Editor: Tunnerminnerwait
We live in an extraordinary time. We live in a time where just about anybody can make money regardless of what happens. The stock market goes up, you make money. The stock market goes down, you make money. Volatility increases, you make money. Volatility decreases, you make money. Housing goes up, housing goes down, you make money. You get the idea. People are quite familiar with the idea that when something goes up in value, they make money. So it should come as no surprise that you could make lots of money when the stock market fell. Welcome to the wonderful world of shorting and options...
Let me start off with the disclaimer that "shorting" stocks and stock options are not for the novice or the faint of heart. Venture at your own risk!
HOW TO MAKE MONEY IN A FALLING MARKET
Thanks to our modern world the markets have developed enough for almost all markets that there is now enough people to facility a bet on a falling market. A bet that you can profit from. That's right, now thanks to shorting ETFs (Exchange Traded Funds) and options, it's now possible to "easily" (technically, but not actually) make money when prices fall. What are these two mysteries I speak of?
Shorting
Shorting a stock has been called a lot of things over the centuries. Risky (true), foolish (possibly), and unpatriotic (false) to name just a few. The basics of it work like this. You put in an order to short a stock, say IBM. This means that you're betting that the price will fall and you'll make money. How so? Because what you're essentially doing is entering into a trade where you agree to buy that stock at a later time of your choosing (there's no expiration date though). You don't actually own the stock, but you will have to shortly in the future to close out the trade. So you short IBM at say $142 for 100 shares. If IBM goes down to say $130 you can close out your short position by buying it at $130 and thus netting a profit of $1,200 ((142-130)*100)). Conversely if IBM went to say $154 then you would lose $1,200. It's the completely opposite of buying long a stock, where you own part of the company and you're hoping that it increases in value.
In the past two decades there has been an explosion into the ETF market. This enables you to invest in an entire market instead of having to make a bunch of individual trades to accomplish the same thing. With that there has been great variety added for shorting ETFs as well. This enables you short the entire stock market with just one trade. Hugely convenient and potentially more dangerous. Along with this is the ability to trade "leveraged ETFs". This enables you to not only short an entire market, but also to short it by certain factors. So if you do a 2X leveraged ETF it enables you to make twice the amount of money that you normally would. Conversely you could lose twice the amount of money! Here's an example: You bet that the market is going to drop. You buy a shorting ETF and the market drops by 50%. Great you made 50%. If you had done the same thing with a 2X shorting ETF you could have made 100%. If the market goes up instead of down, you lose those same amounts and could be wiped out. See the risk?!
Caveat: A word of warning about these things. They never move exactly how they say they will. Reason being is that they mimic these markets with options and options don't exactly move in tandem with the underlying security. They also warn you that they meant to be owned only for a day versus long periods of time. It's been my experience that as a general rule, you'll only make half of what you theoretically would. So a 2X leverage ETF, IF YOU HOLD FOR A LONG PERIOD OF TIME, will actually only yield you as much as the market moved or 1X. This is largely due to a "decaying" time factor that the underlying options have. More about that below...
Options
How about a less risky way? Stock options have been around for over a century, but they haven't really become mainstream until the last 50 years or less. Other types of options, like agriculture, known as "futures" go back thousands of years. It is what it sounds like. Somebody has the option to buy or sell a stock that will either increase or decrease by some future date. This gives you the "option" to trade the underlying stock at a future date. Depending upon whether it goes up or down depends on what you buy. There's a whole host of tutorials on options via youtube or investopedia.com that can teach you more about them and better than I ever could. They can be complicated but I think it's mostly only due to the verbiage, not the underlying complexity.
Here are some analogies to help you flesh out what an option actually and to demystify how it can help you. I'll relate to simples subject matters like insurance and real estate since most people are more familiar with those products.
Insurance is an option. It's a contract where a profit will be made in the event that a claim is made prior to the contract expiring. If you pay $1,000 for a homeowner's policy and the house burns down. You receive $100,000. You made a profit of $99,000 assuming it happens within the 12 month policy cycle. However, if that does not happen then you lost your premium of $1,000.
