Cramer's Rewrite of His Hedgies Piece

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This piece, an annotated version of a column published Friday, is one in a series of Jim Cramer's rewrites of his columns for "newbie" investors.

Gasoline-soaked rags stored in tightly topped metal trash cans are less combustible than a group of short-sellers loaded with puts jammed on during a nasty selloff.

(What I am trying to establish here is a tableau that ultimately shows that once a selloff begins it is very difficult, unless that selloff goes on for days, to profit off of it. You have to be betting against a market fall beforehand as it gets too expensive once the selloff is occurring. This should make sense if we analogize to insurance. It is cheaper and better to get fire insurance before your house is burning than during the conflagration.)

I ought to know; I've done the self-immolation thing at

Cramer Berkowitz

more times than I care to remember.

(That's just me breaking the unwritten code of money managers again, admitting that I have taken it on the chin on the short side over the years of this great bull market.)

Here's how it works: As long as the market is cruising along at 65 mph, things are just fine. Hedge funds do their best to try to keep up with the straight long boys who are always fully invested, and mutual funds can't resist putting that new money to work no matter what level the market is.

(What I am trying to establish here is the notion of the different ways to run money. Mutual funds take a fee as a percentage of dollars managed. Hedge funds do, too, but also take a performance cut, usually about 20%. My hedge fund, though, which is closed and private, does not allow me to get paid if I lose you money. And, if in year one I lose you money, I have to get you back to even before I can begin to be paid again. So if I think the market is going to go down, I have to bet against the market to make money from it if I expect to get paid. If it goes up instead, that's a double whammy and a nightmare. So, what I do is try to short stocks I think will go down in a correction, or buy puts on them. I like puts more because they limit my losses, as we shall see.)

But then we have that glitch, in this case on Monday when

Fed Chairman Greenspan

leaked to the


that a tighter bias beckons, which causes a correction.

(Money managers fear Fed rate hikes. A short-term boost, among other things, starts to slow the economy, can hurt earnings and makes cash more competitive to stocks.)

Immediately hedge funds flew into action, and while the futures pointed to oblivion, egged on by a host of negative talking heads, they went to work betting against the market.

(I know a number of you are bothered by what the press does on a down day. But let's figure this out. Television shows have bookers who try to have topical guests. They are doing their job. They are like casting agents in movies. If you get the call in a movie that you have a nasty villain, you call Gary Oldman. In our business you call Michael Metz. He is our Gary Oldman. He may not like the typecasting, but it is very difficult to switch directions and become bullish at 9000 if you hated the market at 5000, 6000, 7000 and 8000. That's why he gets the call. Many of you ask why he keeps his job. I have no idea. But you can be wrong and keep your job in our business for a very long time. This isn't the same as managing a baseball team, although I think it should be.)

As soon as a correction consensus has been reached,

(as soon as the majority of people feel like the market is going to take a fall)

short-selling hedge funds, anxious to make back what they didn't get when the market rallied, go to work buying puts on virtually everything that moves.

(There are lots of different options here. You can buy index puts, betting that a whole index could go down: Dow Jones, S&P, Nasdaq, for example. You can buy puts on individual groups, like the new computer-box maker index or the drug index. Or you can buy puts on individual stocks that you think are going to go down.)

They all have their stocks they want to operate against but have been afraid to because the market has been so strong.

(Tons of stocks, both good and bad, get carried up in bull markets. Lots of times stocks like, say, Yahoo!, which I am long, seem ridiculously overvalued to people and they want to bet against them. But as long as the market looks strong they fear that they will be overrun by momentum. Once that momentum breaks, however momentarily, these short-sellers want to start profiting from the rollover. They are not un-American or anti-capitalist; they are opportunistic.)

There was a time before there were 8,000 hedge funds

(last count)

when you could make good money buying puts and then selling them when the selloff had run its course. The moment I felt a correction was about to occur I would whip out my list of five targeted stocks and begin to buy in the money puts aggressively seeking to capitalize on the downturn. But the lesson of buying on the dips, a brilliant lesson in retrospect, has crushed my in-the-money put strategy.

(Okay, let's go over shorting again. I hate IBM at 110. I can sell it short at 110 and cover it at 100. I make $10. I don't need to own it to sell it, remember, the brokerage houses will lend it to me. Now, let's say things go awry. I short IBM at 110 and it rallies to 125 before I cannot take the pain any longer. I buy the stock back and I lose $15 (125-110, where I shorted it). How about if there were a way to limit how much I could lose on the short side? There is. I can buy puts. There are three kinds of puts: the in-the-monies, the at-the-monies and the out-of-the-monies. The term "the monies" refers directly to where the stock you are trying to bet against is trading. So, if IBM is at 110, the 115 puts are in the money, the 110 puts are at the money and the 105 puts are out of the money. Each is priced according to supply and demand. If you are certain that IBM is going down, you might want to buy the 115 puts. You would probably have to pay about $6 for them -- put pricing encompasses many issues, including volatility and timing, that I want to gloss over here so you can at least get comfortable with the terminology first. Now IBM drops to 100, like in the first example. How much money do you make? Nine dollars. You have created the short of IBM at 109 (115 strike minus $6 for the put). It goes to 100. You make $9 when you sell the put. Now let's say it goes to 125. You only lose the $6. You are stopped out at $6. You can't lose more than your put. That is why I rarely, if ever, short common stocks, and always use puts to bet against them. It is much easier to sleep at night knowing that the short can't wipe out all of your other investments. Now, let's say you are not totally sure that IBM is going to go down. You are afraid you will lose that $6. You could consider the at-the-money puts. These are tougher to value. With the stock at 110, the 110 put might be as high as $2.5, meaning that you won't make any money until the stock goes through 107.5. That's a tough risk/reward. Those seem dear to me. So, you might consider putting on a bit of "deductible" insurance, like the 105 puts. You don't make any money from 110 to 105, but below 105 you are protected. Again, think cars. You insure a car for damage, but not the first $500 of damage. That IBM insurance might cost you $1 to insure below 105. So you begin to make money at 104. Remember, puts expand or contract as you go toward or against them. So when IBM is at 105, in practice, the put will have zoomed to at-the-money status and probably rallied to $2.5. In other words, you don't have to wait until the stock goes below 105 to make a profit in the put. You could sell it right then for a point-and-a-half gain. But this is a door number one versus door number two scenario. Some might want to go for bigger game and hold on for a giant break in IBM. I usually take enough off the table to pay for the put in these situations and then I let the rest ride. I often ask for a menu of all puts. I price them out using a broker and decide what is a fair price. Here's the rub: I have been doing this for so long that it is by rote for me. I can sense expensive merchandise the way a good hitter can sense a breaking ball. I know what a grooved pitch it. You may not at least at first, or second or even third. It takes practice!!!)

