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It was a pretty brutal week in the markets this week, especially for the long investors.  The Dow Jones lost 2.8% for the week.  The S&P 500 lost 3.2% and the Nasdaq was off even more at 4.7%.  In markets like this, hedging the downside is crucial, as is maintaining cash reserves.  The cash reserves can be used for modest returns (2-4% in treasuries or CD’s) and is also very handy to buy deeply discounted stocks after a vicious week like the one that just ended.

The volatility index (^VIX) closed up over 12% for the week.  It topped out at 24.67 and now sits at 23.06, a healthy and potentially profitable level for outsized returns by SELLING options.  Covered calls are one way to play the increased volatility.   But selling puts can be just as effective.  There are two methods of selling puts – naked and covered.

Recall that the buyer of a put has the right to SELL shares of the underlying at a predetermined price, for a predetermined duration.  That means that the seller of a put may be forced into buying the shares that the put buyer is PUTTING to us.   The best time to sell puts is when volatility is high (as the shares go down, volatility generally increases), and when you are willing and able to purchase the shares at a later date, and for a lower price, if they are put to you.  Let’s explore the idea, using some of the Dow Jones components as examples.

Exxon Mobile (XOM) closed the day at 75.62.  The September 75 puts traded last at 1.36.  If you sell to open (1) contract of the XOM September 75 put, you will bring in a credit of $136.  By selling the put, you are granting the buyer the right to force you to buy 100 shares of XOM for $75 per share, or $7,500.  For this reason, most brokers will require you to maintain $7,500 of cash or margin in your account to cover the potential purchase for as long as the put contract is open.  As long as XOM remains above $75 through September expiration, then you will not be forced to buy it for $75, and that initial credit of $136 is yours to keep.  If XOM goes below $75 prior to September expiration, then you may be forced to buy 100 shares for $7,500.  However, in this case, when factored with the initial credit of $136, your effective purchase price is only $7364 (7500-136 initial credit).  If you liked XOM enough to buy it at $75.62, then in many cases it makes sense to sell a put in lieu of buying the shares outright.  The risk of selling the PUT when compared to buying the shares, is that any significant rally in XOM shares goes on without you.  Your maximum credit by selling the put is only $136 in this case, regardless of how high XOM goes.

As another example, consider Boeing (BA).  It closed today’s session at 62.89.  The September 60 put last traded for .90 ($90 credit per contract).  The October 60 put last traded for 2.00 ($200 credit), and the October 55 put last traded for .80 ($80 per contract).  If you are willing to own 100 shares of Boeing for $55 or $60 per share anyway, then selling one of the September put contracts in lieu of buying the shares may work in your favor.  By selling the puts, you may be forced to buy the shares at the agreed upon price (strike price), but if not, the initial credit is still yours to keep anyway.

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen

Note and Disclaimer: examples used are arbitrary and not recommendations.

“Professional” hedge funds may not know how to hedge properly in these markets, but that doesn’t mean you shouldn’t know. The 2008 market is shaping up to be quite the roller coaster ride.  Just for today, the major indexes are already down over 2% each. But down markets are no reason to worry and panic over your positions, *IF* you know how to properly hedge.

There are several ways to protect your investments, but the exact approach you take depends on your portfolio, your degree risk aversion, and your own style.  Some methods include:

• Taking on Dow or S&P Index Puts to protect your long positions
• Playing the market through pair trades – a balance of long and short positions.  Or take on a short index while going long one of its components.
• Using covered calls to limit downside risk on the securities you own
• Implementing collar trades to protect your positions – Buying put protection on your long positions, and partially or fully funding that purchase by selling out of the money covered calls on the same position.
• Offsetting your long positions with short index positions, such as Proshares or Rydex short ETF’s.

But all of these methods require knowledge and experience to use effectively.  Stock options are a great tool for protecting your positions, but using them improperly is a sure way to damage your portfolio even more.  Education is key to using stock options properly.  If you are disciplined enough to learn on your own, then here are a few recommended books to help you master the art of options and portfolio protection, and also help you sleep better at night:

Covered Calls and LEAPS–A Wealth Option + DVD: A Guide for Generating Extraordinary Monthly Income (Wiley Trading) by Joseph R. Hooper

Options as a Strategic Investment by Lawrence G. McMillan

Put Options : How to Use This Powerful Financial Tool for Profit & Protection by Jeffrey M. Cohen

If you are not familiar with the Prophet.net Industry group rankings, you should re-read the following post:

• Sector rotation and industry ranking information free for everyone

From today’s view of the industry group rankings, it looks like sector rotations are going full speed ahead.  The chart below shows several industry groups with new money going in, such as:

• Education and Training services – Apollo Group (APOL), Career Education (CECO), Corinthian Colleges (COCO), Devry (DV)
• Dairy Products – Dean Foods (DF), Lifeway Foods (LWAY), Synutra International (SYUT)
• Research Services – Advisory Board Company (ABCO), Albany Molecular Research (AMRI)
• Healthcare Info Services – Cerner (CERN), Eclipsys (ECLP), Quality Systems (OSII)

The stocks and symbols listed above are just a few samples from within the industry groups that have significant and recent improved rankings.  As always, these are just examples, and NOT recommendations for action.

