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The Great Transition, Part II: Profiting from Trend Changes

The thesis of this series, The Great Transition, is really quite simple: Things are not as they were before and we can never go back again. In order to see the future that's coming, we need a fresh set of eyes, unbiased by the past. This is not a radical idea in and of itself but it is one that we humans, in our stubborn refusal to let go of old ideas, have a difficult time adapting to. What makes this Transition so Great is that it is taking place on so many different levels of society and is being driven by underlying fundamental changes in technology, demographics and economics, not to mention the world's ecological environment. As these changes interact with each other and create new trends, a different world is being created, one that we must adapt to or be forever left behind.

The first chapter of Jeremy Rifkin's book The Hydrogen Economy is titled, "Between Realities." He begins:

Throughout history, human beings have occasionally found themselves caught between two very different ways of perceiving reality. . . Today we live in similar times of great tumult, of failing orthodoxies and radical new possibilities. After two centuries of industrial production and commerce, the use of mass human labor yoked to fossil-fuel-powered machines in factories, offices, and commercial businesses is slowly falling by the wayside... within a matter of a few decades, the cheapest workers in the world will not be as cheap as the intelligent technologies that will replace them, from the factory floor to the front office.

Rifkin's words echo those of Peter Drucker's that I quoted in last week's essay. Neither directly addresses the investment environment - Rifkin is speaking specifically about energy - but fundamental changes such as these are directly tied to the types of investments that will or will not be profitable in the future because they define the world we will live in. Drucker states that we are currently in the middle of the transformation, which will not be completed until 2010 or 2020. But if we will have a completely new world as he predicts, it means that our old structures must simultaneously crumble away to make room for the new world that is being born. In the context of investing, this means that old ways that were once profitable will likely meet with failure as old ideas are swept away to the dustbin of time. Buy and hold is dead, and a new approach is in order.

The Downfall of a System - Is It Wrong to Profit Off It?
Some people feel that buying puts, selling stocks short or otherwise profiting from the fall in an asset is somehow wrong, that it is parasitic or worse, unpatriotic. I do not share that opinion. If the current global capitalist system is in decline, it is not the end of the world; it is simply one half of the complete cycle of growth and renewal, and this must be taken into account when making investment decisions. My primary goal is to give investors a bigger toolbox with which they can attack the problem of investing. My suspicion is that short selling, puts and inverse funds are not part of most peoples' thinking when it comes to investing.

Just out of curiosity, I put a up poll asking if readers had ever sold a stock short. Out of 112 votes, about half the people had, half hadn't, and about 12% didn't know what the term meant.

A Bigger Toolbox
The erstwhile 'day-traders' of yesteryear should more aptly have been called 'day-buyers' for in truth they were just one trick ponies. They knew how to buy and make money when stocks and the overall market were going up, but selling was an entirely different matter. For those heady green amateurs taking their first try at trading for a living, selling often came too late, after their 'easy profits' had been transformed into even easier losses. And as for short selling or options, those weren't even in their lexicon. So when the tide turned in 2000, the day-buyers quickly became another part of modern market history and lore. The traders that have continued to be successful adapted to changing times because they had a bigger toolbox, and knew how to make money in falling markets as well.

This article is not meant to serve as an exhaustive guide to prepare you for a future great depression. Rather, it is narrowly focused as an introduction to ways to profit from a declining stock market. In short, it aims to give you expanded flexibility and ideas on how to profit in different kinds of markets. The tools that I will discuss are: 1) Short-selling 2) Simple options strategies, and 3) Bear funds. It is aimed primarily at the 60+% who have never shorted a stock or don't know what the term means. As such, it may be elementary (though hopefully entertaining) for experienced traders, but it is by no means exhaustive for beginners. The purpose is to serve as an introduction and overview for further departure.


How it works:
Many people have never sold a stock short because it sounds confusing, dangerous and very risky at first. Actually shorting is just the opposite of buying a stock (also known as "going long"), and if done correctly, is no more risky. When you go long, you buy a stock because you think it will go up. When you sell short, you do the opposite: you sell a stock because you think it's going down.

But how can you sell a stock you don't own? No problem. Without going into excessive detail, most stocks can simply be borrowed from your broker and sold short, with the proceeds of the sale going directly into your account. After the stock falls (which you have been expecting), you buy it back, return it to your broker and say, "Here's your stock back, thanks for the loan." You keep the difference between what you sold it for, and what you bought it back for. I know it sounds bizarre, but it is perfectly legal and traders in the know do it all the time. If you're confused, here is an example.

Example: Ebay 2005
Say it's back in January, and you think Ebay is getting a little expensive and is in for a rough year, so you sell 100 shares short at $55. After the transaction there is now $5,500 in your account. You keep the money, but you still have to return the stock eventually. Based on your analysis, you know that Ebay is set to announce earnings later in the month and you expect them to disappoint. Sure enough, after the earnings report the stock tanks badly, gaps down at the open and you promptly close out your short. You call your broker and buy back 100 shares of Ebay at $42, using $4,200 of your original $5,500 to buy the stock back, leaving you with a $1,300 profit after only a few trading days of "work."

