Since it looks like the market will be handing us lemons for the foreseeable future, perhaps we could parlay this sour state of affairs into some sweet profits. There are many ways to play a bear market. Popular techniques include shorting the indices, buying index put options, and going long the short and ultrashort index ETFs. This last strategy is especially popular in retirement accounts.
We've looked at these strategies before in previous blogs (see 6/18/08 and 7/15/08) and thought it's time to compare them again since the market is much more volatile than it was last summer.
Here are the following strategies that I selected:
- Short the index tracking stocks: QQQQ, SPY, DIA
- Buy their short counterparts: PSQ, SH, DOG
- Buy their ultrashort (2x) counterparts: QID, SDS, DXD
- Buy March 2009 at-the-money (ATM) puts on the above tracking stocks
- Buy 2010 ATM puts on the tracking stocks
- Buy 2011 ATM puts on the tracking stocks
I wanted to look at a recent downturn so I choose the (relative) high peak put in on January 6th of this year and used March 5th closing prices. The table below summarizes the results.
Options still rule
The table reveals several interesting observations. The first is that buying the short ETF did better than shorting the underlying. (I've written before on the dangers of the short and leveraged funds (see 2/10/09 blog) so be aware that they may not perform in the way you think they should.)
The second observation is that instruments based on the S&P 500 and the Dow Industrials generally outperformed those based on the Nasdaq 100 (the Qs). Most likely this is due to the constituent makeup of each index.
The last observation is that short-term options trounced the returns of their LEAP counterparts. Using my handy-dandy Black-Scholes options calculator applet on my Blackberry, I found that the implied volatilities of the short term options are higher than that of the LEAPs, confirming my suspicion.
The effect of volatility
Before you race out and buy short-term puts, you should be aware that volatility is a double-edged sword. If you purchase an option in times of higher volatility, it's very possible that you can lose money if the volatility decreases, even if the market goes in your direction. To illustrate this point, I looked at the 2010 Jan90 put on the SPY. On 11/20/08, the VIX (market volatility index) hit a high of 80. That day, the S&P 500 closed at 752 and the put option at $27.15. Three months later on 2/26/09, the S&P again closed at 752 but the VIX had dropped to 45. What was the put worth? It closed at $22.15, 18% lower! The drop in value is due almost entirely to volatility as time decay is minimal for this LEAP.
Does this mean that you shouldn't take the options plays? Of course not! You can mitigate the volatility effect by using options spreads. A long put can be replaced by a bear-put debit spread where you buy the higher strike put and sell a lower strike put against it. One nice feature of this strategy is that your cost basis is decreased but it comes at the price of capping potential profits.
It's worth noting that not only do options offer you more leverage, but they're cheaper than buying the underlying instrument, giving you an extra bang for your buck. Plus, your risk is limited to the price of the option unlike shorting a stock which has potentially unlimited risk. However, if you've never traded options before I strongly urge you to learn about them and paper trade them first.
I hope this exercise has been instructive. That's the long and the short of it!