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BEARISH INVESTING
Yes you can make money in a declining market!
One of the most common ideas among investors is that it is difficult to make money when the market
declines. There are really two major reasons for this belief and I will consider each one separately.
Belief #1- In the long run the Market Always Rises, so don’t try
betting on a decline!
Here is a typical scenario advanced by the proponents of the long term bullish view: Say in November
1932 your grandfather had bought $1000 worth of the stocks in the Dow Jones Industrial Average, then
kept the Dow portfolio for 68 years. Assuming he was still alive, by January 2000 he could have
cashed out for about $200,000.
At first glance this looks like a fantastic return, and it certainly wasn’t bad, especially considering
he could have spent the dividends during that whole period. But we should note the effects of inflation
before rejoicing too loudly: During those 68 years the Consumer Price Index rose from 13.2 to 168.8.
This means that each dollar spent in January 2000 could buy only about 8 cents worth of merchandise when
measured in terms of 1932 money. Making the appropriate adjustments, we observe that he was really only
getting $15,639. Sure that’s a good gain, but not quite so stupendous as it first appeared.
But let’s add another element of sobriety. Suppose that instead of buying in 1933 and selling in 2000
that your grandfather had bought in 1929 and cashed out in 1949. Twenty years seems like a fairly long
time to most people, and some would expect any short term fluctuations would even out for any such span
leaving a decent net gain. As (Figure 1) shows, this is not the case at all. If your grandfather had
purchased $1000 worth of stocks the first day of 1929 he would have received a mere $570 when he sold
them the first day of 1949. To put that in modern perspective, this would be like purchasing $10,000
of Dow stocks in 2005 and cashing out in 2025 for $5,700.
Even worse, suppose your grandfather had purchased the Dow stocks September 3, 1929 then needed the money
12 years later to pay college tuition for one of his children. Sadly, over this span he would have seen
his $1000 wither to $335, barely a third of its original value. Translating that into a modern perspective,
it would be like investing $10,000 in 2005 and cashing out in 2017 for $3,350.
It is not that I disagree with the assertion that the stock market rises over the long term. It does. But
the idea can be misleading. The September 1929 Dow close of 381.17 was not seen again until November 23,
1954 when the Dow finally squeaked past and closed at 382.74. To cite a more recent example, the Dow’s
February 1966 close of 995.15 wasn’t seen again until November 1980 when the Dow squeezed by and closed
at 997.95. Unfortunately, in that case, inflation had eaten away substantially at the value of money (the
CPI had risen from 32 to 85.5) so in constant dollars the investment had actually declined 62%. When
corrected for inflation, the Dow didn’t recoup its 1966 glory until September 1995, a span of nearly 30
years!
Belief #2- Shorting Stocks is Hard to Understand.
Many people find the idea of selling short somewhat confusing. This adds yet another obstacle to their
ability to make money in declining markets. In reality shorting stocks is a very simple process. In
essence it is just the reverse of a long transaction.
Let’s begin by looking at the familiar long or “normal” transaction. Say the investor begins with
$10,000 in his brokerage account. He decides to buy 100 shares of Bilkum Pharmaceuticals at $20 each.
So 2000 dollars are deducted from his account, and 100 shares of Bilkum are added. At that point his
cash account is at $8000 and his stock account is plus 100 shares of Bilkum. A week later he sells
his 100 Bilkum shares at $25. At that point 2500 dollars are added to his account and 100 shares
of Bilkum are subtracted. So his cash account will be $10,500 and his stock account will be zero.
Excluding commissions and interest, his profit is the difference in his cash account before and after
the process. In this case it is the difference between the purchase and sale of Bilkum shares: $500.
In a short transaction it is almost exactly the same only reversed. The investor begins with $10,000
in his brokerage account. He then ’borrows’ 100 shares of Bilkum, and sells them on the market for
$2000. His account is minus 100 shares of Bilkum, and plus the 2000 dollars cash from the sale. At
that point he will have $12,000 in his cash account and have a negative balance of 100 shares Bilkum.
