But first things first: Don’t panic.
Don’t Expect a Crash – Tops Take Time
There’s no reason to panic. The stuff you see bandied about saying to sell everything because the market is about to crash is nonsense. Markets don’t crash immediately after making a new high. When crashes occur at all in a bear market, they happen at least a couple of months after the peak. For example, in both the 1929 and 1987 crashes, the markets topped out two months before they crashed.
Likewise, the 2008 crash came in late 2008, well after the 2007 market top. There was plenty of time to get out as the 2007 top evolved over the second and third quarters of 2007. Maybe there’s a first time for everything, but my technical work says this isn’t one of them.
Unless you are following a good market timing service like my proprietary Wall Street Examiner Pro Trader, I believe that a systematic selling program is the best approach under current circumstances. Without the guidance of technical analysis, averaging out is the way to go.
Of course bear markets sometimes involve crashes, but most of the time they are a series of ups and downs over many months. The typical bear market lasts from 24 to 30 months. Grinding, rotating losses kill portfolios. Interim rallies keep the public “hooked” into the market, hoping that each rally is the beginning of a new bull. But it’s usually not until the third or fourth of those swings that a new bull market emerges. By then it’s too late.
Some stocks take many years to recover. Others never recover at all. Even without a crash, the typical grinding, long term bear markets have the same effect, especially for those investors who sell after it’s too late. Then they fail to take advantage of those big bullish turns that always come when the Fed starts pumping liquidity into the system. They either don’t want to because they no longer believe, or they have too little cash left to do any material buying.
Don’t be one of those investors. If you have been raising cash, continue to do so. If you haven’t started, there’s no better time than now.
And it’s also a good time to start dipping your toe into the waters of short selling, though it may be too early to buy puts. (Buying options requires pinpoint timing for success, and until the market has really signaled the start of the bearish trend, it will be tough to profit with puts.)
My Quick and Dirty Primer on Short Selling
More than just raising cash to ride out the storm and take advantage of the next buying opportunity, there are ways to surf those downhill waves for fun and profit. If you have been around the markets for a while, you know where I’m going here.
In a bear market, the pros profit by selling short individual stocks, as well as both industry and market ETFs. There are also inverse ETFs and leveraged inverse ETFs, which hold short positions in stocks, that enable market savvy traders to pile up tremendous profits when the market declines. We’ll address those in another report.
The most sophisticated and market savvy traders also buy puts on the market or individual stocks. Puts are essentially a bet that prices will fall below a stated price by a stated date. We’ll also take a look at that strategy in another report.
With short selling, you can do just like the pros and profit from market declines.
But before you do, you must understand the risks. The most important of those risks is timing risk. Your timing must be very, very good indeed, or you will probably suffer losses, even though eventually the market will go your way.
To be profitable, these trades need to go your way virtually immediately. When they do, your profits can quickly pile up to multiples of your initial investment. Increased risk brings increased reward, when you are right about the market’s direction, and when your entry timing is good.
When you place an order to sell short a stock or a market ETF like the SPY, which mimics the S&P 500, you are ordering your broker to sell a stock that the broker holds as collateral in their margin accounts. The broker sells the stock and credits the cash proceeds to you. At the same time, you become obligated to buy back the stock in the future and return it to your broker.
For example, if you sell short 100 shares of the SPY at a price of 250, your broker will sell those shares from its collateral accounts and credit your account for $25,000. You then owe the shares back to the broker at some undefined point in the future. However, there’s theoretically no time limit on a short position. You could hold it forever if the price drops low enough.
Of course, if the SPY drops in price, at some point you will want to buy back the shares you sold and return them to your broker. Let’s say the SPY drops to $200 and you buy the stock back to return it to your broker.
That type of order is called “Buy to Cover” because you are covering your obligation to return the shares. We say that you are “covering” your short.
At the price of $200 in this example, your cost is $20,000. But you originally sold the stock for $25,000. You have made a profit of $5,000. Here’s where the leverage comes in. Your initial required margin on the short sale was just 50%, or $10,000. You have just earned a $5000 profit on a $10,000 cash investment! And it probably only took a few weeks.
Let’s look at another example. Let’s say you again sold the SPY short at $250. Then things really get bad in the market and SPY drops to $150. You buy to cover your short at that price. You pocket a profit of $10,000 on your initial margin of $10,000, a profit of 100%! The price of the SPY has only dropped 40%, but you have made 100%.
That’s how leverage works in your favor on a short sale when the price of the stock or ETF drops.
But if the price rises, you can quickly get into trouble.
I won’t get into the intricacies of margin rules. They are extremely complicated. If you have ever traded on margin you are well aware of that.
Here’s what’s important. You open a short sale with 50% required margin. You must make a cash deposit of half of the total initial value of the short sale. If the price goes up, your cash margin starts to be depleted very quickly.
Then the brokers have what’s called maintenance margin. While the legal maintenance margin is 25%, your broker may require more. Some require as high as 35%. On highly volatile issues or situations they may want even more than that. And they can even increase the margin required in mid-stream. It can be very painful.
If, in our hypothetical trade of selling short the SPY, the SPY rises from $250 to $275, a gain of just 10%, you would have a paper loss of $2500. That would be subtracted from your initial margin of $10,000, leaving you with just $7500. The value of 100 shares of SPY at 275 would be $27,500. $7,500 divided by $25,000 is just 30%. That’s how much equity would remain in your account.
You would then immediately get a margin call from your broker telling you to bring your equity up to 35% of account value (or more than that) within a couple of days. If you don’t deposit more cash, your broker would cover the short and settle the account. You would lose 25% of your initial investment on a 10% rise in the stock!
Back in the when I was a teenager in the 1960s the old heads in the customers’ gallery at Walston and Company were fond of saying, “He who sells what isn’t his’n, and holds it while the price has risen, must buy it back or go to prison!”
Well, it’s not quite that bad, but you can clearly see from this example why you don’t want to have a short position go against you. It doesn’t take much to put you in a position of having to take a forced loss because of what the industry calls a short squeeze. Even professional traders who get caught on the wrong side of a short sale come under immense pressure to either put up more cash, or buy to cover the position. When that happens, and a large scale short squeeze develops, prices can rise for days, pushing the market averages higher, seemingly in a vacuum.
So selling short is a great way to profit in a bear market. But you DO NOT want to be early, even in the tail end of a bull run like now, when short squeezes can levitate prices for no apparent reason. Short covering feeds the rally. Often it may be the only force that’s causing prices to rise.
Here’s How I’d Profit Right Now
I would be willing to short the market via the SPDR S&P 500 ETF (NYSE:SPY) or PowerShares QQQ Trust (NASDAQ:QQQ) from mid-September on, on any rally in the market.
If you have a large portfolio and the will or ability to take speculative risk, I would consider devoting 1-2% of it each month to puts on the SPY. However, I’d buy them after the market had rallied for a week or two. I would look for actively traded puts that are out of but near the money, with about 6-8 weeks until expiration.
This is not for everyone, as these option plays could result in 100% loss of premium. On the other hand they could also result in big gains that would cushion any losses on your long equity holdings. Technical analysis would be essential in this regard. When it comes to market timing, there’s no substitute for the technical charts. If you are interested, I cover that in my Wall Street Examiner Pro Trader market updates and Daily Trades list.