Ospraie Management recently announced to investors that its fund was closing due to substantial losses of 38.6% so far this year, according to The Guardian.   For the month of August, it lost a staggering 26.7%.

Dwight Anderson is was the manager of the Ospraie fund, and in an apologetic letter to shareholders, he blamed the losses on a “very difficult year” and a “sell off in energy”.  Apparently, Dwight did not get the memo stating that hedge funds are SUPPOSED TO make money in both rising and falling markets.

Recommended reading for Dwight Anderson:

• It’s a “Market Sum” game
• Fooled by Randomness
• Value at Risk
• When Genius Failed

Today’s market is proving to be very interesting.  The Dow Jones was was up over 2% for the day and the S&P 500 was up over 1%.  With just 15 minutes left in trading, both indexes are in RED territory (-.4% for the the dow and -.6% for the S&P).  But if you are a short term trader, today proved to be a perfect day for watching the VIX indicator and getting out while the getting was still good.

Under normal circumstances, volatility goes up as the market goes down because traders are willing to pay a higher premium for option contracts when they expect a bounce back from the lows.  Similarly, volatility normally goes down as the market continues upward.  Take a look at this 1 day chart of the S&P 500 and the VIX index.

Take special note to the circled area.  Notice that even with the S&P 500 up over 1%, the VIX was also up about the same 1%.  The VIX can be an excellent indicator of investor/trader sentiment, and today’s chart clearly shows, according to the VIX, that traders were not buying into today’s early rally.  At 12:00pm the VIX started it’s path toward the 2% daily gain mark, as the S&P slowly tapered off the 1% gain mark.  That early warning would have been an excellent opportunity for short term traders to heed, and protect their positions.  In fact, most traders did exactly that as we can see from the late day losses in the market.  The crucial key to day trading the markets is to see the early sentiment warning signs and beat everyone else to the exit door.

Take a look at the 7 year chart of the U.S. dollar vs the Euro below.  The dollar saw a triple top in the 1.15 range between late 2000 and early 2002, and has gone steadily down ever since.  But that decline may be on the verge of a significant and long lasting recovery.   Are you prepared for the dollar recovery?

There are many reasons why a currency can become weak over time, and the United States has had significant factors justifying a decline in the dolalr, including:

• Prolonged and costly wars in Afghanistan and Iraq
• Fiscal recklessness and runaway deficit spending
• Large debt to GDP ratios
• Huge trade imbalance – trade deficit
• Low federal funds interest rates (currently just 2%)

While all of these factors have indeed impacted the dollar over the last 7 years, it is important to realize that currency analysis works in pairs.  It’s not enough to justify a weakened dollar on its own merit.  The dollar weakens or strengthens only in relation to other currencies.  And often times the extent of a weakening currency (dollar) can be overdone due to perceived values. The United States currency decline may have been overextended due to several factors including:

• United States budget and debt statistics are freely available to anyone around the world, making it convenient to target United States fiscal recklessness and ignore other currency problems.
• By many accounts the housing weakness and bank failures started in the United States
• Multiple dollar doomsday books available such as the Demise of the Dollar, and The Collapse of the Dollar.

But eventually the currency traders will realize that for every problem pointing to a dollar decline, there are just as many or more pointing to an even greater chance of a euro and pound collapse.  Consider these facts:

• From Nationmaster, the United Kingdom debt per GDP ratio is a staggering 387%.  France has a ratio of 173%, Germany 144%, Greece 148%, Ireland 758%, Italy 117%, and Finland 135%.  Those staggering figures make the United States ratio of “only” 86% seem less atrocious.
• The United Kingdom chancellor of the Exchequer, Alistair Darling, recently stated that the U.K. economic environment is the most difficult in 60 years.
• Forbes magazine recently predicted the Demise of the Euro.
• On a lighter note, the Big Mac purchasing power parity indicator points to a strengthening U.S. dollar as compared the euro and pound.

If you believe that despite the U.S. fiscal problems, the dollar will still lead a prolonged recovery against the euro, pound and other currencies, then here are a few ways to play it:

• The Rising U.S. dollar ProFund mutual fund.  (symbol RDPIX)
• The Rydex Strengthening Dollar 2x fund.  (symbol RYSBX)
• Powershares DB US Dollar Index Bullish Fund.  (symbol UUP)