Saturday, August 14, 2010

The double dip

The euphoria has ended and there is now a convincing talk about the double dip. The question is, do you buy into the hype or do you hold on?

Most times I have observed that one is willing to hold on early in downturn. The confidence from the previous uptick generally gives the investor a false sense of confidence and he or she rationalizes the portfolio and its holdings. But as in a bear market, once the downturn becomes sustained and the pain becomes unbearable, the confidence erodes and everyone starts bailing out.

We are at the cusp of something similar here. The road ahead is dark and there is little clarity on what is going to happen next. There is a lot of merit in not riding the market all the way down and bailing out now if you are convinced that the market is going down. But what if it doesn't and what this is a head fake. If you get out of your positions and the market turns after that, you would be left looking like a fool.

As in every downturn, if you ride the market all the way down, even if the market recovers, there is a lost opportunity cost of the money that is already in the portfolio that has lost value and is simply recovering losses in the uptick. What we need is a way to make money on the downturn to compensate for that opportunity cost. Since I do not want to give up my holdings yet, enter options trading.

Though this might be a little late given the sentiment in the market has already turned, PUTs on S&P might be the thing to invest in for the next 3-6 months. The question is the strike price and the time frame.

Depending on your threshold for pain, October puts 100$ puts is currently trading at over 2$. If you are convinced that the market is trending down for a double dip, 2.23$ might not be a bad insurance premium to pay.

For a 10,000$ portfolio, if you were to buy 1 SPY PUT option you are covered for a value of 10,000$ at 100$ strike for a cost of 200$. Assuming the market doesn't tank, you lose 200$ but if it tanks like it did for a recession, it would happen in the next 3 months, and we will look at a 20% correction taking SPY to 90$. That is loss of 2000$ in the portfolio that you are holding but a recovery of 1000$ through your options for a cost of 200$ for a net recovery of 800$. So your percentage loss on the portfolio is 10%

That was best case scenario for this investment idea, all the normal disclaimers for the worst case still apply :-)

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