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The Dow Industrials fell more than 877 points between May 10th and the close on June 12th; the Nasdaq dropped 279.61 from April 19th to the June 12th close; the SP-500 fell 90.13 from the high on May 5th to the June 12th close. As I write this piece on June 13th, the markets are still in bear mode. What is a trader or investor to do? The answer, as it so often is, is "it depends".

In my view, the first thing an investor or trader should do is be aware of his or her own trading personality. If one is a "buy and hold" type, then the answer is easy. He just hangs on and rides it out. That course of inaction can be very painful. We need to remember that a drop of 50% in price requires a 100% move back up just to return to even. If I buy a stock for $100 a share and it loses 50% it is down to $50; it needs to double to get back to $100. Maybe it would be easier to sleep if I didn't continue to hold that stock as it plummets. Instead, I could exit when it drops below a horizontal price support or below a moving average or below a trend line. It is often said that the first loss is the best loss so an early exit is an answer. Of course, if the stock starts back up, I could always buy it again. So the first thing I think about doing when markets fall is to exit bullish positions based on the break of some support whether it be trend, horizontal price support or a predetermined moving average. In other words, the trader with the truly bullish trading personality may want to go to cash and go fishing or play more golf or spend more time in the garden or .... you get the idea.

Of course, if I see a bearish move underway and I have some knowledge of markets and strategies, I may try to profit on the down move. How could I do that? There are many ways. I could consider selling a stock short. That means I borrow stock from my broker (I must first learn whether the broker I use has it to borrow it or not) and then I sell it. That's right, I sell something I don't own. I sell borrowed stock. Of course, I know I must replace the stock at some time so I know I will eventually have to buy the same stock to cover the position I sold. Instead of first buying low and later selling high, what I am trying to do when I sell short is to first sell high and later buy back low. Since I know I am going to have to buy to cover at some point, I know there is risk if the stock goes up in price. In fact, the risk is theoretically very high since there is no limit on high the stock may go. I could provide some protection by selling a stock short and also buying a call option. Let's say XYZ stock is trading around $50 and I sell 1000 shares short at $50. That means $50,000 would come into my account in 3 days. Suppose the stock dropped to $30. Now I could buy XYZ to cover my position for $30,000 and keep the $20,000 difference. Great! However, what if I sold the stock for $50,000 and it then turned up and went to $75 over night. Could that happen? Of course it could. Now I would lose $25,000 if I had to buy to cover at $75 a share. Instead of just selling XYZ at $50 in the beginning, suppose I did that and also bought some 55 calls for let's say $1 a share. I'd still get the $50,000 in my account, but I'd have to pay $1 x 1000 shares or $1,000 to buy the calls. What does buying the calls do for me? Well, when I buy the call option, I get the right (but don't have the obligation) to buy the stock any time before expiration for the $55 strike price I chose. Now, suppose I sold 1000 shares of XYZ short for $50 a share and took in $50,000; suppose I also bought those $55 calls for $1. $50,000 coming in and $1,000 going out. Now, the stock rockets to $75 a share overnight. Well, I can now exercise my calls at $55 a share, buy the stock for $55,000, suffer a $5,000 loss on the stock transactions and an additional $1,000 for the cost of the calls. Instead of losing $25,000 as in the first example, I would be down $6,000.

Another of the many ways to make money in a falling market is to buy put options. Without giving an options course here, I'll just say that as the price of a stock goes down, the value of a put goes up. When I buy a put, my risk is limited to the price I pay for the options. For example, in Option Trader, I bought the Dec 40 puts on QQQQ on May 11, 2006 for $1.45 a share. I had 20 contracts (which controls 2000 shares) so I paid 2000 x $1.45 plus a $25 commission for a total of $2935. That was my complete risk. The Q's did drop and 2 weeks later, I sold my puts for $2.35 and, after another commission, brought in $4,674.86. On my risk of $2,935, I made a net profit before taxes of $1,749.86 or a return on risk of 1749/2935 = 60% --- in two weeks.

Yet another way of making money in a down move is to enter spreads which are option plays with two or more legs. Spreads are a little beyond the scope of this Article, but, as an example, I currently have a credit spread on the "Diamonds" (DIA) where I have the potential to earn a return on risk of about 80% in a month if I don't have to make any adjustments.

As is often the case, the bottom line involves the trader's personality and her knowledge. Buy and hold, go to cash, or employ some strategy or strategies that make money in a down move are the alternatives for investors and traders. Without knowledge of strategies and risks, the investor would probably either hang on or go to cash. With greater knowledge of both strategies and risk, the trader might consider employing bearish strategies to add to profits even as a market falls.

Good Trading!
Bill Kraft

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