Easy like pie, right?

Wrong. The biggest risk in the market comes from a lack of respect for the market, of thinking that making money is easy. Every trade, whether you buy long or sell short involves considerable risk. Your job is not to make money on every trade, but to effectively manage your risk. Your broker will tell you that selling short is much riskier than buying long for a simple reason - your potential losses are unlimited. The logic behind this is true: when you go long a stock, you cannot lose more than the amount you have invested. If the stock falls to zero, you've lost all your money, end of story. On the other hand when you sell a stock short, eventually you have to return it. Because there is no limit to how high the stock could go, this means your potential loss is unlimited, in theory. In practice, every trade you make, whether long or short, should have an effective risk management strategy to limit your losses.

Without a proper exit strategy, going long is just as risky. For example, if you bought Enron at its 2001 high of $85, you could have lost all your money within the year. Many people thought Enron was such a big company that it would never go out of business, plus they were "buying for the long term" so they held on. Others wanted to get out, but were waiting for a little rally that never came. They rode the stock down the infamous "slope of hope" to bankruptcy. Anyone who held on to the bitter end lost everything. Current holders of GM and Ford beware: this is not your father's market. I recall reading that the average stint in the S&P 500 for a company is now down to just 12 years!

Risk: Counter Example
Say that you're so pleased with your Ebay trade above that you decide to try it again, only this time with another high tech stock and more money. In mid April, you see that Google appears to have stalled out at $195 and once again, you know that earnings are just around the corner. The price is high, meaning it has a long way to drop. Emboldened by your first success at selling short, this time instead of 100 shares, you decide that because you are now an expert (as well as being invincible) you're going to roll the dice (should have done it the first time, you think) and risk half of your retirement nest egg to sell short 1000 shares of Google at $195. After the transaction, you have $195,000 in your account as you wait for the earnings release to approach. Almost immediately the stock begins to sink and you feel vindicated in your admittedly risky play. Since you think this is the easiest money you will ever make, you risk the other half of your retirement money and sell short another 1000 shares. Now your entire retirement is riding on investors' response to a single stock's earnings.

Much to your chagrin, four days before earnings, the trend suddenly reverses and the stock begins spiking upwards. You realize something is wrong, but you hope against hope that the tide will turn and hang on for the ride. The morning after the earnings release (which you scoured and didn't think was that great), the stock opens at 225. In a panic, you buy back all your shares at the open and cover at the high of the day. Total loss: $60,000 in one week.

This is not prudent risk management. We are in a secular bear market, but markets and stocks will still rally, sometimes sharply and sometimes for long periods of time. That's just the bear, putting out some honey, trying to attract some lonely, disoriented bulls.

Shorting Exchange Traded Funds (ETFs)
If you'd rather deal with an entire index than individual stocks, then you should investigate exchange traded funds (ETFs). These are baskets of securities (stocks or bonds) that track highly recognized indexes like the Dow, Nasdaq or S&P 500. They are similar to mutual funds, except they trade on a stock exchange and anything you can do with a stock, you can basically do with an ETF, which means you can short them. There are also ETFs that track emerging markets or sectors such as commodities or energy allowing you great flexibility and the ability to go long or short different market sectors.

Options on common stocks are a derivative financial instrument. This means that they don't have any value of their own, but their value is derived from an underlying asset - a common stock or an index. Two kinds of options are commonly traded, puts and calls. Like the name implies, they give you an option, either to call a stock away from someone, or to put your stock onto someone.

If you thought short selling was confusing, options are even more so at first. Not only are there puts and calls, but you can be long or short depending on your strategy. Due to time and space limitations, I will give only the briefest introduction to puts. Entire books - and fat ones, too - have been written on options and strategies.

Going long puts is the one common way to profit in a falling market. To take the Ebay example once again, say that instead of selling short 100 shares at $55, you bought an April 55 put. Owning the April 55 put gives you the right to sell 100 shares of Ebay (put it onto someone) at $55 in until April. Lets say that the put was selling at $5 per share at the beginning of April. You can only buy options in lots of 100, so your total cost is $500. First, much less of your capital is at risk than selling short, which requires 50% margin ($2,750 in this case). Second, options give you the power of leverage. When Ebay falls to 42, your put options are worth $13 each. Subtract the $5 you paid, and your net profit is $700. This is less than in the short sale example, but you risked only $500, giving you a return of over 100%. Third, your potential loss is strictly limited. The most you can lose is the amount you invest, regardless of how high the stock goes.

Options are risky. They are riskier than buying long or selling short because they are a "wasting asset." Like milk, they have an expiration date after which they are no good. Options on common stocks usually expire on the third Friday of every month, so you have to be careful about your timing. If Ebay is at 56 when the third Friday in April rolls around, your April 55 put expires worthless. Even if Ebay gaps down to 42 on the following Monday, you're out of luck because the option no longer exists. It has expired.