There are real estate options as well. What if an investor came to you and said that they would give you $5,000 for the option to buy your house at a certain price within the next 5 years. Sounds pretty good. You get $5,000 now and a guaranteed future sale price if the investor exercises the option. It's good for the investor because s/he now has control of the property and can potentially make a lot of money if there is a real estate boom, but only has to pay $5,000 for that investment.
Hopefully that makes more sense about how options work. And now you can see where they are less risky then betting the whole amount like with shorting ETFs or their underlying stocks. It's more like buying insurance for your portfolio.
YOU CAN'T TIME THE MARKET or can you?
While it may sound easy and enticing to say that you can make money in markets whether the price goes up or goes down, you should know that it's not. It requires market timing which is practically a cliche on Wall St in that you can't do it. I would agree, but I think they also are referring to trying to time the market perfectly and over short periods of time. What I would recommend though is a system of parameters where systematic things happen when those parameters are met.
HANDICAPPING THE STOCK MARKET
History may not repeat itself, but it rhymes.
-Mark Twain
If you work from the assumption that you can't time the market, what are you supposed to do? Well I prefer a system that slowly takes off risk and then adds it back over time. When things become too expensive you move them to less expensive markets or to cash if you can't find anything. As a result this enables you to not only make more money, but also to do it with less risk. A natural and logical progression should look like this...
CASH
As markets become expensive you move your investments to cash if you can't find anything else. As a result, you'll eventually become very cash rich in that a large chunk of your holdings are now in cash, not other investments.
SHORT
The next step is to slowly move that cash into either shorting ETFs or options, both discusses above. This will enable you to profit from the upcoming market crash. A NOTE OF WARNING: YOU BETTER BE DAMN SURE THAT THE MARKET IS EXTREMELY OVERPRICED AND THAT THERE IS A RECESSION/CRASH COMING SOON. This is not for the faint of heart.
LONG
Once the impending crash has coming and things start to look cheap again, then you can start to look at going long. "Going Long" simply means owning stocks and mutual funds where you profit when it rises. This is how people generally associate buying in the stock market.
With luck you can potentially triple your investment over the span of a decade or less depending upon whether it's a fast crash or a slow one.
THE COMING RECESSION
Be fearful when others are greedy and greedy when others are fearful.
-Warren Buffett
The next step is to short the market. Are we there yet? I don't think so. We're moving into cash and that's good, that means that we can't really find anything else to buy. Pretty much everywhere you look things are expensive. Real estate, bonds, and stocks are all expensive, even in foreign countries now. There are a few pockets of value from the singapore exchange to options, but for the most part, due to low interest rates, it's all expensive. Cash is cheap and lending is increasing. For instance, borrowing on margin to invest in the stock market is at an all time high. Not a good sign.
WHAT AM I GOING TO DO?
This cycle is going to have 4 trades.
1. Sell and move to cash. As securities become more expensive, I will be selling them and moving to cash. For the most part all I currently have are some foreign ETFs and some small positions in financials securities, which I think have lagged the overall market ever since the recover 8 years ago. When these become overvalued, that will most likely be the final straw to break the camels back.
2. Buy leveraged short ETFs in the USA stock market. Ultra short ETF for the broad USA market like SDS should give me a 100% profit if the timing is right. Even though this is leveraged by 2x the underlying securities are options and they rarely get priced perfectly with the market they're supposed to track.
3. Sell the leveraged ETFs and move into cash. This is simply closing out the position above (#2).
4. Buy long ETFs in the USA and foreign stock markets. I could possibly buy leveraged ones as well and double the profit, but that's a sort of decision that will have to be made in the midst of the panic. I have a feeling that this recovery will not be like the last. Instead we could see very little appreciation for over a decade and then another boom. This would be something more akin to the market of the mid 70's to early 80's. Inflation, with little job growth, and little GDP growth. They called it stagflation.
WHEN AM I GOING TO DO IT?