A few years back I used to go out and buy bushels full of out-of-the-money puts for fractions of a dollar on individual stocks betting that if the selloff materialized into a deeper correction I could bang out these puts for hefty profits. But now so many hedge funds do this strategy that there are rarely any puts that sell for less than a dollar that have a legitimate shot at making you money.

(Now, back to the insurance business. You can insure your house cheaply. But how about a beach house right on the oceanfront? So many people want insurance and there are so few ways for the insurers to make money -- it is too risky -- that you can get insured all right, but at a price that isn't worth doing. It is not economical. You would rather sell the house. That's what has happened in the market. So many people want insurance that it has gotten very expensive and it's cheaper now just to sell the stock. )

Of course on Monday not everyone knew that these puts were too expensive to capitalize on. So plenty of funds came in and bought millions of dollars of expensive puts to take advantage of the imminent 10% decline.

(Now, you are a faithful devotee of Ralph Acampora. When he says jump, you say how high. He says the market could correct 10%. In that scenario IBM, which is at 110, goes to, say, 99. You want to make money from that. You may overpay for puts in the selloff and get stuck with them when Acampora gets it Wrong!)

When the market failed to roll over on Tuesday, these put holders figured why not hold on.

(As I said in my piece earlier this week, that was not a sign of weakness for the market, it was a sign of strength. Put holders should have trimmed positions in retrospect that day.)

But when the market rallied on Wednesday and Thursday, these puts were now chickenfeed.

(Back to the IBM example. You bought the 115 deep-in-the-monies for $6 when the stock was at 110. Now the stock has rallied to 115. Voila, you now own at-the-monies, which have been crushed to $2.5. Now it rallies to 118; these puts would be at about $1.)

In fact, the only thing worth doing against them is taking a free shot to the upside.

(When the market took off, you could mentally transfer your puts into insurance from bets against a stock and say, "Hmm, I can buy IBM and know I can be stopped out on the downside from the puts." Picture yourself with a Porsche 911 and an insurance policy against collision that you have paid thousands of dollars for. The insurance policy is about to run out. You might be motivated to drive a bit more aggressively with the 911 before the insurance runs out, rather than after. Afterward, that machine is staying in the driveway. Well, put holders feel the same way: Hey, I have this asset, why not use it before it is worthless and used up? Buy something for it to insure.)

Which is what many hedge funds did, driving prices much higher than they would go had not put buying been rampant.

(The collective surge of hedge fund managers selling puts, and buying stocks against puts, causes immense upward pressure on the market.)

(I want to skip the specific example I used to demonstrate the upward pressure, and instead focus on the market in general. If you own S&P puts, and the market stops going down, you will either sell those puts or buy a bunch of stocks knowing that you are protected to the downside. Sometimes whole sections of the market get so heavily shorted that on any good news, or even if the news isn't that bad, they go up. That's what happened, for instance, in the Competitive Local Exchange -- mini-Ma Bells -- stocks, which have been heavily shorted. There was so much put buying in this group that when it stopped going down, the short-sellers panicked, just as long owners sometimes do in a correction, and caused a rout to the upside with their buying of common against puts and covering of shorts.)

Every major selloff in this decade reflects this pattern.

(Every time the market looks like it is going to roll over, hedge funds overdo the put buying.)

Now I get looks from each firm's options desk

(I call my broker and ask if anyone is buying puts and if so, what kind, and whether put activity is much greater than normal)

because in my mind it is ingrained that the reason markets snap back higher and harder than we expect it to because of this instantaneous, and wrong, put buying. When we see a selloff like Monday's and we don't see put buying, I will be far less sanguine about the market's prospects than I am now.

Not to belabor the obvious too much, but what I am saying here is that as long as skepticism is turned into action -- bets being made against the market -- while the selloff is occurring, I feel better about the market because we are developing a natural set of buyers for when the market settles down. A quick anecdote: When I worked with my wife, as soon as a correction had started and strategists grew emboldened about the coming chaos, I would urge us to buy puts and short. I would get my way, but her discipline said that unless you anticipated the selloff, you couldn't short into it. In retrospect, that was dead right advice for all but the 1990 and 1994 corrections, an awful long time to not make money in puts! Hope that helps. Promise me, though, you will not ask me for good books on options. There aren't any. You must come to to get the straight dope on these instruments. Period.

James J. Cramer is manager of a hedge fund and co-chairman of At time of publication, his fund is long IBM and Yahoo!, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Mr. Cramer's writings provide insights into the dynamics of money management and are not a solicitation for transactions. While he cannot provide investment advice or recommendations, he welcomes your feedback, emailed to