The credit freeze has left the market with a chill, and in some sense, investors are asking for vanilla while the market is serving Rocky Road.
Investors would love to go back to the days of the 1980s and 1990s when a buy-and-hold strategy would yield about 10% returns per year. But since 2001, it’s become clear that the buy-and-hold market is no longer profitable.
Take almost any of the S&P 500 (SPX) exchange-traded funds (ETFs) and look at their performance over the past eight years. Almost all of them show no appreciation — and many have posted substantial losses.
The good news is that you can have your cake and eat it, too. The market has what we want, but we have to know where to look, given the structurally elevated volatility levels.
Take technology.
Even in a world where we are all steadily using more technology in our daily lives, the Technology Select Sector Fund ETF (XLK) has gone from about $35 at the start of 2001 to about $16 today.
However, since 2001, there have been spectacular trading opportunities, including buying the index in July 2006 and selling in November 2007 for a 50% gain.
We can safely say that the 17-year span from 1982 to 1999 was a buy-and-hold time. We also can safely say that from 2000 to some point in the future that’s still several years away, buy and hold will not be the most effective strategy.
Studies of the past 80 years show that the market alternates between trading and trending cycles, with the market switching between these two states about every 16 years.
And right now we are in a trading atmosphere that is predicted to last until 2015.
The Dark Side of Day Trading
At the opposite end of the spectrum from buy and hold is day trading. But how do you trade a market that can move 7% or more in either direction within an hour?
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The market’s radical, intra-day moves have become virtually unpredictable, as opaque global financial factors drive the market in the very short term.
The pros at hedge funds, who have the best information flows and fastest trading technologies, are generally getting hammered by attempting to keep pace with the daily market moves. As the market became more volatile in September and October, average losses at hedge funds for each month have exploded upward.
Long/short hedge funds lost more money in September than they had year-to-date through August. And losses in October make those in September look small.
The Sweet Spot
So, if buy and hold is no longer the ticket, and day trading will likely lead to an aneurism, where does the answer lie?
Where it usually does — somewhere in the middle.
Intermediate trends that last anywhere from a few weeks to several months are predictable and profitable. They allow traders to capture the bulk of the value from a longer-term trend while lessening overall market exposure and capital commitment.
The intermediate trend also allows traders to hang-on through the crazy day-to-day swings without being whip-sawed out of every hard-earned dollar.
It is our belief at Big Money Options that the intensity of this current crisis will subside and market volatility will “normalize” at a new, higher level. With more normalized patterns in place, our options indicators will once again regain their predictive force.
Options have been, and should soon be again, excellent predictors of intermediate-term trends. On a stock-by-stock level, they track many of the most sophisticated, leveraged market participants. On a broader market level, they capture current market sentiment in real-time.
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With the intermediate market trend identified, we take the extra step of finding the most lucrative, low-risk options plays available.
By going long with a call option versus buying the underlying equity, we effectively have implemented a stop-loss trade. Capital is protected in the event the underlying stock moves in the wrong direction by a large amount (an everyday occurrence lately) and the upside is captured in a leveraged trade.
Further, with put options, you can capture profit on the downside, thus you’re protected in any market.
Keep Your Swing Under Control
One of life’s great little pleasures is watching a golf ball fly long and straight after having hit it in the middle of the sweet spot with a nice, easy swing. The same is true with options.
If you try to “kill it,” you’ll likely lose money. Invest a comfortable amount where if the trade goes badly, it’s no sweat.
With too much money on the table, fear may make you lock in losses as the volatility of the trade moves through its normal course.
Don’t worry about missing the big one. When option trades go well, they usually go very well, which can cover even several smaller losses.
The point is, you should buy when fear is at a high and sell when fear is at a low. As Warren Buffett says, be greedy when others are fearful and fearful when others are greedy.
Although the negative news and credit crisis issues are not going away immediately, you should start to look at companies with top-notch management, strong balance sheets and secular growth stories.
But remember, while the best view is always the one with a lot of profit on the horizon, the way to get there — for now — is to put buy-and-hold strategies on hold. Take the middle road and let options lead the way.
Andrew Houghton and Nick Atkeson are the editors of Big Money Options. To learn more about them, read their bio here.