Pricing puts is difficult because you must take into consideration the time to expiration, how close the strike price is to the price of the stock, and how volatile the stock is. You will be competing against the market maker who has sophisticated computer modeling software to price the option at a price that will not lose him any money.

Because of these considerations, your account has to be approved for options before you can trade them. You will have to sign an options agreement stating that you understand how options work and are aware of the risks involved. Because there is the potential for extremely high returns, it can become very addictive, like gambling, making it quite dangerous.

If this is the first time that you've heard of options, then you're most certainly completely confused, and you shouldn't be trading them any time soon. Poke around at the library or bookstore, visit the Chicago Board of Options Exchange, talk to knowledgeable people, and post any questions you have to my message board. I will be watching the board and responding to questions as they arise.

Just about everyone knows about mutual funds, but not many seem to know about inverse funds. Here are just a few:

The Gabelli Mathers Fund. The fund is a managed fund for "Investors who seek long-term growth of capital and are skeptical of a fully invested buy and hold equity investment strategy, or. . . who seek a portfolio that is flexibly managed to potentially take advantage of a decline in the U.S. equity markets."

Then there are the Inverse Profunds. These are index funds that allow you to go inverse, or double the inverse of the Dow, S&P 500, and Nasdaq 100 in one fund. This means that if the market falls 5% your fund could increase 5% or 10%, depending on the fund you choose.

These are not the only funds available, there are more out there and you will find them as you poke around. As far as I know, there are no bear ETFs, but if I'm wrong someone please correct me: mailto:bull@bullnotbull.com?subject=Short ETF

Moral of the Story
There are many morals to this short story. First and foremost is that big changes are afoot, and in order to capitalize on them, you must remain flexible and keep your eyes open to the emerging environment. As one bull market ends, another is invariably beginning somewhere else. But as Dr. Mark Faber states quite clearly in Tomorrow's Gold, "While everyone's eyes are fixed on the cycle that's peaking, enormous opportunities arise elsewhere." Currently it is the housing market that has everyone mesmerized. This will be the subject of Part III of this series. (Click here to sign up for updates.)

New trends are hard to spot and can take years to materialize. In the mean time, you can bide your time and profit from falling assets while remaining alert to new opportunities. In times of transition, the future is always unclear. Last week I quoted the opening of Drucker's introduction to Post Capitalist Society. This week, I quote his closing:

Nothing "post" is permanent or even long-lived. Ours is a transition period. What the future society will look like, let alone whether it will indeed be the "knowledge society" some of us dare hope for, depends on how the developed countries respond to the challenges of this transition period, the post-capitalist period - their intellectual leaders, their business leaders, the political leaders, but avove all, each of us in our own work and life. Yet surely this is a time to make the future -- precisely because everything is in flux. This is a time for action.

In Closing
There is a lot going on in the world, the least of which is learning how to short stocks. The ideas that I have presented here are merely tools, not answers. If there is anything that had interested you, go out and do more homework and put the tools to use. The more tools you have the better off you will be in any given situation.

Finally, here are a few trading rules not only to remember, but to practice in you trading, whether long or short, whether trading stocks, options or mutual funds.

  1. Never risk all your eggs on one trade or one security. Even mutual funds can (and likely will) go out of business. As the old saying goes, there are old traders, and there are bold traders, but there are very few old, bold traders.
  2. Always have an exit strategy, in price or time. As an earnings play, you know that there will be considerable volatility around the time of the earnings release, which can make it a good time for a short term trade, as long as you limit your risk. Don't expect to be right all the time, but make sure that those times your are right count in your favor. Having a long career with a .300 batting average will get a baseball player into the hall of fame, but it also means that he fails in his mission seven out of ten times at bat.
  3. Don't invest in things that you don't understand. You worked hard to earn your money - don't throw it away on a whim because you read an article about short selling on the internet. In this age of information, there is no excuse for not educating yourself.
  4. Buying stocks long is not the only way to make money in the stock market.
  5. None of the strategies I have introduced here is intended to be a buy and hold and forget strategy. Making money is not that easy - if it were, we would all be retired by now! You must always be diligent in your research and vigilant in your actions.
  6. In troubled times such as these, don't stay focused on the negative events that seem to surround us. It is important to be aware of them, but try to focus on the good and productive changes, for these will be the source of future growth and promising investment opportunities.

This is Part II of a five part series examining the opportunities and pitfalls of living through the Great Transition. Part I explored the "Giant Popping Sound" heard around the world as markets kicked off the next leg of the global bear market in April. Next week, part III will look at the housing bubble and why you should stay away from it. Part IV examines money in general and the U.S. Dollar specifically, while Part V examines some potential scenarios for the future.

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I welcome your comments on this article. Post them below or email me directly.

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