I recently spent some time on the phone with five trusted (and trustworthy) guys who are managing money on Wall Street to learn what they are thinking and doing.
The bottom line: What I heard from them is good news for those of us who are buying put options to profit from falling stocks. And if you haven’t yet ventured into what I call the “short side,” where we’re making some nice dough while others are scrambling to protect theirs, there’s still plenty of time to get in on the action.
Here’s a summary of what I learned from my friends on the Street:
The Hedge Fund Guy — He’s beginning to look at Rogaine ads because he’s running out of hair to pull out. Of course, even some of his short-side plays are not working fast enough for his taste. He entered the business three years ago and focused on the financial fundamentals of little companies and now trades a great deal. He is upbeat but sees only gloom in the market.
The Research Adviser — He has 14 investment bank/brokerage-type clients and a long-term life sciences focus. The market is confounding him, and his clients are very unhappy with the current environment — they’re not exactly rushing to put more money to work. His clients, however, still live (and invest) by fundamentals.
The Broker/Adviser, Pensions — He’s sitting back. His clients are calm because they have a very long-term perspective. He is a gold and commodities guy — plus plays on very long-term secular trends. He is relatively unconcerned about markets and focuses on fundamentals as well.
The Broker/Adviser, Individuals — He’s also sitting back, focusing on long-term fundamentals and short-term, short-side opportunities. He still hates the homebuilders and the banks, especially the regionals.
This was this person who first turned me on to the regional banks and homebuilders in the very early days of 2007, leading my ChangeWave Shorts subscribers to gains of 300% in Hovnanian (HOV), 173% in D.R. Horton (DHI), 311% in Centex (CTX) and 223% in Lennar (LEN), among other notable wins. I owe this guy a really nice dinner!
>
The Trader — This trader actually manages a small chunk of my personal money, which is up 20%-plus in the past 11 months. He trades volatility using some proprietary math and credit spreads, although he has to apply a bias and it is to the downside — and he maintains it will remain that way for a while. At lunch a couple of weeks ago, he pooh-poohed a decline in oil prices and gave me the following great data point:
The average American consumes 25 barrels of oil per year. Indian and Chinese people — and there are many, many more of them — consume a mere two barrels a year.
If Americans cut usage by 20% (down to 20 barrels each) and people in India and China grow at current rates, their annual use will grow to three barrels of oil in a heartbeat and there will be no net decline in the price of oil.
These five conversations confirmed for me that it’s a traders’ market with a downside bias that will send companies with poor fundamentals sharply lower from here. And that is great news for us on the short side!
Crude oil futures closed at $144 a barrel on Thursday and pulled back a bit today, but many speculate that it’s just a reprieve on the way to $150. Because it seems that what goes up (i.e., oil) means that something else (i.e., the market) goes down — and since the world’s usage of and need for oil is far from abating anytime soon — I’m confident in my prediction that there are lots of opportunities ahead in the near future to make big profits in bad times.
>
STARTING YOUR SHORT-SIDE JOURNEY
My wife tells me there’s a television show called “What Not to Wear.” I am hoping she’s not taking down the show details and sending in photos of me, but if I were the host of my own TV show about stocks, I’d be amenable for calling it “What Not to Buy.”
For example, thanks to a decrease in consumers’ discretionary spending, that sector is quite-fertile ground for stocks you don’t want to buy. Toilet paper, gasoline and macaroni and cheese are doing well; everything else is in trouble.
When I say that you don’t want to buy a company’s shares, you can translate that into the fact that it’s OK to look into shorting their shares.
If you’re adventurous (or perhaps a little crazy), you can short stocks directly by selling them outright. Or you can do it the safer way — OK, since it’s my way, I can call it the “right” way — and buy put options. That’s why I call it the “short side” — you’re buying puts as a way of shorting a stock, and your risk is limited to what you spend to buy the puts. Better yet, your upside potential can be unlimited!
FINDING THE BEST COMPANIES TO SHORT
My tried-and-true method of finding stocks to short, via buying put options, has been to exhaustively research a company’s “fundamentals.” It’s exactly what it sounds like — looking at a company’s foundation, from its leadership to its core products and everything in between — and seeing how many cracks there are and evaluating how possible it is to fix them in a reasonable amount of time.
If you don’t have a specific company in mind, think about the various sectors out there. You can narrow those down to find the well-run companies that keep increasing their sales and coming out with more innovative products every year. (You have my blessing to think about buying their stocks!)
>
Then you separate the stars from the slugs. Do you see a company or two that couldn’t make a good decision or manufacture a successful product to save its life? Do you hear about executives dropping off like flies and see its competitors absolutely crushing it in the marketplace? That might be a great place to start your short-side journey.
LOOK FOR OPPORTUNITIES EVERYWHERE
Going back to our consumer-spending example, people start cooking at home more when money is tight. So, you might examine restaurants and department stores as natural avenues for short-side profits.
Personally, I’ve noticed that it takes half as much time to get a pair of pants hemmed at my favorite clothing store because their seamstress isn’t deluged with alterations requests. I’ve also started getting seated immediately at restaurants where you had to leave your name at the hostess station two hours in advance of when you would be feeling hungry.
Take a look to see if the stores, restaurants, manufacturers and other names you come up with in your research (or simply your everyday experiences) are publicly traded, and make sure they have an options chain available.
Also check out things like short interest, which can let you know how many traders have shorted the stock the traditional way. If the number is high, chances are that put premiums might be expensive, too, as other people have gotten the hint that poor sales this quarter are going to translate into less-than-stellar earnings next quarter.
>
WHICH PUT POSITIONS SHOULD YOU PICK?
Then take a look at the at-the-money or slightly out-of-the-money puts in the option chain. If XYZ Company is trading for $35 a share but you can hear crickets when you walk into their establishment, you could check out the at-the-money puts at the $35 strike or even opt for the out-of-the-money puts at $32.50 or even $30.
Just be sure to buy yourself enough time for the trade to work in your favor — while longer-dated options (also called LEAPS) can let you buy up to two years of time, those tend to be more expensive. If you’re looking to be in a trade till its next quarterly earnings announcement, though, you may want to buy options that expire in four to six months so that you can benefit from any bad news that may come out three months from now.
Playing the short side with puts is an exciting adventure that is actually independent of how the market performs, as we’ve made short-side profits on days that the Dow (DJI) jumped 200 points. But when the market’s stuck in neutral or reverse, the negative sentiment tends to drive up put premiums … good news for us when we’re betting on a stock or sector going down anyway.
A bad day in the markets can accelerate your returns on a good short-side trade. And I’ve never been one to get mad at making profits faster than I planned! I hope you’ll check out my ChangeWave Shorts service and get in on all the latest trades … I’m finding new companies each day with worse fundamentals than the last, and I’d love to have you on board for the next round of happy returns. Try it out — risk-free for 90 days!
If you enjoyed this article, check out Michael Shulman’s “Profits in Martha Stewart” and “Short-Selling With Put Options 101.”
