How to Invest If You Are Living in a Bubble

Binary options could possibly be used as hedging, to try and benefit or protect from a stock market crash

With many equity markets around the world only going up and breaking record highs every day most investors are in euphoria. But for a few of us the situation seems dire and only getting worse. If you’re sure that we are in another bubble, then any record broken just makes you fear the bursting of it more. That fear might be paralyzing, leading you to take the conservative choice and stay out of the markets – but is that the most logical course of action possible?

Recently, there are more signs and indicators tripping over our collective bubble alarms. People are concerned about a variety of markets being ripe for bursting, from the Chinese housing prices to the billion dollar “unicorn” tech startups scene. And after a six years long bull market there is certainly room to fall, just look at the world’s two biggest economies.

U.S. equities are now trading at almost seventeen times annual earnings, about one standard deviation above their ten-year moving average. That’s lower than where they were at the peak of October 2007, and much lower than the average 19.6 P/E ratio of U.S. market peaks since 1929.

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Meanwhile, China’s market capitalization has tripled just in the past year to $9.8 trillion. At 84 times projected earnings, the average stock on mainland exchanges is now almost twice as expensive as it was when the benchmark Shanghai Composite Index peaked in October 2007. The Shanghai Composite, which has about half its weight from financial and industrial companies, is valued at eighteen times projected earnings.

There are also obvious candidates for the “pin prick” that will burst the bubble looming on the immediate horizon. Both an interest rate hike by the Federal Reserve or a Greek exit from the Eurozone could cause a cascade of events that would wipe out trillions from the global economy.

Furthermore, these are only a few of the known issues, some black swan might come out of left field and hit us unexpectedly and the whole house of cards will come down. This is why we are recently seeing more talks about a crash in many financial forums and not just in the paranoid fringes of the internet anymore.

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So What Can Be Done?

Faced with all this gloom and doom the natural reaction for many is to simply stay out of the markets altogether. However, that is not really a possibility, because even if you just sit on your money you are making a call on the dollar or whatever local currency you use. That might be the smart bet in the end, but it has to be a deliberate decision, not a default. And indeed, recently more funds managers are saying they put more of their portfolios in cash.

But what if your goal is to make better returns than zero? Sounds very modest, but if you believe the sky may be coming down at any moment anything more seems unreasonable. Besides, what if your job or business depend on actively trading, (think hedge fund manager) but you think the crash is coming and in the meantime not making any moves. How long can you wait? A month, six months, a year? The market is rising and everyone else is celebrating the new records and you are not even showing any efforts – that’s hard to explain to people whose greed demands actions if not results.

One possible course of action to overcome the problem is to short the market consistently until the bubble bursts, however, stock brokers could ask for large collateral over a long period of time. Binary options are a much more affordable choice as no collaterals are asked for, but can they be used this way?

Expert Opinion

To see if binary options might be able to help with trading inside a bubble we turned to Idan Levitov, the Vice President of Trading for anyoption, an expert in the binary options hedging field. He was asked if it’s possible to use binary options to benefit or protect from a stock market crash.

Levitov answered: “Bubble investing is very challenging because understanding when the bubble is going to burst is very difficult, even for the seasoned professionals. Intervention from Central Banks has been the driving force behind the valuation of financial assets over the last few years as they attempted to reflate the bubble. However, there are many concerns they have gone too far. The warnings are dire and the predictions unpleasant, but that does not mean a losing proposition for binary options traders. The beauty of binary options is being able to profit from increases or decreases in financial markets.

Aside from the ability to trade directionally in the event of a bubble environment that could potentially pop, binary options affords investors the ability to hedge positions. Let’s say an investment portfolio holding the S&P 500 as a core position needed to be hedged with options. An investor could conceivably take an offsetting short position in an equivalent amount of binary options. The investor might see the value of the S&P 500 position decline, but would be able to capitalize on the gains from the binary options position. By utilizing this strategy, the investor has lost no money despite the downside in the core S&P 500 position.”

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