Well folks, there ya go. We've been warning you for a while now the market was a little too frothy for its own good, and we're paying the piper today. While the odds of a dead-cat bounce tomorrow and/or Monday are pretty good after Thursday's drubbing, we believe the damage is done - the ball is rolling, so to speak. The chart of the S&P 500 below is what it is. The selloff pulled the index below its lower Bollinger band as well as below its 50-day moving average line. The VIX blasted past its ceiling at 13.2 and reached a new multi-month high of 17.11. Yikes. We weren't pulling your leg when we said there's a good chance of a bargain-hunting bullish pushback within the next couple of days. Just don't get lured in by it. The S&P 500 could rally all the way back to the 1970 area and still not undo today's damage. And on something of a side note, while Argentina's default on its bonds may have been named as the culprit for putting this selloff into motion, I'm telling you, if it wasn't Argentina it would have been something else. This market was ripe for a correction. All it needed was a catalyst... any catalyst. That, however, is a discussion we can have another time. There's something else we need to put on your plate today. My Favorite Way to Play a Bearish Swing Now that the bulls are on the ropes and it looks like we're heading into a full-blown correction (not that I'm worried a bit about my long-term portfolio), I thought it would be relevant to talk about all the ways to make money in a down market. And, just for the sake of giving you some additional value, I'd like to show you why my favorite bearish play is my favorite. Before we get to any of the nitty-gritty, let me be clear about one thing - the strategies we're about to discuss are in no way meant to be used as long-term holdings. These are strictly short-term hedges against a short-term correction. It won't be difficult to see why once we get into the discussion. In simplest terms, there are three ways to make money in a bearish environment. You can short stocks (or ETFs), you can own bearish ETFs (which gain in value as the market or a sector loses value), or you can buy put options (which increase in value as the underlying stock or index declines). Real quickly, let's go through them one by one. 1. Shorting a stock: Most of you are probably familiar with this trade, but just to make sure we're all on the same page, let's explain it. While the usual stock-trading approach is to "buy low and sell high", you don't necessarily have to go in that order. You can sell high and then buy low. Yes, you can sell a stock short at a high price in anticipation of it dropping in price, and then you can buy it back "to cover" later at a lower price. Just like a conventional buy-then-sell trade, you pocket the difference. Honestly, of all the ways to make a buck with a pullback, this is my least favorite for a couple of reasons. The first of the reasons is, stocks don't move much - in percentage terms - in the short run. For perspective, remember the previous bearish stumble from late March and early April? The S&P 500 SPDR ETF (SPY) only fell about 4.5% over that seven-day span. That was a big stumble by market standards, but not really worth the risk of trading even if you could pick the exact top and bottom (which is pretty much impossible, by the way). Worse, the theoretical risk with a short position is infinite, meaning the market could conceivably move higher even when it looks destined to go lower. In fact, it could go higher and never ever revisit your entry point again. You have to cover your trade at some point though, and you may find you avoided taking the loss for so long that you lose a small fortune. 2. Buying a bearish fund: As an alternative, rather than short a stock you could simply buy a bearish fund or ETF that rises when another sector or index loses value. More specifically, you could buy a leveraged fund, which increases at a faster pace than the underlying index loses value. The Direxion Daily S&P 500 Bearish 3X Fund (SPXS), for instance, gains 3% for every 1% the S&P 500 loses. This solves the risk/reward problem, meaning the 4.5% decline from the S&P 500 in March and April would have meant a 13.5% gain from the Direxion Daily S&P 500 Bearish 3X Fund... worth the effort. Even so, it doesn't solve the absolute risk problem of a market that races higher thanks to a surprise rally. These funds also lose value at a pace of three times the market's gain, and it would take no time at all to get deep underwater if you don't pull the plug on such a trade immediately after things turn against you. 3. Buying a put option: While the word "option" may intimidate some of you, all I can say is, don't let it. While option trading has been associated with great risk, in this particular hedging scenario, it's the least-risky of your three choices. Just as the name suggests, an option contract effectively gives you the option - without the obligation - of selling an index or a stock at a high price after buying it at a low price. Of course, most options traders don't bother buying or selling the underlying instrument; they just buy and then sell the option contract for the equivalent profit. The thing is, option profits can be greatly magnified relative to a movement of the underlying stock or index, yet the dollar amount of risked capital is capped and clear from the onset. An example will explain it a whole lot better. As of right now, the S&P 500 (SPY) August 195 puts (SPY 140816P195) are currently priced at $2.40. This option is simply a bet that the SPYders will be priced below $195 by the time the option expires on August 16th. Moreover, it's bet that SPY will move well below the $195 mark anytime between now and then. The profit potential is the difference between the strike price of $195 and wherever SPY is trading before August 15th, At $188, for instance, our put options would be worth at least the $7.00 difference between the two... and maybe even a little more. The amount it would cost me to make that bet is 100 times the current price of $2.40 [option contracts control 100 shares, but the pricing of option contracts is just on a per-share basis], meaning this put option contract would only cost me $240 apiece. Or more realistically, if I had a $100,000 portfolio I wanted to hedge, I might want to buy something like 20 contracts for a grand total of $4800. Here's the thing. After today's implosion, the SPYders closed right around $193 and appear to have kick-started a full-blown downtrend. It's entirely possible - maybe even likely - SPY could reach a floor around $182 (a fairly typical 8% correction) within the next couple of trading weeks. How much would the August 195 puts be worth then? Assuming the ETF hits that price by the 15th, each contract would be priced at $13.00 each, or worth $1300 per contract. Our $4800 investment would be worth $26,000... a 440% return, or more than a $20,000 gain. Of course, we'd settle for half of that! And what's the maximum we could have lost on the trade? Our original $4800 is our maximum loss, and we would have only lost that much if SPY didn't close below $190 or so by the August 15th expiration date. For the sake of comparison, shorting the S&P 500 SPDR Fund at $193 and gunning for a drop to $182 would only give us a 5% return, and we could have potentially lost all of our initial investment (and even owed money) if we didn't get out before SPY pushed its way above $198. A triple-leveraged bear fund would lead us to a 15% gain on the eleven-point move, turning a $5000 investment into about $5750, which isn't bad. But, even a mere five-point move in the wrong direction could just as easily turn that $5000 investment into $4700 or so in an instant... and that assumes you have the intestinal fortitude to take the loss as soon as it becomes clear you're on the wrong side of the trade. Better still, you can change the risk/reward profile on an option trade just by changing the strike price and the expiration date. The point is, on a risk/reward basis AND on a control basis, options just make more sense to me. You can lose more on an option trade than on a stock or ETF trade or a short trade, but if you've got good exit discipline, it's more than worth the risk. And, if you don't have a good exit discipline, at least your loss on an option trade is limited to your purchase price; your potential loss on a short or bearish leveraged ETF is theoretically infinite. The only caveat is, with options, you're on a time limit - they all expire eventually. A short trade or a bearish ETF can be held indefinitely. That doesn't bother me, however, since we usually only want to hedge for a near-term timeframe. Of course, just because I prefer options as a hedge doesn't make it wrong for you to do otherwise. As always, do what you're most comfortable with. I simply recommend all of you get comfortable with the idea of using options in certain situations. Paper-trade them until you get a good feel for them. I think you'll be glad you did. In any case, don't forget Friday's the big day. That's the day we're going to tell you about the new small cap stock pick we've been poking and prodding all week long. Just remember we're going to be sending that newsletter before the market opens tomorrow morning. You'll see why then.