Sponsored Link:

Bear Market Investing

The Smart Profits Report: Issue #449
Tuesday, August 21, 2007

Bear Market Investing: Don’t Get Burned By Bears… Here’s Your Five Point Plan
By Marc Lichtenfeld
Senior Analyst, Mt. Vernon Research

See, this is what happens when you put beers and bears together… I can’t think of many worse ways to pass away than by getting eaten by two bears. But that’s what just happened to a Serbian fellow at the Belgrade Zoo during its annual beer festival.

No doubt a little ticked off at having their space invaded by a bunch of drunken revelers anyway, the bears were probably more annoyed when the guy decided to say hello in person by leaping into their enclosure. So they ate him. “There’s a good chance he was drunk or drugged. Only an idiot would jump into the bear cage,” said zoo director Vuk Bojovic. Gee, you think? Talk about understatements!

Right now, investors are worried about the bears currently prowling around Wall Street. And while they won’t eat you, there’s a decent chance bear market investing might take your money. Find out how you can protect yourself with today’s five-point “Bear Plan.”

Rampant Fear + Wild Volatility = Fed Action

Last week’s market action certainly showcased the level of fear in the market at the moment. The wild Dow Industrials index plummeted nearly 400 points in one day before rebounding.

It seems market opinions are all over the place. Some say the intense selling and volume of last week points toward capitulation, while others claim the selloff was just the beginning.

Either way, volatility is rampant, as evidenced by the CBOE Volatility Index. Having traded around 23 at the start of August, it rocketed up to a 52-week high of 37.50 last Thursday. To refresh your memory, when the VIX is that high, it means fear is pretty intense.

But all it took for that fear to subside a little was a 0.5% rate cut from the Federal Reserve last Friday morning. A cut to the discount rate, that is - the rate at which it lends to banks.

I’m not usually a glass half-empty type of person, but when the Fed takes such drastic measures to prop up the markets, I can’t help but sit up and take notice. I suspect Fed chairman Ben Bernanke and his fellow bankers did not make the decision without a great deal of thought.

So what does it mean for us?

Bear Market Investing: Your Five-Point Bear Plan

Whether the next bear market is about to start now or later, it always pays to have weapons in your arsenal that can combat market downside, as well as upside. So here are some ways you can profit during a bear market.

  • Sell Short: This is when you sell a stock before you own it and buy it back at a later date. The premise is that you expect to sell high and buy low, in that order. But you need to borrow shares first in order to be able to sell them. And of course, the risk is that a stock can go infinitely higher. Your broker must also approve you before you can sell short.
  • Buy Put Options: You can buy put options on a stock or index that you expect to decline. This gives you the right to sell the asset to the seller of the option at a specific price in a pre-specified time. To do so, you must buy a certain number of options contracts - with 100 underlying shares equivalent to one contract. For example, if you think that Schlumberger (NYSE: SLB) is going to decline, you can buy the November $85 puts. This gives you the right to sell the stock at $85 anytime before the third Friday in November (options expire on the third Saturday of each month but transactions need to be completed by Friday), no matter where the stock is trading. If the stock heads lower, your put options should increase in value. Conversely, if the stock is trading above $85, your put expires worthless.
  • Sell Call Options: If you own shares that you don’t want to sell, but think the price may fall, you can sell call options against them. This gives the buyer the right to “call away” your shares at a specific price. Let’s say you own shares of Washington Mutual (NYSE: WM). You can sell the January $40 calls for $2.50, meaning the buyer has the right to buy your shares for $40 at any time before the third Friday in January. No matter if WM is trading at $50 at that time, you’ll still be forced to sell at $40. However, if the stock is below $40, the option expires worthless and you keep the $2.50. Your account must be approved to trade options if you want to do this.
  • Bear Mutual Funds: There are several mutual funds that seek to profit when markets go down. They include the Prudent Bear Fund (BEARX), Bear ProFund (BRPIX) and Ursa Fund (RYURX). Be sure to read their prospectuses and holdings carefully before you take a position. You’ll also be required to invest a minimum amount up front and pay annual maintenance fees.
  • Bear ETFs: If you don’t want to short stocks or indexes, don’t have approval to trade options, or don’t want to pay the higher fees associated with funds, you can buy ETFs (Exchange-Traded Funds) that short various indexes instead. For example, the Short QQQ Proshares (AMEX: PSQ) seeks returns that correspond to the inverse of the Nasdaq 100. In other words, if the Nasdaq 100 declines 10%, PSQ should be up roughly 10%. There are also various bear ETFs, including sector specific and leveraged funds such as the Ultrashort Oil & Gas Proshares (AMEX: DUG). This fund seeks returns that equal twice the inverse performance of the Dow Jones Oil and Gas Index.

(Please note: The companies/funds mentioned above are not actual recommendations, just examples).

Make sure you research all these investment vehicles thoroughly before using them, since most aren’t as conventional as buying and holding stocks or most mutual funds. However, they can provide valuable downside protection for your portfolio - and actually help you make money while others are losing it.

Hoping your longs go up and your shorts go down,

Marc Lichtenfeld

Sign Up for The Smart Profits e-Report!

Today’s Smart Profit Action Center

  • Is Big Ben baffled? According to Senate Banking Committee Chairman Christopher Dodd, Fed chief Ben Bernanke is a bit miffed that his 0.5% cut in the discount rate last Friday hasn’t had more impact on Wall Street. In response to Dodd’s comments, plus an assertion that policymakers will do whatever it takes to bring more stability back to the markets (perhaps implying that a cut in the broader federal funds interest rate could be on tap), stocks headed higher during the morning session today.
  • But the afternoon session proved a little more sluggish once Fed President Jeffrey Lacker essentially reminded investors that it’s not the Fed’s job to dictate market activity and that it won’t base its monetary policy on market fluctuations. Right now, with the market seemingly split between those who want the Fed to do more to help investors and the economy by cutting interest rates and those who believe Fed intervention isn’t the correct way to solve the problems, expect continued volatility.

Related Articles:

Smart Profits Report Archives

Sphere: Related Content

Written by admin · Filed Under 2007 

Comments

One Response to “Bear Market Investing”

  1. 5 Ways to Beat the Bear on November 3rd, 2008 10:46 am

    [...] Let me take you back to my colleague Marc Lichtenfeld’s “Five-Point Bear Plan” that he published here back in August 2007. What was true then is even truer [...]