There are a lot of theories about how to play the current market. Some are predicting Armageddon. Others think this is the mother of all bullish trade opportunities. Then there are those who think it's best to stay out of the market altogether. Very few of these theories provide a sound strategy that allow you to take advantage of your thesis without risking a major chunk of your portfolio.
Here are five sound strategies and how I would employ each one with the idea of staying solvent, while allowing you to "play" without risking your financial future.
1. The "cash is king" strategy.
The simplest, low risk and stress-free way to play this market is to sit back and let everything play out. Only once "normal" trading patterns present themselves should capital be deployed. You won't make anything, but you will have plenty of ammo once it's time to play.
2. Short like there is no tomorrow, but with a safety net.
There is no question that our economy is in horrible shape, and technically the indexes are still far away from multi-year support levels. If you think these levels will be reached, go ahead and short. However, make sure manage entries and risk. Bear markets can have unbelievable bounces before heading lower. Make sure not to get caught in one, and if you do, make sure to get out before it hurts you. I would not risk more than .5% on any trade. Entries on pullback will also help limit risk.
3. Catch the falling knife, with padding.
It's always risky going against a bear market trend. However, if you manage risk, you can take a bunch of small losses and still make money if the market reverses or bounces strong. For instance, you could take 6 losses of .5 percent and still make a lot of money if we get a major bounce in the coming days and weeks. The last five 2008 bear market bounces in SPY all averaged over 7 percent.
4. Go "all in" with a slice of the portfolio
So you are sure the market will scream higher and don't want to worry about managing risk or getting stopped out of a good trade. At the same time, you're scared of being wrong and losing it all. Take a percentage of your portfolio and go for broke with that small slice.
For instance, let's say you have $100,000 in your account and are willing to lose 10 percent of it. This number can vary according to your own risk tolerance and personal financial situation. Take $10,000 and put it to work. For simplicity sake, let's say you only are trading one position, SSO (leverage long S&P). You set $40 as your entry with a target of $67, which is the 200 day moving average. The most you could lose on this trade is $10,000. You will still have $90,00 when all is said and done (though it's hard to imagine that happening--SPY going all the way to 0). If your target is hit you make $6,700. Thus, you're either going to end up with $106,700 or at the worst, $90,000.
Note that this still is not a good risk/reward ratio, though the probability for this trade hitting $106,700 is greater than dropping to $90,000. How do we increase the reward-risk?
5. Put a bigger percentage of the portfolio to work, but risk only 10 percent
Let's take the same SSO trade. This time, instead of only putting 10 percent of the account to work, we use the entire $100,000, buying 2500 shares at $40. The target is still $67. Now, if you are correct, you will make $67,500. To make sure you don't lose more than $10,000 of the $100,000 stake, you must place a stop 4 points from entry. Thus, you would be stopped out if the stock hits $36.
We have turned the reward/risk on it's head. Instead of the negative reward to risk from strategy 4, we have a positive 6:1 risk to reward! The upside is now $167,000 instead of $106,700, while the downside is still only $90,000.
I know it sounds like the only way to go, but there are two major negatives to this strategy:
*If the market did something completely unexpected (As Nassim Taleb would say, a Black Swan event), and SSO gapped down 20 points in one day, you would lose half your account ($50,000).
*You are forced to use a tight stop to maintain proper risk management. This could take you out of a trade that ultimately goes your way.
Note: For strategy 5, I personally would risk a "cumulative" 10 percent of the portfolio, but not with one position. I use one position in the example of simplicity.
While all five of these strategies are very different, they all are viable and will likely keep you solvent. In this market, limiting risk and maintaining the necessary chips to play once we have aces is vital. Don't make any big bets without proper trade and risk management, and trade safely.