Lemons to Lemonade: How to profit from the next downturn

Well folks, the volatility index, the VIX, finally broke through major resistance at 70 today. Most of the major market indices followed in the opposite direction by breaking through major support levels. The most notable hold-outs were the Dow Industrials, the NYSE Composite, and the Dow Transports. This last one could be a glimmer of sunshine in an otherwise stormy sky because the Transport Index typically (but not always) is a leading indicator of market direction.

I began pulling together today’s blog before the big rally hit just before the close. Although the VIX closed below 70, I do believe that we’re not out of the woods just yet. For those of you who are firmly attached to your rose-colored glasses, hope and pray these support levels will hold. For those of you who feel that the credit crisis has yet to play out completely, you may want to put on some short-term bearish positions. Here are some ideas…

The VIX and what it’s signaling
The chart of the VIX shows major resistance at 70 which it just broke today. I’ve said it before and I’ll say it again, but I think it could well go to 100. Well, at least 80 which is the next level of resistance.

My prediction is that the market will be heading down at least in the short term. So, assuming one has a few shekels left to trade with, how can we profit from this?

Profiting from a continuing bear market
There’s many ways to profit from a continuation in the bear market. I’ve touched on some of these schemes in earlier blogs while one will be new. Before we go into them, we need to look find which markets have the greatest downside potential.

Index dogs
Technically, the Russell 2000 (RUT.X) and the Nasdaq composite (NASDAQ.X) are the worst of breed followed by the S&P Midcap 400 (MID.X), the Russell 1000 (RUI.X) and the S&P 500 (SPX.X) Let’s take a look at potential ways to play them.

Buy index put options. It could take the VIX several weeks (or longer) to reach its maximum value, so you’ll need to buy at least the January puts. But because of the accelerating time decay, I’d advise buying short-term options. In fact, my June 18th blog showed that the most profitable option plays were the January 2010 LEAPs. (A LEAP is an acronym for a long-term option.)

Buy put options on the corresponding index ETFs. The options will probably be cheaper but check on liquidity and bid/ask spreads. And don’t trade options if you don’t know anything about them. Here are the index ETFs:

IWM: Russell 2000. Liquid stock and options.
ONEQ: Nasdaq composite. This tracking stock isn’t nearly as liquid as…
QQQQ: Nasdaq 100 tracking stock. Highly liquid stock and options.
IWB: Russell 1000. Liquid stock; thinly traded options.
SPY: S&P 500. Liquid stock and options.
UVM: Ultralong Russell 2000. (2x the Russell 2000). Liquid stock; fairly liquid options.
UVG: Ultralong Russell 1000. Stock thinly traded. No options.
BGU: A new family of funds that are 3 times the Russell 1000 index. (Ultralong and ultrashort funds are 2x.) Since this is a brand new fund, the options are highly illiquid and I would avoid them. (See the short version, the BGZ, below.)

Short the index ETF. Instead of buying puts, short the tracking stock. Don’t forget to set your stop-losses!

Go long the short/ultrashort ETF and/or buy calls. Here are the short and ultrashort equivalents.
RWM: Short Russell 2000. No options.
TWM: Ultrashort Russell 2000. Liquid stock; fairly liquid options.
PSQ: Short QQQQ. No options.
QID: Ultrashort QQQQ. Fairly liquid options.
SFK: Russell 1000 Growth. Thinly traded stock; no options.
SJF: Russell 1000 Value. Thinly traded stock; no options.
SH: Short S&P 500. Thinly traded options.
SDS: Ultrashort S&P 500. Liquid stock and options.
BGZ: 3x short the Russell 1000. Liquid stock; very thinly traded options.

Note: All of the above strategies were summarized on a performance basis in the June 18th blog ETF or Options?

Another strategy
If you’re more comfortable playing individual stocks, try going into the index and finding which stocks have been the worst performers. No, this doesn’t mean you have to go through every stock in the Russell 2000, but looking at the top 20 or so will be enough. (Click on this link for Morningstar’s list of the top 25 holdings in the Russell 2000.)

The Morningstar list gives the year-to-date returns for each holding, and I’d focus on the ones that are the biggest losers. Look at the fundamentals of the company and how they are performing relative to their sectors. Look, too, at the relative performance of the entire sector. Is it still in a downtrend? Has it broken major support?

Now apply the same criteria to the stock and if you have a real dog, then by all means short it or use a bearish options strategy.

When to exit
Exiting short positions is one of the holy grails of investing. Everybody has their own opinion and I’ll toss in mine. Exit your short positions when the VIX has reached at least the 80 mark and shows a large topping tail. That’s your cue to get out. If you’re really adventurous, you could then start entering long positions.

If the VIX heads back over 70 tomorrow, I’ll try to identify the worst of breed stocks on the above indices.

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