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How to Cash in on a Down Market

The current market remains vulnerable to downside weakness, especially if the recession is longer and deeper than expected and if world economies continue to struggle. The DOW has fallen in 11 of the ...

The current market remains vulnerable to downside weakness, especially if the recession is longer and deeper than expected and if world economies continue to struggle. The DOW has fallen in 11 of the last 13 sessions, while the S&P 500 closed below 700 on Tuesday. The outlook does not look enticing at this time, as there could be more downside moves given that a valid bottom has yet to be established.

So, while the long side looks shaky, there are profits to be made from betting on stocks moving lower. However, unless you have ample risk capital and know what you are doing, the strategy of short selling is risky -- it entails very high risk should the market trend higher.

What you may want to do to benefit from the market decline is to buy put options. Versus short selling, put options require less upfront money and entail far less risk. For example, let's take a look at Cisco Systems, Inc. (NASDAQ/CSCO) at the current $14.52. Say you expect Cisco to fall by July. Note that this is only an example and should not be construed as an actual trade.

To short 100 shares of Cisco, the required initial margin requirement is 50% on the short position, or $2,178.00 (150% x $14.52 x 100 shares). And this money is at risk.

Alternatively, you're only required to pay the $208.00 premium if you buy the Cisco July 2009 $15.00 Put option. The $208.00 is also the maximum risk; whereas, you could lose an unlimited amount via short selling, since the price of the stock can rise indefinitely in theory.

In my view, put options represent a more prudent bearish strategy than short selling. Here's why.

A short seller simply borrows a particular stock that he or she does not own and sells it in the market at the prevailing price. For the strategy to pan out, the short stock must drop in price so that the short seller can buy it back at a lower price and replace the borrowed position with the registered holder. The problem occurs if the short position goes against you -- in that the stock rises instead of falling.

For example, say that you had decided to short Cisco and placed a short on 100 shares at $16.50. Now, let's assume that the price of Cisco rallies to $20.00 by year-end. At this price, you would have to short cover by repurchasing the 100 shares of Cisco at the much higher $20.00 in the open market and returning the shares to the holder. You would end up losing over about $548.00. Compare this to the buyer of the put option, who would have just lost the $208.00 premium.

Bottom line: short selling has more downside profit potential than put options, but the limited risk of put options far outweighs the extreme losses that short selling can generate.

The key in this market is to play the flow in stocks. Downside momentum such as what we are seeing now may be right for buying puts rather than short selling.

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Article Tags: Short Selling

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George Leong, B. Comm., Senior Editor at Lombardi Financial, has been a technical analyst for 12 years and a financial analyst for seven years. His overall market timing and trading knowledge is extensive. George is the editor of several of Lombardiís popular financial newsletters, including The China Letter, Special Situations, and Obscene Profits, among others. He has written technical columns for stock market news web sites, and he is the author of Quick Wealth Options Strategy and Mastering 7 Proven Options Strategies. Prior to starting with Lombardi Financial, George was employed as an analyst with Globe Information Services.

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