Beats the hell out of me! I'm suspecting that this will start before the end of the decade. I could be off by years though. Above I talked about handicapping the stock market. This is the transition from stocks to cash to stocks to cash based upon certain criteria that would make it more likely (but not completely by any stretch of the imagination) for an investor to be right. What is that criteria?
1. Market valuation. I like looking at the total market to gdp ratio along with the Shiller PE or CAPE. Both are currently at dangerously high levels. There's only time they've been one time when the market has been more overvalued then it is right now and that was the dotcom bubble of 2000. It wouldn't surprise me if we surpassed that this time. We only have 8.7% to go in order to do that. Scary!
2. Inverted Yield Curve. Shorting the stock market is risky business. You better be damn sure that you're right! How do I help compensate for this? Bull markets almost always begin their crash when recessions start to show their face. A great indicator of when a recession is going to come is when you have an inverted yield curve? WTF is an inverted yield curve? The natural and healthy progression of interest rates is when long term rates (think 30 year mortgages) are at a higher rate than short term loans (think borrowing money for a few months). The spread between these is generally substantial enough for banks to borrow short term money and loan it long term to home buyers. They borrow short and lend long. Everybody is happy. But what happens when savers can make more money on short term treasury bills than they can on long term mortgages? They don't loan out the money. As a result the economy comes to a halt and you have a recession. CRASH! The acts as a great catalyst for reversing a booming stock market.
3. Stock market volatility. The USA volatility index (VIX) is currently at an all time low. This means people for the most part are complacent and don't see anything significant about to happen.
So where do we stand with all of these?
1. Market is significantly over valued: check
2. Yield curve is not inverted: most likely will take a few years.
3. VIX is at an all time low: can change very quickly.
I don't have a problem with moving to cash in the mean time. But in order for me to short the stock market the yield curve will have to become flat to inverted and the VIX will have to increase significantly. That's why I don't think a crash is eminent, but will eventually happen if the proper conditions are met.
*On a side note. There is another intangible component to the market and that is greed. I don't sense greed yet. It's one of those things that you just have to sort of sense or feel. What does it feel like? It feels like Bitcoin. That's a prime example of a bubble market with greed built into it. When people constantly talk about prices for the sake of prices, it's a clear sign of greed and that they've lost all perspective on the underlying fundamentals. There's also a general feeling of it's not going to happen because "it's different this time."
WITH THAT SAID, NONE OF THIS MEANS SHIT IF WE HAVE A WAR!
HOW TO MAKE MONEY IN A FALLING MARKET
Thanks to our modern world the markets have developed enough for almost all markets that there is now enough people to facility a bet on a falling market. A bet that you can profit from. That's right, now thanks to shorting ETFs (Exchange Traded Funds) and options, it's now possible to "easily" (technically, but not actually) make money when prices fall. What are these two mysteries I speak of?
Shorting
Shorting a stock has been called a lot of things over the centuries. Risky (true), foolish (possibly), and unpatriotic (false) to name just a few. The basics of it work like this. You put in an order to short a stock, say IBM. This means that you're betting that the price will fall and you'll make money. How so? Because what you're essentially doing is entering into a trade where you agree to buy that stock at a later time of your choosing (there's no expiration date though). You don't actually own the stock, but you will have to shortly in the future to close out the trade. So you short IBM at say $142 for 100 shares. If IBM goes down to say $130 you can close out your short position by buying it at $130 and thus netting a profit of $1,200 ((142-130)*100)). Conversely if IBM went to say $154 then you would lose $1,200. It's the completely opposite of buying long a stock, where you own part of the company and you're hoping that it increases in value.
In the past two decades there has been an explosion into the ETF market. This enables you to invest in an entire market instead of having to make a bunch of individual trades to accomplish the same thing. With that there has been great variety added for shorting ETFs as well. This enables you short the entire stock market with just one trade. Hugely convenient and potentially more dangerous. Along with this is the ability to trade "leveraged ETFs". This enables you to not only short an entire market, but also to short it by certain factors. So if you do a 2X leveraged ETF it enables you to make twice the amount of money that you normally would. Conversely you could lose twice the amount of money! Here's an example: You bet that the market is going to drop. You buy a shorting ETF and the market drops by 50%. Great you made 50%. If you had done the same thing with a 2X shorting ETF you could have made 100%. If the market goes up instead of down, you lose those same amounts and could be wiped out. See the risk?!
