Reasonably Thinking

Quote from John Hussman on Monday:

Many investment professionals have developed a habit of forming expectations based on nothing more than extrapolation of short-term trends in the data, even when those extrapolations are inconsistent with market history or well-established economic relationships.

Quote from Laszlo Birinyi on Thursday:

If the market is continually picking black, picking red is not necessarily a good idea.

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I’m bearish on the stock market because I believe the US economy has the potential to encounter hardships in the near future, and valuations are too high.  Even though some advisors continue to play the momentum game (Birinyi above), I would like to believe that a little a leg work will be rewarded.

To execute this line of thinking, I sold three bull put spreads on SDS (-33+26 Sep10).  SDS performs 2x the daily direction of the S&P 500.  Since I believe that the S&P 500 will go down, SDS would then go up.

Dissecting the put spread…

Sold SDS 33 Sep10 P @ $4.22

Bought SDS 26 Sep10 P @ $0.74

Possible outcomes:

• If the market falls only slightly by September, SDS will close at $33 or higher.  In this case, both options would expire worthless, and I would then keep the proceeds of today’s trade:  $1,028.97.  This is the difference between the sale of the $33 strike option ($4.22) and the purchase of the $26 strike option ($0.74) minus a commission.  (Remember that each option is worth 100 shares, and I sold 3 option contracts; $3.48*100*3-$15.03 = $1,028.97).  Even if the market tanks and SDS significantly increases, my maximum gain is $1,028.97.
• Perhaps my thesis is wrong (the trade moves completely against me), and SDS falls below $26 in September.  I now owe the difference between the $33 strike that I sold and the $26 strike that I purchased ($700 for each spread, meaning a total of $2,100).  The $2,100 loss would be offset by the $1,028.07 already in hand, so my maximum loss is $1,071.93.
• Now, let’s say that SDS ends up somewhere in between $26 and $33.  I could win or lose depending on where it ends up.  My Breakeven point is $33 – $3.48 = $29.52.  Now add a fraction to account for commissions to make the breakeven $29.57.  So above $29.57 I make money, below $29.57 I lose money.