By David Popper
We are now veterans. Anyone who has traded for the past three years has witnessed a complete market cycle and the panorama of emotions that go with each phase. I have felt every emotion from giddiness to frustration over this time. Even though I understand many aspects of the market, I constantly have to fight the emotions that would influence me to behave in an irrational and detrimental manner. There are times when it pays to step back, look at the big picture and evaluate anew what is really going on in the market. This is one of those times. First, we now have experience. There will be a certain security that we will have when we see similar market action in the future. Second, we have another chance to trade those great stocks at an extremely long-term entry point, once the market gives us the green light. Below is a personal antidote that may shed a bit of light on what will eventually happen in the market.
In 1992, Hurricane Andrew visited Miami, Florida and caused horrible damage. The hurricane not only destroyed several billion dollars of property, it also caused several economic winners and losers. The insurance companies, of course, were losers in the aftermath as were people who were inadequately insured. The construction industry was a huge winner however. Hurricane Andrew created an economic boom for certain sectors of the economy. This hurricane altered the lives of everyone. For those who were prepared, the hurricane turned out to be a good thing. For those who were not prepared, the hurricane was devastating. We too are surviving a hurricane. This economic hurricane is called the Bear Market of 2001. For those who are prepared and protect their cash, this is the opportunity of a lifetime.
After Hurricane Andrew, I traveled often to Miami. I was an attorney ired by a large insurance company to evaluate their exposure and defend any lawsuits that emerged. I noted the bustling of activity. Contractors from all over the country were trying to get their piece of the pie. I noted that several million yards of carpet were sold over an extremely short period of time. By 1994, most of the construction was done and the carpet market went down the tubes. People were terminated as companies struggled to stay in business. The outlook appeared dismal.
Three years later, however, people needed carpet again. Businesses were profitable again. The business just had to go through its cycle. At the lowest point of the business cycle, astute investors bought many of these businesses from owners who just did not realize that the economy would turn in their favor in due time. Those astute buyers made a fortune.
Likewise, all of this discussion in the tech industries about the "lack of visibility" will eventually be replaced by optimistic reports by analysts. There is still a lot of internet infrastructure to build and rebuild. The internet is not going away. The infrastructure is just temporarily overdone. The great tech companies that we know and love will eventually have their day. Those that have cash at that point will have the opportunity of a lifetime. The good news is that you don't have to guess the bottom to make a fortune. Remember October 8yj, 1998? The market "crashed" for the second time in 45 days, but it turned out to be the bottom. Stocks then began to rocket. Those who waited for "all clear" signals and waited until November did not miss too much.
Here is the dilemma. The lower stocks go, the more attractive they seem. However, because everything that seems cheap today is 10% cheaper next week, I have become gun shy. The Investor's Business Daily recommends that an investor stay out until a bottom is clearly formed, and that is probably good advice. The problem, however, is me. I like to be in the market when it explodes, but what happens if stocks go down 50% from here? If that happens, I lose my opportunity of a lifetime. So how can this dilemma be resolved? Options can help.
I can buy stock and buy puts. This gives all of the potential upside of owning the stock, plus crash insurance. I could also just buy a small number of calls. This would provide substantially the same upside potential but at only a small percentage of the risk. In this kind of market, if a call cost 10% of the actual stock, it is the equivalent of setting a 10% stop on your stock. Additionally, if the stock dips, the investor who owned stock would be out. You would still be in just in case the market turns around. As you know, however, if the stock is at or below the strike price at expiration, the option expires worthless.
The question now arises, what duration and what strike price to pick? This is a hard question. Longer term LEAPs can cost a lot more, but you have additional time. It is really a personal decision.
Purchasing a few calls is a great way to be "in" the market without waiting for the bottom to form. You may catch the bottom and make substantial profits. If you are wrong, however, you have not bet the farm. You are still in position to take advantage of the upcoming opportunity of a lifetime.