If You're Gonna Be a Bear...

Eddie Braverman's picture
Rank: The Pro | 21,215

Most of you have figured out by now that, while I am never without an opinion, I very rarely recommend specific trades on this site. This is for several reasons, not the least of which is the fact that I don't know any better than anyone else what the future holds, and I've already been responsible for the loss of (at least) millions of dollars over the course of my trading career, and the real number is probably in the tens of millions. These days I sleep well at night secure in the notion that no one else is going to lose their ass because of my often drunken prognostications.

That said, every once in awhile the stars align and a trade stands out as one that appears to have a much better than average chance of working out, and doing so with a substantial profit potential. Know this - I will never recommend a trade that I personally have not taken a position in. The last time I recommended a trade on WSO, it was to buy December GLD 108 Calls at $2 or better (I owned them at $2) on September 23. I sold the calls last Wednesday for $3.05 apiece, or a 53% profit.

I say this not to brag, only to illustrate what a no-brainer the trade was. The only thing necessary for the success of the trade was the continuation of Ben Bernanke's deer-in-the-headlights approach to perverting the U.S. money supply. Gold probably goes much higher, and I probably left money on the table, but I pulled the trigger because I'd achieved the price target I set out to achieve when I entered the trade ($1,100 gold = GLD 108 Calls at a $3+ premium).

The trade I'm about to recommend (and that I entered yesterday) is nowhere near as safe a bet as the GLD trade, in my estimation. However, I feel the profit potential more than offsets the risk, and that the success of the trade is simply a matter of "when" and not "if".

Yesterday, the DJIA closed at 10,227 - well higher than it has any business being, in my humble opinion. I'm not typically a bear (over the course of my career I made a lot more money to the long side than the short), but the fundamentals of this market are a joke. So I put my money where my mouth is.

I bought DXD December 33 Calls for $1 apiece. For those unfamiliar, DXD is an exchange-traded fund that is short the Dow x 2. In other words, if the Dow Jones rises 2% (like it did yesterday), DXD falls by 4%, and vice versa. Now, I have no doubt that the Dow is going to fall, and fall substantially. Frankly, I wouldn't be surprised if the Dow saw 8,000 before it saw 11,000 again. What I'm not sure about is whether or not that will happen in the 38 days before these options expire.

I can see the options doubling pretty easily, though. Here's how: if the Dow drops from here to 9,600, the options are roughly $2 in the money, plus whatever time value is left. Here's the math: a 627 point drop in the Dow is roughly 6.2%. That would increase the value of DXD by 12.4%, or take the price from $31.09 (where it closed yesterday) to $34.95. Safe to say you could off the $33 Calls you paid a buck for at $2 or better, depending on how much time is left.

Obviously, a more substantial move pays a lot better. If the Dow drops to 9,000 before expiration, the options you paid a buck for will be worth around $6 apiece.

So why options? Why not just buy DXD and wait, with no expiration date? This is where it gets a little elementary, so experienced options traders can skip this part as I'm writing it for the guys who aren't as experienced or comfortable with option trading.

Let's say you have $1,000 to invest. You could buy 32 shares of DXD at $31.09 a share. If I'm right about the market dropping, and the Dow drops to 9,600, DXD will be trading around $35 a share. You'd make a profit of $3.91 per share, or $125 profit on the trade. Not bad, but nothing to write home about. If you used that $1,000 to buy 10 December 33 Calls, however, you'd double your money. And that is something to get excited about. If I'm wrong about the timing, you lose everything (unless you sell out for a loss somewhere along the line).

Another very real risk is bucking the trend. We used to have a saying back in the day, "Never try to catch a falling knife." Meaning, if a stock is dropping you don't buy it until it bottoms, even if you believe it should be much higher. The Dow has been in a major up trend, and this trade is a bit like catching a falling knife in reverse. If, however, you believe like I do that the market is way overvalued, and that the necessary correction is going to occur at some point in the next 38 days, come on aboard. The market might even be up today as well, which means you'll get to buy your options cheaper than I did, or you might be able to buy a better strike price.

For those who think I'm completely full of shit, that the good times are here again, and that the Dow is on its way to a million, the opposite of this trade can be achieved by purchasing the DDM December 44 Calls, currently offered at $1.10 apiece with the underlying ETF at $42.02. To achieve a double in these options, the Dow needs to reach 10,738 by the third Friday in December. Good luck with that.

Here's hoping we all make a bundle. Sorry for the length of the post.

Perma-Bulls, you may fire at will...

Comments (19)

Nov 10, 2009

Your analysis ignores the decay element of these levered ETF's. If the Dow, 60 days from now, goes down 2%, DXD not only will likely NOT go up 4%, but it may even go down.

Nov 10, 2009

While you are technically correct (and your argument speaks to the esoteric nature of maintaining a set leverage against an index and factoring in fees on top of that), if the overall bias of the market is negative in the period given (which is my expectation), the decay will be negligible and will be offset by any remaining time value in the options.

