Two Profitable Ways To Play Stock Market Uncertainty
Tuesday, June 2, 2009
by Karim Rahemtulla, Investment Director, Smart Profits Report
Dear Smart Profits Report Reader,
What do you do with your portfolio positions when the stock market moves strongly in one direction?
I ask because moves like this trigger a spike in volatility because the risk of reversal increases. In turn, this throws up a conundrum for many investors - and hamstrings them from making the correct decision.
For example, after a strong move higher, it’s wise to lighten up on a few positions in advance of a pullback, especially the non-core positions. But invariably, the market continues to rise. Similarly, you may use a fall as a chance to buy some undervalued stocks at a discount. But what if the market keeps heading south?
It’s at this point that panic can set in.
Did I sell/buy too soon? Did I sell/buy too much? Stock market uncertainty can cause some serious stress. So how do you bet both for and against the market - specifically on individual shares - in order to alleviate some of the anxiety of being out of the market completely?
The answer is below…
Exposure To An Entire Market Through One Simple Investment
There are several vehicles that allow you to bet on the market’s direction.
Take ETFs (exchange-traded funds), for example. One of the fastest-growing areas of the market in recent years, these funds allow you to participate in a sector, industry, currency, country, etc. because they hold a specific basket of stocks that represent them.
In the financial sector, this includes the Direxion Daily Financial Bull 3X Shares (NYSE: FAS) and the Direxion Daily Financial Bear 3X Shares (NYSE: FAZ). These funds allow you to participate in the direction of financial stocks to the tune of three times the move of the underlying shares.
So if a normal financial ETF were to move by 2% in one day, FAS or FAZ would move by 6%. But here’s the rub: This is for day-traders only. If these ETFs really were triple up and triple down, you could buy 1,000 share of each and retire, since one would eventually go to close to zero, while the other would soar in value. Each ETF is reset every morning and the gains or losses are dependent on the trading action for that day.
There is a better way…
Unsure Of A Stock’s Direction? “Straddle” It…
Since practically no one can predict the market’s direction with 100% accuracy all the time, it makes sense to employ a strategy that allows you to hedge against the uncertainty.
You can do that through an options “straddle” play.
A straddle is when you make a bet on both the market’s potential upside and downside. The goal is for one side of the trade to move substantially higher, offsetting the losses from the other side of the trade.
For example, let’s say you’re looking at a way to play US Bancorp (NYSE: USB). The stock’s 52-week high is $42, while the 52-week low is $8, and the current price is around $19. So for the sake of this example, let’s use the $20 option.
The Upside Scenario:
- The January 2010 $20 call option is trading for $3.
- The January 2010 $20 put option is trading for $4.
- If USB hits $30, you’d make a $7 net profit on the trade.
- That’s because the put option would be $1, meaning you’d lose $3 on it. But the call option would rise to about $7, meaning you’d make $4 profit on it and offset the loss on the put.
If USB were to reach its 52-week high, you’d lose your premium on the $4 put option premium… but make $19 on your call option ($22 minus $3 = $19).
The Downside Scenario:
If USB moves to the downside, the equation is the opposite.
- If USB moves to $10, the put option would be worth $10 ($20 strike minus $10 price) and your net profit would be $6 ($10 current value minus $4 invested).
- The call option would be worth $3 at most, so the $6 would more than offset the loss.
A straddle is best used when you are unsure which direction the stock/market will move… but you know that whether it’s up or down, it will be a strong move when it happens.
Next week, I’ll tackle the Strangle trade.
Karim Rahemtulla
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