The Absolute Beginner's Guide to Making Triple the Profits in a Downturn

Stocks lurched lower yesterday as nervous investors digested an errant Trump tweet that threatened to blow up U.S.-China trade talks.

Those folks are losing sight of the fact that we're in a different, more dangerous fever swamp altogether - the Fed's "great experiment," cheap-money fever swamp. It's a bizarre place where it's perfectly normal for markets to tank by double digits in one quarter and soar by double digits the next after an announced rate-hike "pause."

Yes, cheap money is a hell of a drug.

Case in point: More than 20% of today's stock "buyers" are actually companies drinking their own cheaply financed, poisoned Kool-Aid.

Expect the resulting $270-plus billion in stock buybacks expected this quarter to push this "most hated of all bull markets" higher... because there certainly isn't a business case for going higher.

As stocks rise, investors are bailing out of equities, where some $132 billion recently left global stock mutual funds for the dangerously deceptive green pastures of the bond market.

Those "green pastures" are now the home of around $1.3 billion worth of horrible "leveraged loans," packing appallingly weak loan documents and egregious terms. These loans threaten to see hordes of bond holders ripped off; they'll be lucky to recover maybe $0.40 for every $1 of bad debt they've bought into.

The situation is so dicey that right now, as I write this, teams at Guggenheim and Blackstone's GSO Credit are furiously combing through these horrific bonds in an effort to create their own internal rating system; they're bracing for a tipping point in the equally absurd bond market.

But that's the new normal for you.

And today, I'm going to show you how to get ready for the next normal, when the Fed's cheap-money party ends and markets enter free fall.

If you're ready when this happens, you'll find just as much - if not more - profit opportunity around every corner.

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Buy into Strength; Make Money for the Melt-Up

At the moment, with the stock markets hitting what look like fragile, new global highs, country exchange-traded funds (ETFs) tracking markets like China, India, the Netherlands, Singapore, Spain, Switzerland, and others are on a roll.

Financial services are doing well across the board, so blended ETFs are doing well. Growth and income ETFs are favored at the moment on the large-cap side, but so are value/large-cap funds as the Fed's stimulus keeps puff-puff-puffing away.

Drilling down on the sector level, technology and utility funds are favored. On the bond side, corporate/preferred and government agency ETFs are performing, although some of this can be attributed to that flight to quality I mentioned as we approach a market top.

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Commodities have been weak, the U.S. dollar strong - use ETFs accordingly.

That's how to maximize your profit potential on the way up. All this could turn on a dime, though, with global markets as fundamentally unhealthy and unsound as these.

Expansions time out. While the current expansion is on track to be among the longest in American history, it will have a bookend. It will end.

The good news is there are a TON of ways to make money - and keep the money you have - in a downturn. There are hedging strategies, short-selling, options trading... it all depends on whether you want to be safe or make money as stocks and bonds go over the edge.

First Things First: Keep Your Portfolio Safe with Hedging

Portfolio hedging helps to manage risk as growth cycles peter out - especially after needle tops. When markets sell off big-time, correlations among traditional diversifiers rise, which renders diversification about as useful as the proverbial screen door on a submarine.

Stocks and bonds have climbed a wall of worry since the Fed lowered interest rates to zero after the Great Recession, and we have not heard anyone provide sound reasoning as to why these "diversified" allocations will not fall as fast as they rose, when interest rates rise and/or bad companies start missing their loan payments.

What goes up together can fall together, especially during periods of extreme market declines, and that's where hedging comes in. The Fed's unconventional monetary experiment has put traditional portfolios at risk. Let's say that again: The Fed's unconventional monetary experiment has put traditional portfolios at risk.

That makes hedging - and a healthy cash position - essential. It's what the professionals use to keep risk at comfortable levels and offset the pain when markets turn without selling out and incurring painful capital gains taxes.

Popular strategies to hedging portfolios, and to just flat-out make money when markets tank, include short selling, buying put options, and using inverse ETFs.

There's More Than One Way to Short a Stock

Shorting stocks (i.e. betting against them) is a highly effective strategy - but only for the most experienced investors.

I'll give you a rough idea of how it works, if only to illustrate my preference for using another strategy altogether.

When you "short" a stock, you are borrowing a stock you don't own with the intent of buying it at a lower price later. Simply stated, one "shorts" a stock if one thinks the price will go down rather than up.

This is very different from the traditional idea of going "long" a stock that you think will go up in price. When you go long a stock, say International Business Machines Corp. (NYSE: IBM), and you buy it at $100 a share, and if it scoots up to $150 a share, you're up $50, or 50%.

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Shorting is the opposite. When you go short IBM, you borrow the stock and sell it later at $100/share as per a contractual deal. Hopefully, the stock has dropped to $50 a share in the interim and you buy it back at that discounted price.

Thereafter, and as per your pre-arranged contract, you then sell that $50 stock to your contractual counterparty for $100. The result? You are again up $50 on every share.

After all, you bought it (back) at $50/share and you sold it "short" at $100/share. Only this time you doubled your money. When you sell the stock, you return it to the lender, thus "covering the short."

Nice job. In other words, you doubled up on the way down. Hedging via outright shorting can make you gobs more money than long investing in declining markets.