A week later Bilkum shares have declined to 15 dollars per share. The investor goes into the open
market and buys the 100 shares he needs to cover his position. This costs him $1500. At this point
the investor’s cash account is $10,500 and his stock account is zero. At the end of the process, the
investor has no Bilkum shares in his account, just as was the case in the long transaction. Excluding
commissions and interest, the profit is the difference between the sale and purchase of those shares:
$500. The main distinction between a long (normal) and a short transaction is the order. In the case
of a long transaction, the investor buys first and sells later. In a short transaction the investor
sells first and buys later.
Though it is not especially complicated, there are some important things to recognize about short
selling. First, anyone short the stock during a dividend payment is technically responsible for making
that payment. Second, like any other transaction there are commissions and interest which have to be
factored in when computing profit. Third, it is always a good idea to make sure the stock trades at
substantial volume, preferably more than 500,000 shares per day. Most importantly, it should be
recognized that a stock’s price is theoretically unlimited in its potential for rise, whereas is
bounded on the bottom at zero. This means that the risk in taking a short position is theoretically
infinite. A stock may seem absurdly overpriced at $15 per share, and yet climb to $65 or even $150.
The short seller is responsible to buy back the stock to cover his position no matter how high the
price has climbed. In practice it is probably less risky to short weak, high volume stocks in a declining
market than it is to try to ride glamour stocks up to their peak. But as always, it is important to
study the technical situation carefully and follow prudent money management. This is true of all
investing whether on the long or short side.
OPTIONS: ANOTHER WAY TO MAKE MONEY IN A DECLINING MARKET
One of the best ways to make money in a declining market is by using options. Though they can be risky,
if they are used properly they can deliver substantial profits.
Call Options
To understand options it is probably easiest to begin with the call. Really a call option is a contract.
As with any contract there are certain rights and obligations on the two sides.
By purchasing a call, the buyer obtains the right to buy a given number of shares at a fixed price over a
specified period of time. The call seller is required to sell those shares at that price to the call
holder should he request it. In exchange for assuming the risk implied by granting this right, the seller
receives a premium over the intrinsic value of the option.
Let’s say an investor buys a call option on 100 shares of a company called Boundless Entertainment. The
contract has a strike price of $20 and is due to expire in three months. At the time it is purchased, the
stock is trading at $25.
We know the contract must be worth at least $500. We know this because by the definition of the contract,
the holder has the right to buy 100 shares for only $2000 (100 shares times $20) while the market price
of the stock is $2500. The owner of the option could in theory exercise it at any time and receive
those 100 shares for the price specified by the strike, then resell them at the market price. So a call
option will always be worth at least the positive difference between the market price and the strike
price. This is called the intrinsic value. However there is almost always some additional value in an options
contract. This is called the time value, and it is the price the market puts on the value of the time
remaining on the contract.
The put option
The put option is essentially the opposite of a call. The person who buys the put option hopes the market
price for the stock will decline, since he is buying the right to sell a given quantity of shares at the
strike price. Say he buys a 100 share put contract on Erstwhile Asset Management, Inc. The contract has a
strike price of $32 and an expiration due in four months. At the time of purchase, the shares are trading
at $25. We know that there will be an intrinsic value of $700 on the contract, since this is the positive
difference between the market price and the strike price times the number of shares. At any time the option
could be exercised: The 100 shares could be purchased in the open market for $2500 and sold to the option
holder for $3200. The market will always reflect at least this value. But, just as with the call, there is
almost always some additional value to the contract which reflects the market's assessment of the likelihood
the contract will expire in the money.
Probably the easiest way to think of the additional time value in an options contract
is in terms of the extra risk assumed by the issuer. Obviously no one knows for sure which way the market is going to move. A call seller
expecting a stock to fall could wake up the following morning and find the market has gapped up 5 percent
overnight. Conversely the put seller may have been placidly expecting the market to climb rendering the puts
worthless, only to find the market has suddenly plunged 10 percent in a matter of days. Everyone understands this, and the market factors in the value of risk assumed by the option
seller.
The premium is something like the payment of the same name given to an insurance company for
assuming the risk of an asset’s damage or destruction. If a calamity occurs, then the insurance company
is out of luck and must pay for repair or replacement. However, in general, the company calculates that
it will sell enough premiums to cover the claims and still make money. Similarly, the options seller
knows that in some cases the contract will expire far enough in the money to result in a net loss. But
over time he or she hopes that those losses will be offset by gains from the premiums collected.
