October 10th, 2008

How to Play a Recovery Bounce

On June 28 in “How Do Ultrashorts Work?” if offered some charts depicting the relationship between the Proshares Ultrshort etf’s (SDS, TWM and QID) and the underlying market indexes (S&P 500, Russell 2000 and Nasdaq). Almost 4 months have passed and the market is down about 30% (as measured by the S&P 500). What happened to the double shorts? I can sum it up in one word – “Amazing!” [By the way, I learned that these etf’s pay dividends so I adjusted their prices for cummulative dividends paid.]

  • S&P 500 (SDS)
  • Nasdaq Composite (QID)
  • Russell 2000 (TWM)

Just look at the percentage moves, 60% increases as the indexes dropped 25-30% – just the way they were supposed to. If you’re wondering whether I acted on what I felt strongly would happend I must confess “yes and no”. I did have positions (I was chicken so weren’t that significant) for most of this decline (chicken again, I sold at the end of last week).

Many are asking “what should I do now?” First you have to take an strategic stance and mine is that the market isn’t going to decline to zero, we may not even go to the 2002 Tech Bubble Crash low. The 1987 crash cost 27% over three days, this time it took 2-3 weeks. In 1987, the recovery 6 months and then onto a huge bull market. This crash will recover too even though we can’t see it or imagine it today.

One strategy for you to consider is trying to trade the bounce/recovery. In the same way that these etf’s rocketed as the market collapsed, you could buy put options, sell them short or, my preference, by their mirror image, the double longs; mirror image of the SDS is SSO. I’d also look at the severly damaged regional banks and a resurgent in the commodity trade (oils, fertilizer, steels and other metals, mining equipment, farming equipment). The world isn’t going to come to an end although it looks like that might be just around the corner.

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