09 when the stock price began trading under $5. The stock hit a low of a buck and change on 2/3 and has stayed below the $2 mark until yesterday when the acquisition was announced. With more than the float changing hands below $5, this was the reassurance I needed to jump in at today's opening price of $5.20.



Right after my purchase of NCX, I bought shares of Hifn (NASDAQ: HIFN) for $3.80, a maker of processors used in network and data storage security. Chip maker Exar (NASDAQ: EXAR) agreed to buy all Hifn stock giving Hifn shareholders the choice to receive 0.3529 shares of Exar plus $1.60 per share in cash, or $4 a share. Based on $4/share, the deal is worth $58.9 million. It has been unanimously approved by both boards and is expected to close early in the second quarter.



The MANDA portfolio table will be updated to reflect these new additions.

The market in free-fall

First, my apologies for again harping on the dismal state of the market. I'm not trying to be boring; believe me, I'd much rather be reporting on something that's a lot more interesting and useful to my readers. However, I feel it's my fiduciary duty to impress on you how serious this downturn is and how likely it is to continue.

I mentioned last Tuesday that the Dow Transports (DTX), generally considered a leading indicator, broke major support. Two days later, the Dow followed suit. It's now trading at over a 10 year low. Since my charting service doesn't carry Dow data any further back, I can't even give you the next support level.

The S&P 500 broke major support today, closing at 743. There's minor support at 670; next major support is in the 470-480 range. Ugly.

Sector indications
Looking at sector ETFs shows most either breaking major support levels and/or making new all-time lows. (Note that ETFs are relatively new inventions and most haven't been around for more than several years.) All sectors are sucking big-time except for the metals. Gold bounced off of $1000/ounce and if it starts to trade above that, I'd be very bullish on it. As mentioned before, the pure gold play is the GLD, an ETF that holds gold bullion,* but the gold miners represented by the GDX is also doing well. (I'd wait until it tops $39 resistance before buying.) The only metal that has been outperforming gold is silver. One way to play it is to buy the SLV, the silver ETF.

Other market indicators
Two stocks that are considered market bell-weathers are Berkshire-Hathaway (BRK.A) and General Electric (GE). GE is down 85% from its $60 peak. It just broke $9 support. It's next support level is at $7.55; below that, there's no safety net. The Oracle of Omaha's managed fund (aka Berkshire-Hathaway) has broken through several support levels and is sitting right on its next major support at 75,600, 45% beneath its all time high. One CNBC analyst today said that at a P/E ratio of 15 the company is still way overvalued. A P/E of 10 is more inline with his estimates. That means the stock has to drop another 33% ($25,000) to reach that value. Now that's really ugly.

One good news/bad news scenario is playing out at Cabela's (CAB), an in-store and online retailer of outdoor wear and sporting goods. The company beat analyst expectations last Friday--the good news. The bad news is that they did it by offering fire arms at fire sale prices. One analyst thinks that this surge in sales could be a reaction to a change in gun policy by the Obama administration. That's one explanation. Another could be that people are fearful that a possible depression could result in an increase in theft, and they are buying guns to protect themselves and their possessions. I sure hope it's the former and not the latter explanation.

Tomorrow I'll have a "meatier" blog. Again, my apologies for another gloomy prognostication but please don't shoot me--I'm only the hapless messenger.

*According to CNBC, the GLD holds so much gold bullion that it's now the seventh largest holder IN THE WORLD!