I remember the first time I read about covered calls, aka a buy-write, I thought it was the stupidest strategy.  Capped upside and unlimited downside don’t seem like a good combination.  Then I learned a little more about position sizing and how to set a constant risk amount so that you don’t just view risk as how much capital you put up to establish the position.  That made the unlimited downside part a little more manageable.

Recently I’ve been reading more about real estate (related to the fact that I need new investment ideas) and getting a much better grip on controlling cash flow.  With a far better grip of expectancy analysis over when I first learned about covered calls, they’re actually starting to seem interesting to me when viewed as cash flow.  After rereading chapter 2 in the McMillan options book as a refresher, I think I may start to dabble in this a little.  I don’t know if I’ll actually follow through on this, but it may add some different types of stocks that I look at in the future.

Also, since it’s just matching the daily movements of the index, over the long run that doesn’t quite work out due to compounding.  Say you started both funds at $100, one which is a double short of the other.  If the index goes up 1%, the double short goes down 2%.   After the first day, the index would be $101 and the ETF would be $98.  If the same thing happened a second day, the index would be $102.01 and the ETF would be $96.04.  Now let’s say the index goes back to $100 on a 1.97% drop; the ETF would go up 3.94% and end up at $99.82.  That’s minor right now, but over the long run it will end up not tracking the index as tightly as you may be hoping for. 

While not a disaster, it helps to understand why the S&P500 may go down 30% but SDS only goes up 50%.  Ideally, if you truly want two times the short exposure to an index, you would play the index futures or options so that you can manage your long term exposure a little more finely, but of course those have a whole other can of worms that go along with them.  Your 401k probably doesn’t have that option though, so knock yourself out with the short ETFs and watch your portfolio at least stay afloat while everyone else is eating it.

For example, if I had $10k that I was putting into SH (1x short), I would instead put $5k into SDS (2x short) + $5k into a safe investment, or $3.3k into BGZ (3x short) + $6.7k into the safe investment.  The numbers today show that the results of the ETF parts would have been SH +5.78% (+$578), SDS +11.22% (+$561), or BGZ +16.98% (+$565).  Depending upon how lucrative the "safe" part is, it could be a good idea to have other investments while still hedging the same amount.  Note, SH and SDS are S&P 500 ETFs while BGZ is a Russell 1000 ETF triple short, but this was just a general idea of how to split your money and why these aren’t just for the crazies. 

Is everyone else also on the edge of their seats with all these wild swings?  From low to high was a 7% swing today in the S&P 500.  There are a lot of months that you don’t even see 7% in the S&P 500, let alone a 7% swing intraday.  I’m still bearish and think these massive bounces are just lots of short covering, but it’s getting excessively difficult to try to do anything other than daytrade right now.  Whatever you do, don’t let any losses get too big.

On a different note, there’s a lot of blame going around for why the economy is so bad right now.  While it’s fashionable to blame the big investment banks or the government, there’s somebody who isn’t getting much heat even though they are just as much to blame… the people that are foreclosing on their houses because they bought more than they could afford.  Obama and McCain (or is he going against Palin now?) are never going to say, "the way to fix this economy is for people to spend a little wiser."  They’re going to keep pumping quick fixes and band-aids to keep from offending the masses.  But the real fix comes from changing the way people handle their personal finances, starting with spending less than they make.  If everyone pays back their loans starting at the bottom, then the credit market keeps running along smoothly.

Sure, there was a lot of bad advice from realtors and mortgage brokers going around, but when it comes down to it, you really should take responsibility and do a little research of your own when it comes to the largest purchase of your life.  Maybe question how you can pay back a $500,000 loan when you only make $3000 a month?  Just a suggestion though.  The banks deserve a lot of blame for not managing their risks correctly, but they definitely aren’t the only guilty party in this whole thing.  Just because someone leaves their door unlocked doesn’t mean you should go in and take their tv.