Caveat: A word of warning about these things. They never move exactly how they say they will. Reason being is that they mimic these markets with options and options don't exactly move in tandem with the underlying security. They also warn you that they meant to be owned only for a day versus long periods of time. It's been my experience that as a general rule, you'll only make half of what you theoretically would. So a 2X leverage ETF, IF YOU HOLD FOR A LONG PERIOD OF TIME, will actually only yield you as much as the market moved or 1X. This is largely due to a "decaying" time factor that the underlying options have. More about that below...
Options
How about a less risky way? Stock options have been around for over a century, but they haven't really become mainstream until the last 50 years or less. Other types of options, like agriculture, known as "futures" go back thousands of years. It is what it sounds like. Somebody has the option to buy or sell a stock that will either increase or decrease by some future date. This gives you the "option" to trade the underlying stock at a future date. Depending upon whether it goes up or down depends on what you buy. There's a whole host of tutorials on options via youtube or investopedia.com that can teach you more about them and better than I ever could. They can be complicated but I think it's mostly only due to the verbiage, not the underlying complexity.
Here are some analogies to help you flesh out what an option actually and to demystify how it can help you. I'll relate to simples subject matters like insurance and real estate since most people are more familiar with those products.
Insurance is an option. It's a contract where a profit will be made in the event that a claim is made prior to the contract expiring. If you pay $1,000 for a homeowner's policy and the house burns down. You receive $100,000. You made a profit of $99,000 assuming it happens within the 12 month policy cycle. However, if that does not happen then you lost your premium of $1,000.
There are real estate options as well. What if an investor came to you and said that they would give you $5,000 for the option to buy your house at a certain price within the next 5 years. Sounds pretty good. You get $5,000 now and a guaranteed future sale price if the investor exercises the option. It's good for the investor because s/he now has control of the property and can potentially make a lot of money if there is a real estate boom, but only has to pay $5,000 for that investment.
Hopefully that makes more sense about how options work. And now you can see where they are less risky then betting the whole amount like with shorting ETFs or their underlying stocks. It's more like buying insurance for your portfolio.
YOU CAN'T TIME THE MARKET or can you?
While it may sound easy and enticing to say that you can make money in markets whether the price goes up or goes down, you should know that it's not. It requires market timing which is practically a cliche on Wall St in that you can't do it. I would agree, but I think they also are referring to trying to time the market perfectly and over short periods of time. What I would recommend though is a system of parameters where systematic things happen when those parameters are met.
HANDICAPPING THE STOCK MARKET
History may not repeat itself, but it rhymes.
-Mark Twain
If you work from the assumption that you can't time the market, what are you supposed to do? Well I prefer a system that slowly takes off risk and then adds it back over time. When things become too expensive you move them to less expensive markets or to cash if you can't find anything. As a result this enables you to not only make more money, but also to do it with less risk. A natural and logical progression should look like this...
CASH
As markets become expensive you move your investments to cash if you can't find anything else. As a result, you'll eventually become very cash rich in that a large chunk of your holdings are now in cash, not other investments.
SHORT
The next step is to slowly move that cash into either shorting ETFs or options, both discusses above. This will enable you to profit from the upcoming market crash. A NOTE OF WARNING: YOU BETTER BE DAMN SURE THAT THE MARKET IS EXTREMELY OVERPRICED AND THAT THERE IS A RECESSION/CRASH COMING SOON. This is not for the faint of heart.
LONG
Once the impending crash has coming and things start to look cheap again, then you can start to look at going long. "Going Long" simply means owning stocks and mutual funds where you profit when it rises. This is how people generally associate buying in the stock market.
With luck you can potentially triple your investment over the span of a decade or less depending upon whether it's a fast crash or a slow one.
THE COMING RECESSION
Be fearful when others are greedy and greedy when others are fearful.
