Most people would say that the most important word in 2008 was either “change” or “hope." But when it comes to the financial markets, that would be incorrect (although it has not been uncommon to hear an investor say “I hope I have some change left by the end of the day”). For there is one thing that the financial markets in general, and the stock market in particular, hates more than anything else. And that one thing is “uncertainty.”  And “uncertainty” has been the most important word for investors in 2008.

We have all seen the market rally in response to good news. Perversely, we have also seen the market rally in the face of bad news. Think of a higher unemployment or inflation number – which is essentially “bad” – but that is lower than expectations, which the market in turn perceives as “good” (proving once again that anyone who thinks psychology is not a big part of trading ought to have his head examined). What the market cannot tolerate is uncertainty, i.e., when there is simply no way to gauge how a given influencer of stock prices will play out. And never before in any of our lifetimes has the market seen so much uncertainty in the course of a year as it has seen, and continues to see, in 2008.

Uncertainty Gone Wild

For starters, there were the presidential primaries, then the campaign for the general election, then the election, all accompanied by the mortgage crisis and the credit crisis and the banking crisis (I can’t tell anymore if that is one thing or three – eek, more uncertainty - so I am now listing them separately). Then there was the soaring acsent of commodity prices – with most fixated on crude oil - which we were told repeatedly was a sign that our economy was going to shut down. Then commodity prices collapsed and plunged, which we are now told is a sign that – you guessed it – our economy is going to shut down. Then we had a stimulus package and massive government bailouts – which have had all of the calming effect of Kevin Bacon in Animal House imploring the raging mobs that “all is well!” 

Now with the election out of the way we are told that the president-elect will flex his worldwide popularity to get the country once again moving “in the right direction.”  However, all indications point to it moving “in the left direction.”  Now I don’t know nor care much about politics (in fact, I hate politics almost as much as I hate politicians), but I think I can sum things up in four simple words: socialism is bad for capitalism. So with the government already bailing out some new entity or industry on a seemingly daily basis, one starts to get the sense that the concept of “free enterprise” may be slipping from our grasp. Likewise, during the early primaries we kept hearing a lot about “two Americas,” which I assumed meant the “haves” and the “have nots.”  This situation has since been clarified a bit. As it turns out there is the half that actually pays taxes and the other half that does not. And inexplicably it appears somehow that the half that are paying taxes are apparently the “bad guys” because they are not yet “paying their fair share” and are being told that they need to be “more patriotic” – i.e., to pay more. Hey, whatever it takes to achieve “unity.”    

OK, this is starting to sound like an op-ed piece, so let’s move on to what really matters to investors and traders. Before turning the page however, please note that the point of all of this is that while change can and hopefully will in this case be a good thing, the only thing that the prospect for rapid and drastic change brings about for sure is more - say it with me now – “uncertainty.” 

I’m not entirely sure how we got to this point but as an avowed capitalist, let me just say, “I’m frightened Auntie Em, I’m frightened.”

The Pitfalls of Buy-and-Hold

So the obvious question for any investor is “what to do, what to do?” If you are a buy-and-hold investor who has gotten your head handed to you over the course of the past year, the good news is that you have learned a valuable lesson. The bad new is that “it’s one of the painful kind.” Anyone who has gotten into the stock market in say, oh the past quarter century, has been conditioned to believe that “the stock market always goes up,” or at the very least that “it always comes back.”  And in the macro sense you can make that argument. Nevertheless, it is instructive to review the nature of some of those “comebacks.”  For example, the stock market topped out in 1929 and did not pierce the 1929 high again until 1954. A “bit of a tough stretch” one might say for the buy-and-hold investor. Likewise, between 1969 and 1982 the market gained no ground. This is the reason I personally always advise people against putting all of their money into say an S&P 500 index fund and “forgetting about it.” 

For a modern day example, consider an investor who put $10,000 into the Vanguard S&P 500 index fund (VFINX) in November of 1998. A scant seventeen months later he would have been sitting on a handsome profit of +36%. So far, so good. Alas, ten years after entering this position, this buy-and-hold investor would presently be sitting on an investment worth just $8,953, for a total 10-year return if -10.5%. Will he eventually make money? Possibly. Has this been a worthwhile use of his money over the past decade? Hardly. Hence, the need to consider the possibilities beyond “buy and hold.” 

Brave New Worlds: Exchange Traded Funds (ETFs)

My frank advice to any individual who is predisposed to favor the buy and hold approach, is simply to say fine, go ahead, invest some of your money on a buy-and-hold basis. Just not all of it. For today investors have never had more possibilities available to them. The advent of option trading and the more recent advent of exchange-traded funds (ETFs) have opened up a world of possibilities that our predecessors could only dream of. In Chart 1 you see a vast array of possibilities – going left to right across the top and then left to right across the bottom:

Top left: Long crude oil (USO)
Top middle: Short gold x 2 (DZZ)
Top right: Long the U.S. dollar (UUP)
Bottom left: Short Dow Jones Financial stocks x 2 (SKF)
Bottom middle: Long the 30-year t-bond (TLT)
Bottom right: Long the Chinese stock index (FXI)

Chart 1 – An array of ETFs

This array only scratches the surface of the possiblities. In fact, the truth is that the bad news now is that there is no excuse for ever losing money since there are ways to play just about any market segment from the long or the short side. Obviously that is an unrealistic expectation. Nevertheless, you get the point. If you choose to open your eyes to the possibilities, you do have at your fingertips the potential to profit in good times and in bad. At the very least, you are empowered to do something besides just “sit there and take it.”

Brave New Worlds: Option Strategies

In Charts 2 and 3 you see the risk curves for a position using options on Amazon utilizing a strategy known as a “modified butterfly” spread. This strategy involves buying one December 50 put, selling three December 45 puts and buying two December 25 puts.  

Chart 2 – AMZN Modified Butterfly Spread

The risk curves for this trade – which we will assume a trader will exit if the recent low is taken out – appear in Chart 3.

Chart 3 – AMZN Modified Butterfly Spread risk curves

Clearly this is well out of the realm of the average buy-and-hold investor. But consider the utility of such a position. If a trader is prepared to cut his loss if AMZN drops below its recent low of 43.21 to say, 42 a share, then he essentially has the potential to make money (as option expiration approaches) or to lose about $400, depending on how soon the move takes place. This trade technically has a maximum risk of $3,039 (which does not appear on Chart 3, but which would only occur if this trade was held until option expiration and AMZN stock was trading at $25 a share or lower).

Obviously a trade like this is not for everyone and it is certainly not for someone who knows nothing about options. Still, the real point here is to alert you to the fact that this type of proactive position also can offer some short-term benefits that do not necessarily require the overall stock market to rally in order for a profit to accumulate.    

Summary

The winds of "change" are upon us. Just what exactly that means for the financial markets going forward is anybody’s guess. One thing it does appear to mean, however, is continued uncertainty (there’s that word again) and volatility for the financial markets. One alternative is to “hold on tight” and to go along for the ride wherever the markets might take you. The other alternative is to educate yourself regarding the myriad possibilities available via ETFs and options to take advantage of the wide fluctuations that appear to be the norm for awhile.

Think of it like taking a ship out onto the open ocean. You can simply go where the current takes you. Or you can attempt to steer.

To me the best choice seems fairly obvious.    

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Jay Kaeppel
Staff Writer and Trading Strategist
Optionetics.com ~ Your Options Education Site