Spotting a Bounce- And Playing it Correctly

Markets never go straight down. Even the most fierce bear periods are punctuated by sharp and severe rallies. Up and down cycles are one of the only constants in the stock market.

Every down cycle is followed by an up cycle, and every up cycle is followed by a down cycle. This is true in the macro as well as the micro definition of cycle due to the fractal nature of the market.

There is a long term up drift in stock indexes that is evident from their inception, although long periods of selling within the up drift can and do happen.

Drilling down from the market as a whole into individual stocks; there are some high flying popular stocks that have kept going down until they were delisted from the exchange and left wallowing in the nether land of penny stock pink sheets. Everyone can likely recall an example of this occurring in the past; however I venture to say that this is the exception rather than the rule.

However, when trying to catch the bounce, it's important to keep in mind that the potential exists that the stock will be delisted and "go to zero" so to speak.

Two stocks come to mind as strong candidates for a potential bounce. These stocks are the venerable US automakers General Motors (GM | Quote | Chart | News | PowerRating) and Ford (F | Quote | Chart | News | PowerRating). They have both been just crushed from several fronts. Oil prices, credit concerns, the housing slump and sharply declining consumer confidence have combined to knock these American stars from the sky.

However, the fact is they are selling products worldwide that industries and consumers simply need at this time. These companies may change radically, they may get bought out, they may merge, but due to the world's economic infrastructure itself, GM and Ford going to zero, anytime soon, is unlikely in my opinion.

In fact, there are some signs that they are starting to bounce now. The bearish sentiment is just overwhelming which is sometimes the key signal for the bounce.

How can you use options to try to catch the bottom in these stocks but still protect your downside? You can simply buy the calls and your risk is limited to the premium paid. For example:

The GM August 7.50 calls GMHR are trading up right now at $4.42 although the open interest is weak. The August 12.50 calls GMHS are exhibiting nice open interest and can be had for $1.09. A 3-point rise in GM between now and August expiration isn't that hard to imagine.

The August 5 Ford calls FHA can be had for $0.60 and the 6 calls FHI are yours for $0.23.

A collar is another way to catch a potential upside yet limit your downside risk via options. This involves writing a call and buying a put on the stock at the same expiration but different strikes. The call is normally written above the current price of the stock and the Put bought below the current price. This strategy is ideal for GM and Ford as it profits with a rise in price but protects the downside.

David Goodboy is Vice President of Marketing for a New York City based multi-strategy fund.