-Warren Buffett
The next step is to short the market. Are we there yet? I don't think so. We're moving into cash and that's good, that means that we can't really find anything else to buy. Pretty much everywhere you look things are expensive. Real estate, bonds, and stocks are all expensive, even in foreign countries now. There are a few pockets of value from the singapore exchange to options, but for the most part, due to low interest rates, it's all expensive. Cash is cheap and lending is increasing. For instance, borrowing on margin to invest in the stock market is at an all time high. Not a good sign.
WHAT AM I GOING TO DO?
This cycle is going to have 4 trades.
1. Sell and move to cash. As securities become more expensive, I will be selling them and moving to cash. For the most part all I currently have are some foreign ETFs and some small positions in financials securities, which I think have lagged the overall market ever since the recover 8 years ago. When these become overvalued, that will most likely be the final straw to break the camels back.
2. Buy leveraged short ETFs in the USA stock market. Ultra short ETF for the broad USA market like SDS should give me a 100% profit if the timing is right. Even though this is leveraged by 2x the underlying securities are options and they rarely get priced perfectly with the market they're supposed to track.
3. Sell the leveraged ETFs and move into cash. This is simply closing out the position above (#2).
4. Buy long ETFs in the USA and foreign stock markets. I could possibly buy leveraged ones as well and double the profit, but that's a sort of decision that will have to be made in the midst of the panic. I have a feeling that this recovery will not be like the last. Instead we could see very little appreciation for over a decade and then another boom. This would be something more akin to the market of the mid 70's to early 80's. Inflation, with little job growth, and little GDP growth. They called it stagflation.
WHEN AM I GOING TO DO IT?
Beats the hell out of me! I'm suspecting that this will start before the end of the decade. I could be off by years though. Above I talked about handicapping the stock market. This is the transition from stocks to cash to stocks to cash based upon certain criteria that would make it more likely (but not completely by any stretch of the imagination) for an investor to be right. What is that criteria?
1. Market valuation. I like looking at the total market to gdp ratio along with the Shiller PE or CAPE. Both are currently at dangerously high levels. There's only time they've been one time when the market has been more overvalued then it is right now and that was the dotcom bubble of 2000. It wouldn't surprise me if we surpassed that this time. We only have 8.7% to go in order to do that. Scary!
2. Inverted Yield Curve. Shorting the stock market is risky business. You better be damn sure that you're right! How do I help compensate for this? Bull markets almost always begin their crash when recessions start to show their face. A great indicator of when a recession is going to come is when you have an inverted yield curve? WTF is an inverted yield curve? The natural and healthy progression of interest rates is when long term rates (think 30 year mortgages) are at a higher rate than short term loans (think borrowing money for a few months). The spread between these is generally substantial enough for banks to borrow short term money and loan it long term to home buyers. They borrow short and lend long. Everybody is happy. But what happens when savers can make more money on short term treasury bills than they can on long term mortgages? They don't loan out the money. As a result the economy comes to a halt and you have a recession. CRASH! The acts as a great catalyst for reversing a booming stock market.
3. Stock market volatility. The USA volatility index (VIX) is currently at an all time low. This means people for the most part are complacent and don't see anything significant about to happen.
So where do we stand with all of these?
1. Market is significantly over valued: check
2. Yield curve is not inverted: most likely will take a few years.
3. VIX is at an all time low: can change very quickly.
I don't have a problem with moving to cash in the mean time. But in order for me to short the stock market the yield curve will have to become flat to inverted and the VIX will have to increase significantly. That's why I don't think a crash is eminent, but will eventually happen if the proper conditions are met.
*On a side note. There is another intangible component to the market and that is greed. I don't sense greed yet. It's one of those things that you just have to sort of sense or feel. What does it feel like? It feels like Bitcoin. That's a prime example of a bubble market with greed built into it. When people constantly talk about prices for the sake of prices, it's a clear sign of greed and that they've lost all perspective on the underlying fundamentals. There's also a general feeling of it's not going to happen because "it's different this time."
WITH THAT SAID, NONE OF THIS MEANS SHIT IF WE HAVE A WAR!
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