Where To Play From The Short Side.

Apr. 08, 2012 9:52 PM ET
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Contributor Since 2013

John Thomas is a 50-year veteran of the financial markets. He spent 10 years as a financial journalist, ten more years trading for a major investment bank, and another decade running the first dedicated international hedge funds. Seeing the incredible inefficiencies and severe mispricing offered by the popping of multiple bubbles during the Great Crash of 2008, and missing the adrenaline of the marketplace, he returned to active hedge fund management.

With The Diary of a Mad Hedge Fund Trader, his goal is to broaden public understanding of the techniques and strategies employed by the most successful hedge funds so that they may more profitably manage their own money.

He publishes a daily research newsletter, and offers one of the most successful trade mentoring services in the industry. He currently has followers in 134 countries.

In his free time, John Thomas climbs mountains, does long distance backpacks, practices karate, performs aerobatics in antique aircraft, collects vintages wines, reads the Japanese classics, and engages in a wide variety of public service and philanthropic activities.

His career has taken him up to 20,000 feet on Mount Everest, to the edge of space at 90,000 feet in the Cockpit of a MIG-25, and to the depths of a sunken Japanese fleet in the Truk Lagoon.

Why they call him "Mad" he will never understand.

This time I am going to start with the fundamental argument first, then follow up with the Trade Alert.

We are getting perilously close to a substantial pull back in global risk assets. While this has already started in commodities, the ags, oil, copper, and precious metals, we have yet to see the whites of their eyes in equities. I believe at these levels stocks are the planet's most overvalued assets, at least on a short term trading basis. So I have begun more aggressively searching for plays that would benefit from substantial moves southward.

My personal preference is to gain downside exposure on small capitalization stocks. You can achieve this through buying put options on the Russell 2000 iShares ETF (IWM).

You have several things going for you in falling markets with this ETF. Small stocks are illiquid and therefore suffer the biggest pullback during market corrections. If Heaven forbid, double dip fears return this summer, small caps will fall the farthest and the fastest. They are most dependent on outside financing which rapidly dries up during times of economic distress.

You can see this clearly during last year's summer swoon. The last time we thought the world was going to end, the (SPX) fell by 20% while the (IWM) plunged by 29.5%. This means that small cap stocks are likely to deliver 150% of the downside compared to big cap stocks. Making money then with shorts in the (IWM) was like shooting fish in a barrel.

You see this on the upside as well. Since the October, 2011 lows, the (SPX) leapt by 30% compared to a much more virile 38% move by (IWM). The (IWM) really does present the scenario where the smaller (or higher) they are, the harder they fall.

If you go into the options market you get this extra volatility at a discount. June at-the-money puts for the (SPY) carry an implied volatility of 15%, compared to 20% for the (IWM) puts. That means you get 50% more anticipated movement in the index for a premium of only 33%.

For those who wish to avoid options, you can buy the inverse ETF on the sector, the (RWM). But the liquidity for this instrument is a mere shadow of its upside cousin, the (IWM). You are better off shorting the (IWM) than buying the (RWM).

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