The Market Skinned It’s Knee

by JDH on August 13, 2011

On Monday (the day the world ended, sort of), I picked my 11 year old son up from the day camp he was at. Since the camp is in a different town, we had a 45 minute drive home, so after he told me about camp, I told him about the stock market crash. He knows what a stock is (since whenever I get notice of a proxy fight in one of my investments, I let my two boys decide how I will vote).

He asked me why the market crashed, and I explained how the government was printing money like crazy, and eventually you have to pay the piper.

He seemed unfazed, and after asking me a bunch more questions, he said, and I quote:

So basically the market skinned it’s knee? Don’t worry, it will scab over. If not the government will put some gauze on it.

Smart kid.

Sure enough, Monday’s crash was followed by an up Tuesday, then a down Wednesday, and an up Thursday, leading to a basic flat week by the end of the day Friday.. Monday started with the Dow opening around 11,200, and by the end of the day Thursday the Dow was around 11,200. Massive swings, but the ups and the downs balanced each other out. Sort of. Except that year to date the Dow is down, and over the last month the Dow is way down.

And gold is way up. Which is good.

This leaves us with two alternatives: stand aside, or play the volatility.

Playing the volatility is fun. You can do a “straddle”, either with ETFs or options or whatever you want. For example, you could buy a call and a put at the same strike price, expiring in one month. If the market goes way up, your put may be worthless, but you make lots on the calls. If the market crashes, vice versa. The fun thing about volatility is that if the market does go way up, you sell the calls at a profit, but hold the puts, because perhaps tomorrow the market will crash, and you can then sell the puts, probably also at a profit.

Of course in practice it’s not that easy.

For example, on Thursday the S&P 500 closed at 1,173. You could buy a September 1175 call for $45. The put would cost you $32.50. (I’m ignoring the bid/ask spread to keep this simple). If you bought one of each, and ignored commissions, you pay $77.50. That’s a massive time premium, so the market will need to move very quickly, very fast, for you to recover your investment and make money.

Which is why I picked alternative #2: stand aside. I have no idea if tomorrow will be an up or a down day, so I sit on the sidelines and wait.

As it turned out, the Dow was up somewhat on Friday, so at the end of the week the Dow was only down a bit.

Gold had a great week, as did most of my gold stocks.

What’s next? I wish I knew.

I will continue to operate under the assumption that the trend for the markets is down, with violent swings both up and down, occasionally. That’s why I have no intention of holding basic stocks.

Gold, on the other hand, and silver, have obviously proven their worth as a store of value during this past week’s volatility. That’s where I will continue to hold my resources, until the bottom is in, many thousands of points from here, I suspect.

Thanks for reading; see you next week.

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