Huh?

This past month has been full of craziness - so much so that I have had nothing constructive to say in my blog. That doesn't mean I haven't been profitable, in fact the past month has been the most consistently profitable trading my account has seen in quite sometime. Many friends have recently asked (somewhat fiendishly) how I'm doing in the market - they are obviously looking (dare I say hoping) for me to say that my ROI has been at least as poor as theirs. When I respond that I have done quite well by taking advantage of the downward move in the overall market I am often met with silence, or a stare that says "Oh, you must be one of those anti-American short sellers that I hear about on CNN." Nothing could be further from the truth and I would like to devote this blog entry to the explanation of how to capitalize on a down trending market.

But first things first...I don't short sell equities. Period. I believe an outright short sale of a company's stock is a bet against the company and the hardworking people that are employed there. It's a personal thing for me - I don't necessarily think short selling is bad, I just don't do it. Short selling plays a vital role in free and open markets by embedding stock buyers at various price levels. If someone borrows a stock from their broker and "shorts" it they have to "cover" at some point by buying the stock back and returning it to the rightful owner. If they buy it back for less than they sold it for they make a profit and if they buy it for more than they sell it for they take a loss. It is this required buying that puts the brakes on a downtrending stock. When you look at an overall downtrending chart and see upward spikes in the price action that last for a couple of days before resuming the downward trend you are witnessing what is known as a "short squeeze". The short positions are buying to cover and driving the stock price up. Not until all (or most) of the shorts have been forced to cover will the price back off and continue downward. If that forced buying wasn't embedded in the markets you would see out of favor stocks (poor earnings, missed FDA approval, false rumors, true rumors, etc.) plummet without pause because there would be no buyers - and that is bad for the company's stock holders, employees, and the market in general.

So....how do I capitalize on a down trending market? I use Options and ETFs (Exchanged Traded Funds) to assert my bias against other market speculators.

If I think the S&P 500 (for example only) is going to tank I step back and watch it...and look for a high probability trading opportunity using equity options to define my projection. When I buy a put (or sell a call) I am taking a bearish position against the speculators that are thinking otherwise. That's what options provide - an alternate market that allows speculators to trade against each other. When I take a bearish option position, I'm taking the other side of another speculator's bullish position - they are typically buying a call (or selling a put). In the end, only one of us is correct and gets paid - the other has to pay up. In this type of market, the speculators are asserting their views against one another and are not directly influencing the price action of the underlying stock. The price of the options are determined by various things - the price of the underlying stock, option supply and demand, time remaining until option expiration, and volatility.

It bears mention at this point that I very rarely trade an individual company equity. Almost all of my trading is done on index and sector ETFs. This limits my risk by reducing my exposure to the unexpected swings of a specific stock in the event of unexpected news or reports. ETFs are often called a "basket" of stocks. One of my favorite trading intruments is the DIA (called the "diamonds"). It is an ETF that tracks (pretty closely) the Dow Jones Industrial Average. When the DOW moves up 100 points, the DIA moves up 1 point (dollar). I typically trade the DIA using complex option strategies that allow me to have defined risk but limited ROI - a trade-off that I am more than happy to make. For example, if I forecast that the DIA (and by extension the DOW) will not fall below $110 in the next 30 days I would sell a DIA OCT08 110 PUT and purchase a DIA OCT08 108 PUT to hedge the position. This is called a credit spread and basically allows me to keep the difference in the 2 prices if I am correct in my forecast. I will dive deeper into credit spreads in my next post...