Hi traders, trading fans and aspiring traders. Welcome back to another edition of Coaches Corner. For this month’s edition, I wanted to address a common question. It’s a question I recently received from some clients of mine. They asked, ‘What advice do you have for the turn in the market? We were doing well with money presses and put credit spreads. How do we choose stocks and what strategy works best for the bear market?’
Great question. First of all, I don’t necessarily agree that we have a bear market as of yet. The market cycle as of today is C- on the Nasdaq and B on the S&P 500. C- is neutral, leaning toward distribution, while B is accumulation. The Dow, Nasdaq and S&P 500 all remain in intermediate-term uptrends above their rising 50-day moving averages. Sequestration is presumed to begin tomorrow, March 1st, and anything can happen, but until we have a 2-grade move down in the market cycle, and the markets break support and begin trending lower, I wouldn’t classify us as in a ‘bear market.’
So what can we do when we do get into a bear market, or ‘distribution market cycle?’ There are several options. We will examine a few including shorting stock, buying puts or put spreads and selling calls or call spreads.
The most basic thing we can do is sell stocks short or short the market. A simple strategy could be to find the weakest stocks in the weakest sectors to trade to the downside. For bearish trades I tend to look for stocks decisively breaking key areas of support. This could be in the form of a breakout on an expanded-range day on big volume or a breakaway gap.
There are advantages and disadvantages to selling stocks short. The main advantage is the simplicity. You just sell the stock with the goal of buying shares back later to cover at a lower price. The stock has to be available to sell short, so you’ll need to check with your broker. You would also have to have the ability to sell short. Not everyone has the trade authorization to do this. Unlike buying stocks long, where you have limited risk and unlimited reward, when you sell a stock short you have unlimited risk and limited reward.
When you buy a stock long, the price paid is the most you can lose, given the stock can fall no further than zero. Meanwhile, there is no limit to how much you can make as the stock could theoretically rise to any price. Alternatively, when you sell a stock short you make money if the stock drops and you lose money if the stock goes up. Since the stock could rise to any price, your risk is theoretically unlimited. Because of this, selling stocks short can be very margin-intensive.
Another option would be to buy a put. This strategy gives you the most leverage and inverses your risk/reward. You would now have limited risk and unlimited reward (until the stock gets to zero). I only buy puts outright when I feel I have a great entry and I am considerably bearish on the stock at that moment. Buying options is a fairly low-probability trade. When you buy a put you have a 1 in 3 (some say 1 in 4) chance of making money. The stock has to drop. It cannot go sideways or up. It also has to do this within a limited period of time. If the stock drops too slowly, you can also lose due to time decay. Volatility can also affect the put premium. If implied volatility rises it would help the put. If implied volatility falls, the put would decrease in value if all other variables remain the same.
You can reduce your risk on buying a put by selling a lower-priced put. This would reduce your risk because it reduces your cost basis. Your maximum risk on a debit-trade is the debit itself. In turn, you would also limit the amount of money you can make on the trade. You would now have limited risk and limited reward. Your maximum gain would be the difference between your strike prices, minus the debit.
Selling calls is another bearish trade. Selling an at-the-money to slightly-out-the-money call theoretically gives you a 2 in 3 chance of making money. If the stock stays at the current price or drops, the call would expire worthless and you would keep the call premium. If the stock were to go above the strike price you sold, you’d have the obligation to deliver the stock at the strike if the buyer of the call were to exercise their right to buy the stock. Your breakeven at expiration would be the strike price you sold, plus the credit received. Your risk would again be theoretically unlimited. Because of this the margin requirements can be large. Many traders are not authorized to sell naked calls by their brokers.
There is a way of taking advantage of the call selling strategy that reduces your risk, and therefore your margin. You can do this by hedging the call you sold by purchasing a higher strike price call. This is called a bear call spread. The call you purchase limits your risk to the difference between the strike prices, minus the net credit received. This is one of my favorite ways to trade the downside. I get a higher probability of success with limited risk.
There are plenty of additional ways of profiting from a bearish market. Some people even prefer trading to the downside. Stocks tend to fall faster than they rise. There is an old saying that stocks take the stairs up and the window down. This is because of fear and greed. Greed causes stocks to go up – the desire to make money. Fear causes people to exit. Between the two, fear is the more powerful emotion. Greed is powerful, but if you yell ‘fire’ in a crowded theater, people will literally break down walls to get out of there. Some other ways of profiting in a bearish market are to do short call or long put diagonal spreads. One could also do bullish trades like money presses on the inverse ETFs. VXX, SDS and FAZ are some of my favorites.
For more information on these and other strategies, please contact the Trader’s Edge office at (801) 733-4190 and get signed up for some 1-on-1 training. You can also come out here to St. Louis and sit down with me 1-on-1 for a couple of days.