Nov 10, 2009

Fair enough. Just wanted to make sure everyone understands the risk of this trade (with both the etf decay and the option decay working against you)

Good luck with the trade!

Nov 10, 2009

Just curious why you think the Dow will fall over the next month - is it the high hit yesterday? I've already lost money on bear etfs and vix futures, and options. I've entered positions like this - and exited with losses - since early Sept, each time thinking that the market was finally going to tank. To justify the timing, there should be a technical element to this trade.

Nov 10, 2009

Technicals suggest a move higher in the Dow and lower in the DXD. I just have a feeling the other shoe is going to fall -- about a dozen times over the next month.

Nov 10, 2009

Trading the leveraged ETFs over a long time frame doesn't make sense. The nominal price of DXD has no meaning relative to the DJIA. DXD's price is entirely path dependent due to the fund only tracking the DAILY return of the underlying. Look at IYF (financial sector index fund)and SKF (2x leveraged inverse financial sector) in 2008.

IYF began the year at ~$92 and closed the year at ~$45.

SKF began the year at ~$104 and closed the year at... ~$103.

Shorting the financials in 2008 was entirely the right move, and if you attempted it by buying SKF, you made nothing.

I know you're only looking at a ~2 month trade, but the path dependent nature of DXD's pricing is something to be aware of.

Nov 10, 2009

1) You have not explained why you are bearish on the U.S. Equities market. I am surprised that you have spent so much time explaining the mechanics of the trade and not much explaining the thesis behind it.

2a) Though you have spent a lot of time explaining the mechanics of the trade, I would argue that it is nonetheless a weak trade. Based on how you project the level and trajectory of the VIX, volatility decay of leveraged ETFs can be significant.

2b) To give color to the comment in 2a, I refer you to the recent writeup of a reasonably strong trade in leveraged ETFs at VIC: http://www.valueinvestorsclub.com/value2/Idea/View...

Nov 10, 2009
HFAnalyst:

1) You have not explained why you are bearish on the U.S. Equities market.

This.

All HOW, no WHY - besides stock market isn't in line with fundamentals. To counter that argument, the stock market rarely depicts fundamentals. My rule of thumb is stocks are based on 10% fundamentals, 20% technical, and 70% perception/psychology.

But what do I know? I bet on money managers by reading their prospectus, looking for their tone and to see if they 'kill' their own ideas so that I don't have to.

I'm neither a perma-bear or bull, I'm just lazy. I own Manhattan RE, and though I can sell now and take a slight loss, I'm waiting for Sex and the City 2 to come out so all obese 20-somethings will rush back into the city to inflate my rent. In the meantime, the depreciation saves me a bit on taxes.

Nov 10, 2009

Hi,

I'm curious on your thoughts for shorting the Dow vs. shorting the S&P 500. Do you see more weakness in the larger caps? It seems that your opinion is that the whole market is not technically sound and that an investment in something like SDS might be worth looking into as well?

Nov 10, 2009

But I think the coming correction is going to be focused on that which represents the American market to the world, namely the Dow.

Also, I'm expecting negative news that could have a major impact, and I don't want that impact diluted over 500 different companies. We're in a very news-driven market cycle right now, and negative news is going to have the biggest impact on the top 30.

Nov 10, 2009

What are some good resources to learn how to trade options?

Nov 10, 2009
nufc:

What are some good resources to learn how to trade options?

http://www.optionmonster.com/

Nov 10, 2009

When the 10% fundamentals finally get through to the idiots making up the 70% of the positive perception in this sham market, maybe things can get back on track.

I'll take 80% any day.

As for all HOW and no WHY, read my posts over the past 6 months. They've been nothing but WHY.

Nov 10, 2009
Edmundo Braverman:

When the 10% fundamentals finally get through to the idiots making up the 70%..

You are correct, but let's not forget one thing. There is an exponentially higher amount of full-time idiots who'll never get it than there are shrewd investors. So even if your theory is sound, there is more dumb money in play than smart money.

I'm not just talking about the Jim Cramer cult et al, but myopic institutional managers (ala Harvard pensions) who forget that market cycles have been around since forever, yet stick to text-book rhetoric.

That's why I stick to a particular investor who's admitted in his prospectus that 99% of the time he never tries to predict, he simply reacts.

Who is it? Winner gets a bottle of Stacker 2. He's pretty famous and vanilla (clue)

Nov 10, 2009
hol3:
Edmundo Braverman:

When the 10% fundamentals finally get through to the idiots making up the 70%..

You are correct, but let's not forget one thing. There is an exponentially higher amount of full-time idiots who'll never get it than there are shrewd investors. So even if your theory is sound, there is more dumb money in play than smart money.

I'm not just talking about the Jim Cramer cult et al, but myopic institutional managers (ala Harvard pensions) who forget that market cycles have been around since forever, yet stick to text-book rhetoric.

That's why I stick to a particular investor who's admitted in his prospectus that 99% of the time he never tries to predict, he simply reacts.

Who is it? Winner gets a bottle of Stacker 2. He's pretty famous and vanilla (clue)

Jesse Livermore

Nov 14, 2009
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