Making Money in a Neutral or Down Market

My hat goes off to Janet Yellen who had the wherewithal to take the bull by its horns and start the process of normalizing interest rates in the United States. Along with a myriad of other fundamental factors, the equity markets are approaching more reasonable values. There goes that word ‘fundamental’ which has finally started appearing in the financial chatter. 

For the past eight years, the central bank interest rates and currency manipulations   have initiated and perpetuated nothing short of a meteoric rise in equity prices. These valuation increases were, in large part, not due to increases in earnings, and, most decidedly, not in revenue, but in companies using cheap, almost free, money to buy back stock. Obviously, the smaller the float, the less growth needed to look like a star. However, under the surface, there was nominal, if any, real growth in many industries. 

Ms. Yellen stated, on more than one occasion, that equity valuations were too high. How wonderful to finally have a forthright Federal Reserve Chairman, not afraid to say it like it is and actually initiate aggressive action upon it.  Realizing that a price/earnings ratio 19 or higher last May, when the market was at it’s all time high, was, in the end, going to create an unsustainable bubble, Ms. Yellen and her colleagues, did the unthinkable – raised interest rates by one quarter of one point!
In fact, the 200 plus point gained from the August low to the November high in the SPX index and 700 plus point gain in the NDX index, were proof that the major market participants were using the Feds inability to take decisive action as support for equities. Finally, the Fed, rightfully, no longer wanted to be the enabler of, to revive a phrase, ‘irrational exuberance’. 

Don’t get me wrong, something had to be done to save the economy from slipping into oblivion and back to the 450 SPX of 1995 where it all started, but, by the same token, they could have stopped mid 2013 when the markets were at fair valuation and the debt, that our great great grandchildren will not be able to pay off, was a few trillion dollars lower. 

So here we are as of February 5, 12 percent below the May high in the SPX and 15.5 percent below the November high in the NDX. Where do we go from here? The media says anywhere from 1300-2300! They say we are oversold, but do you ever hear them say we are overbought? Some are actually going out on a limb and starting to talk about valuations still being high. 

The difficulty in using fundamental analysis on a macro level is obtaining viable information. Depending on which site you look at, projections for 2015 SPX  earnings are anywhere from 117-127.  Albeit a significant difference, playable ranges can be easily found, particularly on the upside, where, instead of having to worry about a new round of QE and interest rates cuts, at least for the short run, you can, actually, handicap the upside risk. 

Therefore, since November those nimble options traders who had the guts to say, “Maybe it’s time to take some risk off the table,” have been smiling all the way to the bank. 

You have insurance on your life, your house, your car, and your jewelry. Why don’t investors ever think about insuring their financial assets? You do not have to sell your equity positions in order to participate in a down market. There are two ways to participate in the neutral/down market action. You can either choose to protect your equities or you can aggressively deploy a variety of index option strategies to actually make significant monies in a dead or down market. So at the next party where everyone is moaning over their stock losses and, saying, “Oh, it will come back. It always does.” You can be in the corner smiling because you are either sleeping nights because your portfolio is protected or, trying to hold back a laugh because you are making a killing. 

There are a variety of strategies to use, depending on your liquidity, margin, time you want to devote, and, frankly, mathematical understanding. What strikes you choose to utilize, ultimately, depends on your own calculations and assessment of where, you think, the indexes might be at a given time. However, with, what I refer to as, range trading, you can create a strategy with an extremely favorable risk/reward with a 200 or more point range. 

It’s all about risk/reward. Therefore, one of my favorite strategies in a ‘volatile’ market is an iron condor (IC) or iron butterfly (IB). In November you could have chosen any SPX or NDX strike and put on a 200 point IC for any strike you personally felt was viable for any month of 2016 with a 1/9 risk/reward ratio. In other works, for 1 contract you would have taken in $9000 and risk $1000.  (In some cases even better). That sounds like much better odds to me than the credit spreads that the average option educator recommends where the risk/reward is 4/1 – you take in $1000 and risk $4000. The beauty of these strategies is you can do them without a lot of assets because the risk is only $1000 for 1 contract. Of course, you can multiply that exponentially for as many contracts or variety of strikes you want to do. The best part of these strategies is, if the strikes you initially chose are proving to be wrong, you can adjust the strikes, however, this may increase margin or risk tolerance.

There are other viable strategies to use to play a neutral or down market, including, directional butterflies (flies), directional condors, ratio spreads, debit spreads, my own creations – slides and crippled bulls or bears. Straight old debit spreads are the least risky but do no have an initial cost. These are best to use for protecting individual equities because the put spreads are usually inexpensive when everyone else least wants to use them. 

The particulars on when, why and how to chose your strikes and strategy will be covered in detail in my forthcoming book. More information on the publishing date will be available soon.


Marlene Sackheim

Author of the upcoming book, Making Money in a Neutral or Down Market

Trader Education