Use Options to Trade the Coming Double Dip

by Michael Shulman | August 4, 2011 12:32 pm

I’ve said many times we never left the last recession — not in the real world — and recent GDP revisions show economic activity is still not back to pre-recession levels. The reality of this real world downturn – in the U.S., for sure, in Europe, absolutely positively for sure, and now China – is this is the “next” crisis. Wall Street wants to trade, not invest, and crises are good for traders. Most traders are now “taking risk off” the table and turning to safe haven investments that had already begun to pick up life due to the twin debt crises in Europe and the U.S.

The economic data really is terrible – the ISM number, which was supposed to be north of 54, came out barely above 50 and boom — that means we are near contraction in manufacturing (any number at 50 or below means the manufacturing component of the economy is headed the wrong way).

And that is the only thing that has been working – housing is bust and mortgage default and foreclosure data show it will be bust for at least another five years. Consumers are pulling back due to unemployment, fears about jobs, high gas prices, the loss of value in their homes and a general feeling of economic uneasiness.

And now, Uncle Sam is going to cut back — the states are already doing so. Twelve percent of the economy is state spending – if they cut back 10%, you lose a point off economic activity. Ditto for the federal government: Make no mistake, with several hundred billion dollars that would have been borrowed and spent to generate economic activity now gone, the economy will take a hit. Forget your politics, do your arithmetic, government cutbacks do not spur growth, they retard growth.

So when the market is this unhappy, how do you make money? Follow market sentiment and trade the fear. That fear is pushing into the market and pushing up sectors of the market. Sell puts or buy calls on gold through the SPDR Gold Shares (NYSE:GLD[1]) exchange-traded fund, sell puts or buy calls on the gold miners via the Market Vectors Gold Miners (NYSE:GDX[2]) ETF, sell puts or buy calls on silver through the iShares Silver Trust (NYSE:SLV[3]).

You can also sell puts or buy calls on the VIX, the options volatility index and a measure of market uncertainty. I like using the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX[4]). Also, sell puts or buy calls on ETFs such as Direxion Daily Financial Bear 3X Shares (NYSE:FAZ[5]) or ProShares UltraShort Financials (NYSE:SKF[6]) that go up when the banks go down.

If you are more conservative and want to protect capital, sell puts. If you are more of a buccaneer, buy calls. If you sell puts, make them short term, no further out than September. If you buy calls, and want to ride out any bumps in sentiment that go against you, look longer-term, into January.

Follow the fear. The double dip is here.

 

Endnotes:
  1. GLD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GLD
  2. GDX: http://studio-5.financialcontent.com/investplace/quote?Symbol=GDX
  3. SLV: http://studio-5.financialcontent.com/investplace/quote?Symbol=SLV
  4. VXX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VXX
  5. FAZ: http://studio-5.financialcontent.com/investplace/quote?Symbol=FAZ
  6. SKF: http://studio-5.financialcontent.com/investplace/quote?Symbol=SKF

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