But all the borrowing, contracting, and counter-party arrangements discussed above reveal how complex such a trading strategy can be for everyday investors.

And it is risky: Remember, the Fed is out there pumping up stocks with cheap money, and even if they weren't, there's no real limit to how high a stock can go. I'll show you how in a minute, but it's important for every investor to appreciate that short-selling can expose you to limitless losses.

Hence my preference is for using put options as both a hedging strategy in volatile markets and a profit strategy in falling markets.

What You Need to Know About Put Options

Buying put options may sound sophisticated, but now that you understand short selling, it's a piece of cake and a whole lot less risky.

Let's recall: When we shorted IBM, we sold it at $100 per share, right? And if it went down by 50% (to $50 a share), we made $50 a share on the trade, or 100%, right?

All good, right?

Well, it could've easily gone the other way.

Let's say we shorted IBM at $100 a share and it went up (not down) by 50%. Uh-oh.

In this example, the trade went against us. We sold the shares at $100 a share and covered the short by buying the shares back at $150 per share. That means we bought at $150 per share and sold at $100 per share, so we lost $50 a share on a $100 per share cost - or 50%.

That could be a bunch of money.

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When we buy a put, however, the trade is infinitely less dangerous if the trade goes against us and is far simpler to transact.

Take the IBM example of using a put option rather than shorting the stock.

With a put, we pay just the premium associated with the put. Say that's a $10 per contract (contracts generally come in 100-share denominations). In the case of put options, that $10 is our "premium," or cost - no matter what happens.

If things go our way, and IBM goes down by $50 a share, we sell the put and are up by $50 a share (minus the cost of the put) - a small price to pay for such a whopping gain.

If, however, IBM sadly goes up by $50 a share, we simply let our $10 contract/premium expire worthless, so we've lost just $10 on a 100-share contract - not $50 per share for 100 shares had we shorted the stock ($50x100 shares = $5,000).

By buying puts, we hedged, and the hedge only cost us $10, not $5,000 if we had shorted. And herein lies the power of put options when markets fall. (The same is true of call options when markets rise.)

Still sound complicated?

No worries, because when the time comes, I'll be letting my Critical Signals subscribers know when to buy puts in a meltdown and calls in a melt-up.

(By the way, you can click right here to subscribe to my research for free - no charge whatsoever.)

There's one more money-protecting, profit-making meltdown tool we can use...

Here Are the ETFs to Buy in a Meltdown

Inverse exchange traded funds (ETFs) are designed to move in the opposite direction of a benchmark or index, by the inverse (commonly denoted "1x") or even by leveraged inverse multiples of two or three (usually "2x" or "3x").

Used as a hedge or an outright "shorting strategy," an inverse ETF on the S&P 500 is designed as a simpler way for a position to rise by 1% (or 2% or 3%) when the S&P 500 falls by 1% (or 2% or 3%).

Inverse ETFs that short the markets broadly or narrowly can make you a bundle - especially leveraged inverse ETFs. Inverse ETFs include the ProShares Short S&P 500 ETF (NYSEArca: SH), the ProShares Short Dow 30 ETF (NYSEArca: DOG), and the ProShares Short QQQ (NYSEArca: PSQ) which tracks the inverse of the Nasdaq Composite. These are all "1x" flavors.

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ProShares Ultrashort S&P 500 ETF (NYSEAcra: SDS) provides 2x exposure (and hence risk). And if you believe the markets will tank big time, straight down, the ProShares Ultrapro Short S&P 500 ETF (NYSEArca: UPRO) offers 3x downside leverage.

Inverse ETFs are much easier to understand and deploy for most investors, and unlike put options, they have no expiration date - there's no need to get approval from your brokerage, either.

Here again, inverse ETFs will be just one of the tools I'll recommend for my Critical Signals subscribers. We'll be choosing from instruments like...

The Most Important Thing to Remember in a Meltdown

Consider what's right for you. Keep it simple.

No worries, because when the time comes, I'll be letting my Critical Signals subscribers know when to buy puts in a meltdown and calls in a melt-up.

Again, you're invited to subscribe to my free Critical Signals research; we're going to be targeting huge returns there.

Short selling can be enormously profitable in a meltdown, but it can cause you to lose more than you invested, conceptually leading to unlimited losses as price goes against you.

Put options solve the unlimited loss problem but come with their own quirks, rollover requirements, and other complications.

Inverse ETFs are by far the easiest to understand and deploy for most investors. No special accounts. No margin requirements. The maximum loss cannot exceed the value of the ETFs you buy. Plus, inverse ETFs are designed to hedge or short stock indexes and individual sectors including stocks, bonds, currencies, and commodities.

You can certainly reduce your risk by selectively, intelligently deploying these tools, but risk can never be eliminated - anyone who says otherwise is a fool, or selling something you don't want to buy. Make sure you're familiar with your own risk tolerances; be clear-eyed and honest about your financial goals and wherewithal, and you likely won't go wrong, even in the worst markets.

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About the Author

25-year run as a hedge fund portfolio manager, family office chief investment officer, managing director and general counsel. Internationally recognized expert in credit and equity markets as well as macro risk management.

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