So a choppy, volatile market will be viewed by the options seller much like an insurance company views a young,
male driver with 3 speeding tickets on his record: much more likely to be an expense. The options seller will
expect to be compensated for the extra risk implicit in such a volatile market by collecting
a larger premium.
Obviously there would be no insurance companies if there were no premiums, since there would be nothing
to gain from assuming the risk. The same can be said for the issuer of options. They take the greater
risk; they are paid for taking that risk by the time value paid by the options holders.
Other factors which may affect the price of options include interest rate, trend direction and dividend yield,
though these tend to be relatively minor.
Options Review
So, to recap: In a rising market calls gain in value, puts decline. In a declining market puts rise and
calls decline.
There are two basic categories of value to an option: intrinsic value
and time value. An in-the-money option will have both intrinsic and time value whereas an out-of-the-money option
will only have time value. Time value begins to decrease relatively slowly and then accelerates toward the end of
the contract.
If a stock is relatively quiet, staying within a tight range and making slow movements in the broader
trend, options based on that stock tend to trade with a lower premium. If the stock is moving a great
deal from day to day and threatens to charge deep into the money of any nearby options, it will tend
to trade with a larger premium.
Options sellers hope that whatever losses are taken from options whose underlying stocks move too far in
the money are offset over time by the premiums collected. Options buyers hope that whatever losses
are taken by premiums will be offset by the gains made from correctly anticipating market direction.
THE BEAR STRATEGY
Bears have several obstacles to clear if they are to make money by buying options. (1) They must
correctly anticipate market direction (2) They must be sure that the gains in the options made
by market action are greater than the losses due to time decay. (3) They must be sure the options
are traded with sufficient volume to avoid difficulties in selling the contract.
Options trading is a complex subject, but the following five points are a good starting point for
those intending to use options to profit from market declines.
First, as a put buyer make sure volatility is low and time is cheap. The VIX should be at least as
low as 22 and the S&P/VIX ratio should be at least as high as 55.
Second, stick with heavily traded options and don’t stray too far from the money. When trying to sell
an option you may be faced with the dilemma of certain shoe salesmen. There are not only different
underlying stocks (shoe styles), but there are also different expirations (seasons) and strike
prices (sizes). So finding a buyer for a thinly traded stock option with a distant expiration and
a strike price far from the market may be like trying to find a midsummer buyer of a rare Yugoslavian
winter boot in an uncommon size. If you do manage to sell, it may not be at the price you had anticipated.
Third, remember the losses from time decay begin slowly then accelerate toward the end of the contract.
As a put holder it is vital to keep expirations distant. How distant depends on your strategy and
market conditions, but as a general rule assume at least four times the length of time you expect to
hold the contract. For instance, if you expect the market to move in your direction within a month, the
expiration should be out at least four months. In general always err in the direction of more time.
Fourth, be careful. Remember, options are a highly leveraged investment. They can, and usually do, expire
worthless. Research options thoroughly before investing. Never risk more than 10 percent of net worth
in options in any given year.
Fifth, make sure you have a good handle on the likely direction of the market and the particular security
whose options you are trading. I would recommend subscribing to several timing newsletters in addition
to Investment Sense, especially if you are new to market timing. It is good to get an idea of how
different analysts approach the issue. Some excellent newsletters include Sy Harding’s Streetsmart
Report, The Elliott Wave Financial Forecast, and The Granville Market Letter.
Bear Funds: A simpler way to make money in a declining market.
Bear funds are ideally suited to the investor who does not want to sweat the details of shorting
stocks or trading options. The fund managers are entrusted to make sure the fund performs well in a
declining market.
For those interested in doing medium term market timing, the funds of choice are the index funds. The
major index funds are Rydex (www.rydexfunds.com),
Profunds (www.profunds.com) and Potomacfunds.com
(www.potomacfunds.com).
While these companies have a variety of sector funds, for the purposes of a market timer, the most
important funds are those which bear a relationship to a well known benchmark or index. For example,
the Rydex Nova fund correlates directly with the S&P 500 index, so a 1% rise in the S&P500 index
should result in a rise of 1% in the net asset value of the fund. Similarly, the Rydex OTC Fund
correlates with the Nasdaq 100 index, so any rise in that index should result in an equivalent
increase in the value of the OTC Fund. All of these funds provide a neutral Money Market fund which
allows the investor to park his capital in an uncertain market.
