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Who’s Next for a Sucker Punch?

Despite all the feel-good holiday joy that propelled the major stock market indexes to record highs in December, this month has been considerably less forgiving judging by the drubbing several retailers took this week after reporting disappointing holiday sales. Leading the downward charge were Macy’s (M) and Kohl’s (KSS), each declining roughly 10% this week after reporting a 2% drop in sales.

I can’t say I’m surprised to see the market react so severely. In fact, in last week’s column I anticipated that many investors would lock in their gains in early January, “perhaps setting in motion a rush for the exits.” That already seems to be the case for the retailers, so the obvious question is who’s next?

The answer is who isn’t next. To give you an idea of just how unbalanced the stock market has become, according to my IDEAL stock-rating system, only one stock in the entire Standard & Poor’s 500-stock index scores a perfect 10, while 33 stocks now have the lowest possible score of 0. That is the most lopsided the ratio has been since I first introduced IDEAL more than two years ago.

That may be bad news for index investors who are fated to receive whatever overall return the stock market dishes out, but it’s good news if you know how to use that information to your advantage. All investors understand the basic notion of buying low and selling high, but not nearly as many are comfortable executing that process in reverse. However, you don’t have to engage in risky short-selling strategies to make money when a stock loses value; instead, you can capitalize on overvalued companies by buying put options on them, which may sound complicated but is actually quite simple.

For the uninitiated, a put option gives its owner the right to sell, or “put,” a specified amount of stock at a pre-determined price within a certain time frame to another investor. That means the buyer of the put option is betting on the price of the stock declining, while the seller of that same option believes it will increase. The total financial risk to the buyer of a put option is only the cost of the option, plus whatever transaction fees the broker executing the order charges.

You can make a lot of money buying put options if you correctly predict that a stock’s price will tank. For example, last month I advised readers of my trading service Systematic Wealth that I thought shares of Cintas (CTAS) were overvalued and ripe for a fall. One week later the company announced disappointing quarterly earnings, resulting in an immediate 5% share price drop.

Short sellers of Cintas would have realized that 5% price change as a profit, which is a nice gain in only a week. But put buyers made much more than that. In fact, one of my followers wrote: “I only bought 2 (put) contracts of CTAS and sold them this morning when it started back down. All in all an 84% profit in just 11 days. Thanks for the Christmas present!”

I believe there will be many more “Christmas presents” like that one delivered in the weeks and months to come, especially when year-end earnings reports get released en masse later this month. While avoiding stocks about to nosedive is certainly one way to enhance your investment returns, knowing how to make money off of them is an even better way to improve performance. If you’d like to know more about how you can put this simple and effective strategy to work for you, please take a few minutes to review the Introduction to Options guide I’ve put together.


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