The Many Ways to Play a Directional Turn

Last week’s article on market extremes elicited several types of responses from readers. There were the very kind thanks for the insights (always appreciated on this end!). There were references to others who had similar opinions (thanks for the insights!). And lastly there were the requests for how to play the potential drop in the equities markets from these lofty heights.

In response to those requests, I have to remind everyone that Tharp’s Thoughts is not a trading recommendation newsletter. On occasion, we present research intended to provide insight into current market conditions that could help traders and investors formulate trading ideas. Providing individual trade recommendations, however, is outside the scope of our purposes for writing here.

With that said, I thought it would be instructive to present several possible ways to play this potential market-topping action. Let’s look at some different ways that a trader might express that the idea of a potential correction. First, let’s review where we are.

This Market Is Technically Stretched

Last week, we looked at a couple of factors that pointed toward a stock market that is overbought and due for a correction. One of these indicators is the chart from last week that showed accelerating price activity.

Since last Tuesday, one market maven has told me, “General market activity has kicked another leg out from under the stool,” meaning that even more elements are pointing to a market correction. First is the general retreat of the commodity complex where most of the major dollar-denominated commodities (gold, oil, etc.) continue to head down.

And as we see in the chart below, acceleration lines are being broken and the subsequent rebound has yet to reach new highs.

Last week I said that one could play this potential market-topping activity by trading the correction. If that correction failed to materialize, you could reverse and play the breakout.

Today, though, let’s look at several ways that you could express the opinion that the market might go down a bit.

Multiple Ways to Play a Potential Market Drop

For this exercise we’ll concentrate on the S&P 500 index, noting that there are similar trading instruments for other market indexes.

Let’s look at a laundry list of ways to trade a market drop:

• The time honored way would be to sell short the index. One could do this by selling the futures contract (S&P e-mini symbol:ES) or selling short the Exchange Traded Fund (symbol:SPY).
• Tax-advantaged accounts (e.g., IRAs, SSRPs and the like) will not allow the use of margin that is required to sell short. For those accounts and really for any trader, there are inverse Exchange Traded Funds (ETFs) that rise in price by an equal percentage to the underlying index’s drop. For the S&P 500, one such ETF that trades over a million shares per day is the Proshares Short S&P 500 (symbol:SH).
• You can also add leverage to your inverse ETF by buying the UltraShort ETF that rises twice as fast, in general, as the market falls. The symbol of the most popular 2x inverse ETF is SDS. Over the past year, this ETF has had an average volume between 25 and 58 million shares per day! With the market at more extreme overbought levels today, SDS is trading at its lowest volumes of the year, but still averaging around 28 million shares a day!
• For even more leverage on a stock play, there are 3x leveraged ETFs such as SPXU, which is trading over 4.5 million shares per day.
• Of course, for really high leverage, one could buy options (puts) on stock for a higher reward-to-risk profile (for example, puts on the SPY). With this play, one would need to manage time decay, volatility changes and the other challenges involved with buying options premium.

Before we move on, let me remind everyone that leverage is very much a double-edged sword. While leverage offers the allure of higher returns, it also demands an increased need to manage a much higher level of risk.

Now, the number of ways to trade a correction is almost as limitless as your imagination; let’s look at one final way to play it. A professional money manager might incorporate leverage and risk controls with the use of an options spread. In this case, with the SPY currently trading at just over 129, you could buy an April 129 (at the money) put for about $4.00 and sell an April 125 (out of the money) put for $2.60 or a net cost of $1.40 per options contract pair.

Your downside risk would be strictly limited to $1.40 per position and your maximum upside is $4.00 per position. Of course by using a stop loss that kicks in before the spread price drops to 0, which is how most would play it, this spread presents a very good reward-to-risk profile.

For all of these trades, the protective stop loss could be placed just above the recent highs. Depending on how aggressive you’d like to be and your time frame expectations, one might place the stop 0.25 times to 1.5 times the Average True Range above the recent highs (or below the lows for the inverse ETFs).

A reasonable first profit target for a correction is the 124 – 125 area on the SPY.

I’d love to hear your thoughts and feedback on this article or about trading and investing in general at drbarton “at” iitm.com. Until next week…

Great Trading,
D. R.