State of the Market and Playing Ebola

I was wrong about Ebola…3 people in America have been infected, contrary to my prediction that there would be no further cases besides Eric Duncan. So now there is the possibility things will get worse – more infected individuals, fear and panic that will spread faster than the virus itself.

The solution for investors is a barbell strategy: keeping abundant cash at hand to buy the dip, far out of the money index puts should things get out of control, and deep in the money call options to take advantage of possible upside.

For example, you can buy 5x deep in the money SPY calls that expire on Jan 2015 for $10,000 which enables you to effectively control 500 shares of the SPY ETF, or approximately $90,000 of the ETF at just 1/9 the cost of buying it outright. The fee for this is the extrinsic value which may be $4 or so per contract (look it up on the options table). The downside is if nothing happens, you lose the extrinsic value ($2000). But if SPY surges 10%, you make $7000 ($9000-$2000). Profits, like going long the index, are unlimited. If the market gets annihilated you can only lose up to $10k and no more.

Before investing in options, do the necessary reading to familiarize yourself with how they work.

If the market crashes say another 10% or so, you can buy XIV or SVXY (inverse volatility) to take advantage of the diminishing returns of going long volatility at extreme levels of volatility. Again, this can get pretty technical. Do the required reading to understand how volatility instruments work before you buy. Or you can go long 5 more SPY contracts with the same procedure as earlier.

The barbell strategy involves buying 20 far out of the money SPY puts for every five deep in the money SPY contracts you own. The cost in extrinsic value is around $500 a week for 20 contracts that are 5-8% out of the money, but should the market crash on Ebola becoming pandemic they can easily be worth $30,000 or more. A long-shot, but unlike easier media generated crisis like Greece and Spain, Ebola is real and theoretically can get worse in America. A dozen or more sick Americans will grip the country in fear, causing business activity to possibly seize up. The market will crash worse than in 2008 if this happens.

Europe slipping into a full-blown recession has the potential to make the market go lower, but Ebola spreading in America is a far worse situation.

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