But it is the inverse funds which hold out the promise of great gain in a bear market. As an example,
the Arktos fund attempts an inverse correlation with the Nasdaq 100 Index. For every 1% decline in
the Nasdaq 100, a corresponding 1% increase should occur in the fund’s value. The Ursa Fund should
rise by 1% for every 1% drop in the S&P 500. Some also apply leverage, or enhanced beta, to give the
potential for greater returns. For example the Rydex Venture 100 fund attempts to produce a double
inverse of the Nasdaq 100 Index. In theory, if the Nasdaq 100 goes down 1% the Venture 100 fund will
go up by 2%. However in general I do not recommend the use of funds with enhanced betas, not only
because of the psychological effect of the large swings, but also because of a phenomenon called
"beta slippage" which can seriously impair your capital in choppy markets. Investors seeking a more
aggressive approach are better advised to use options to achieve their goals.
There are also funds such as the Gabelli Mathers Fund and the Prudent Bear Fund which invest in a
way which generally does well in a bear market though they do not attempt to inversely correlate with
any benchmark. These should be considered investments for those who believe the market is headed down
in the long term. Investors should be prepared to ride through periods - especially during bear market
rallies - when these funds do not perform particularly well. I do not recommend these funds for market
timing. You may be correct about the direction of the market but find these funds do not cooperate and
move inversely.
Exchange Traded Funds: Simplicity of funds, tradability of stocks.
A convenient way to implement market timing strategies.
An ETF is is essentially a fund of stocks (or more rarely bonds) which is authorized to issue tradable shares to the public. Unlike in a traditional fund where the fund company issues to - and redeems from - investors individually, in an exchange traded fund shares are bought and sold on a stock exchange. In a typical scenario, where the ETF issuer is attempting to closely replicate the price action of a benchmark like the S&P 500, shares of the stocks are held by the fund in proportion similar to the composition and weighting of a given index. When the components of the target index fluctuate in price, those fluctuations will be reflected closely in the overall value of the fund and therefore the individual shares of the ETF as well.
Inverse ETFs are especially useful for bearish investors since they move inversely with major benchmarks. For example, the Short Dow 30 (Ticker: DOG) inverts the Dow Industrials, Short S&P 500 (SH) inverts the S&P 500. UltraShort ETFs use leverage to obtain magnified price action. For example the UltraShort QQQ (QID) theoretically moves 2 times the inverse of the Nasdaq 100. This is certainly easier than shorting stocks, and requires much less capital than would be required to attain the same market representation using individual issues.
For the market timer, ETFs offer an excellent combination of low transaction costs, close correlation with major indices and convenience. They can also be used in conjunction with options to allow strategies such as the covered call. In general we consider them preferable to traditional funds. However their convenience and tradability can sometimes work against the investor as it may be tempting to trade more frequently than is appropriate for a given strategy. Further, the ETFs do not always follow their benchmarks precisely. A strategy which works on the S&P 500 index may not do as well when applied to SPY which is supposed to follow its price action closely. Leveraged inverse funds in particular should not be expected to correlate entirely accurately.
MARKET TIMING IS KEY
In every case except the managed bear funds (like Gabelli Mathers and the Prudent Bear), the investor
should expect to keep an eye on the market and respond to important changes in trend. I believe
Investment Sense is first rate, but that does not mean infallible. I strongly encourage
investors to look at other timing oriented newsletters to get other opinions and to view other
approaches to technical analysis.
I believe it is recognizing the broad trends which is the most important. An investor who was long
in 1991 could have held through all of the minor twists and turns of the market so long as he had the
sense to get out in 2000. Anyone short the market consistently between 2000 and early 2003 would probably
have been fine so long as he recognized the turn in March of that year. Timing the market is not rocket
science, but it does require the objectivity to respect what the indicators are saying and to respond
appropriately, even against the well intentioned advice of friends and family.
Chart 1. Dow Jones Industrial Average 1929-1948 (Back to top)
Chart Courtesy StockCharts.com
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