3 Ways to Short This Market

Chris is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The markets may have encountered more than turmoil – could this be the beginning of a new bear market?  The S&P 500 traded well above 1,460 last Thursday before falling to close the week at 1,433.  As the markets fell on Friday, the VIX spiked 13.5% to end the week at 17.06.

With the Presidential election two short weeks away, I think the markets may stay stable until a winner is declared.  However, the markets can rise or fall at a moment’s notice.  If the markets do begin to falter, it would be wise to move to cash or to go short.

If you have the gumption to go short, here are three major ways to profit from a market correction.

Leveraged ETF

Leveraged ETF’s carry much risk – but the payoff can be great.  Pro Shares Ultra S&P 500 (NYSEMKT: SSO) is one example.  The ETF tracks double the daily performance of the S&P 500.  If the S&P goes up 2% in one day, then SSO will rise approximately 4%.

Instead of buying an inverse ETF, one that would rise as the markets fall, shorting a leveraged ETF has an advantage: It is more likely for leveraged ETFs to fall than to rise.

Example 1:

Starting Index Value: 100

Day 1 Rise: 2%

Day 1 Final Value: 102

Day 2 Fall: 2%

Day 2 Final Value: 99.96

Example 2:

Starting Index Value: 100

Day 1 Fall: 2%

Day 1 Final Value: 98

Day 2 Rise: 2%

Day 2 Final Value: 99.96

In both cases the market returned and lost 2%.  However, in both examples the ETF is also worth less than the original price.

Commodity Tied to the Market

While not matching the S&P step-for-step, United States Oil (NYSEMKT: USO) has seen peaks and valleys that have roughly tracked the S&P.  For example, during 2011’s pullback, oil and the S&P both bottomed at approximately the same time, around Oct. 3.

During this summer’s pullback, both markets bottomed around the same time, but oil was hit harder than the S&P.  If the economy sours, expect two events to happen.  First, stocks will drop.  Second, oil will drop as the consumer and commercial sectors consume less energy.  This reasoning makes oil an interesting short play.

One note of caution: Remember that the oil cartels have a strong grip on prices and can drastically influence the oil supply, affecting prices.

<img src="http://media.ycharts.com/charts/9ab4b815837a55b99b2e87716398ba27.png" />

SPY Total Return Price data by YCharts

Short Stocks

Shorting stocks is far more of an art than it is a science.  However, here are two strategies to use when shorting stocks in a bear market.

Short fundamentally weak companies

Hewlett-Packard (NYSE: HPQ) is a great example.  H-P is a good company, and I believe that CEO Meg Whitman will eventually turn it around.  However, H-P has been an awful stock. 

The stock lost 45% of its value YTD and currently has negative earnings of $2.81 per share (data as of quarter ended July 31, 2012).  Further, the company is bleeding value with a -4.5% profit margin and a -15.6% return on equity.  Finally, the company’s net debt is overbearing, with $29.8 billion in debt compared to $9.5 billion in cash at the end of last quarter.

Short companies with high P/E ratios

Amazon (NASDAQ: AMZN) and Netflix (NASDAQ: NFLX) fall into this category.  Trading at $240 and with earnings of $.82 per share, Amazon has a larger-than-life P/E ratio of 292.  Further, Amazon’s forward P/E sits at 100.8.  Finally, Amazon is not all that profitable, showing a profit margin of .69% and an operating margin of 1.17%.  If the broad markets fall, they will likely bring Amazon’s P/E ratio down to earth and put it more in line with other tech stocks.

Like Amazon, Netflix is highly valued – at 37, Netflix’s P/E sits above its peers.  Also, Netflix’s earnings for Q2 fell 91% from the same quarter one year earlier, according to Yahoo! Finance.  Lastly, the company is not forecast to do much better.  The company’s forward P/E is 76.4, indicating more upside to the stock, lowered earnings, or both. 

Netflix reports earnings on Oct. 23 – reporting above analysts' dismal expectations would likely boost the stock.  However, a drop would cause investors losses.

Your Call

If the markets take a nose dive, going into cash would provide safety, but shorting the market would add to profits.  Shorting the broad market indices are a more conservative strategy.  However, targeting leveraged ETFs, commodities, and weak stocks could produce far higher profits, adding to 2012’s already spectacular gains.

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ChrisMarasco has no positions in the stocks mentioned above. The Motley Fool owns shares of Amazon.com and Netflix. Motley Fool newsletter services recommend Amazon.com and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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