Manutius (< 20)

Trading during the correction using contra ETFs

November 17, 2010 – Comments (5) | RELATED TICKERS: DOG , SH , RWM

Investors Business Daily placed the market in general "in correction" in today's issue.  Instead of remaining completely in cash, I have decided to try a scaled-up version of investing in Contra ETFs this time.  I have dabbled in them before and the campaign I'm beginning here might be thought of as an engineering prototype:  I'm not betting the farm; just a few acres of it.

Contra ETFs have as their objective to match the inverse of the daily movement of a specified index.  For example, DOG is a contra ETF for the Dow 30 Industrials index.  If the Dow goes up, DOG falls in price by almost the same percentage.  If, as the buyer of a contra fund hopes, the Dow goes down, DOG goes up by almost the same percentage.  The management fee represents a (small) leakage.  Because the fund is "rebalanced" every day, gains and losses are not compounded exactly as one might wish if there are many consecutive days of losses: the gains in the contra will fall behind.  But for short periods, if the downtrend is persistent, the contra will track the inverse of the downtrend pretty well.  In short, it is a way to "short" an index by going long the contra fund.  The trading technique is quite legal within an IRA (although clearly in violation of the "spirit" of the prohibition against shorting within an IRA).  As a true red, white and blue A'Merkan boy, I applaud the continued invention of new and improved ways to evade the pettifogging restrictions our government feels compelled to save us from ourselves.

At any rate I am taking five modest positions in selected contras, which I let VectorVest pick for me.  I used the simplest of screens:  relative momentum ascending.  I have learned from experience that all of the big gains with contras come early in the downtrend, as the market is dropping like a stone.  At the bottom of the correction when the market begins to whipsay and trade sideways, the opportunity is over.  So a "self-liquidating" campaign portfolio is the ticket: you pick up a basket of contras as soon as you believe a correction is in progress (praying that it will continue), get out fast if you are wrong, and if you are right, selling out at a profit of around 8-10% without replacing your position.  What you don't want, is to be caught with a contra ETF when the market comes out of correction:  the indices will tend to recover explosively and if you aren't out, you'll give up anything you gained.

The reason you use mopmentum ascending is that you want to pick up the laggards.  If this turns into a full-blown correction, it has already been in progress for a few days.  The "leaders" (i.e., the indices that are leading the downward charge) have already dropped a fair piece.  In a correction, ALL of the indices will drop: by buying the laggards, we hope to capture more of the correction than if we chased the leaders.  I've backtested this on paper (as have others) and it seems to work.  The five contras I bought are DGZ (gold), DOG (Dow30), SH (S&P 500), PSQ (NASDAQ 100), RWM (Russell 2000).

As part of my ongoing education in using options, instead of buying RWM outright, I purchased a couple of calls ( the December 2010 strike 35, to be precise.  I chose between the 35 and the 36 on the basis of pricing model: the 35 seemed to be selling at less of a markup to the computed "fair price". (I ended up paying too much for them anyway.) For about $330, I control 200 shares of RWM (about $8500) and any upside that may develop, while my downside isstrictly  limited to the $330. Since I had intended to buy around $8000 worth of RWM anyway, this is clearly a conservative use of options: making the bet I had intended to make anyway, but putting a lot less money on the table.  I like this idea for risky propositions like contra ETFs.  The downside is that I've already learned that options, in general, are less liquid than outrights:  the spreads tend to be large so that you may have to wait a while to get your price.