How to Profit in A Bear Market - part 2

Last time we learned that by using covered calls you can limit loss, reduce your drawdown, and even profit on stocks you currently own during a bear market. Now, let's look at another option strategy that can be applied if no underlying security is currently owned. The simplest of strategies is simply to purchase a put.

A put gives you the right to sell a stock at a certain price prior to a set expiration date. For those unfamiliar with options, this can be confusing -- after all, why on earth would anybody sell you the right to sell them a stock at a certain price? If we step back and analyze the situation, however, isn't this exactly how your car insurance works? You pay a premium to your insurance company to have the right to sell your car back to them at a certain price. If you destroy your car and it is worthless on the open market, your insurance company will write you a check for the original value of your car.

Brining this concept back to the market, if you had your entire retirement savings in the stock market I bet you would be interested in learning that you can buy "insurance" that would protect the value of your portfolio -- however, that's the topic of another blog. What is important to understand now is that those "insurance policies," or puts, have value and can be traded as options on the market. As the price of a stock drops, the value of your put raises inversely!

How to Profit in A Bear Market - part 1

I have talked to a lot of people who have a sinking feeling in their stomach that matches the sinking markets we have watched over the last several weeks. 401K's are taking a big hit and Buy and Hold investors are watching all of their gains for the last few years disappear. Honestly, my heart hurts for them -- so let's talk about a few strategies to preserve capital or even profit from this bear market.

For starters... have you looked at a 20yr weekly chart of the S&P?

While the markets appear scary, it wasn't really that long ago that we encountered a similar experience -- and history often repeats itself in economics. Beginning in 2000 and then fueled by 9/11/01 we saw the S&P retrace from 1,500 to 800. So this market adjustment isn't completely out of the blue. It is also interesting to note that that parabolic decent has been more drastic during this bear market than what we experienced in 2000-02, which typically means a shorter trend. However, I don't want to minimize the retracement over the last 7 days -- I know it has been painful for many individuals. One thing we do know is it's unlikely the market will flip immediately bullish again as it will likely take several months to establish a strong support level after this speedy decent. Therefore, we need to be prepared to implement strategies that will enable us to continue being profitable in a sideways or bearish market.

One simple strategy that would work well for our Buy and Hold friends would be to execute the sale of some covered calls. For every 100 shares that you own of an underlying security you are able to sell 1 option contract. Therefore, if you don't expect your stock to rise in the next month, and you don't really intend to sell it -- you may as well sell somebody the option to purchase your stock at a premium price (after all, you don't really expect the stock to hit that price!)

EXAMPLE:
If you don't expect GM to increase much over the next month, you might be interested in selling a $7 call option for a profit of $105 -- all of which is yours unless the option is exercised.

The only potential "loss" in this scenario would be unrealized gains -- that is, if GM jumped to $8, you would be forced to sell your shares for $7. The reality is, you should be ecstatic to sell GM for $7 in the next month! If that did happen, you could then turn right around and buy the stock again if you'd like.

I have heard of people applying this strategy so consistently that they paid off the entire initial purchase price of their underlying security and were simply collecting "rent" on the stock each month. In fact, if you bought 100 shares of GM right now for $4.89 you would have it "paid off" in 5 cycles -- or roughly 5 months! Or perhaps look at the numbers this way: for roughly a $1,000 investment you could generate about $200 a month cash flow!

Strangle the Bailout Vote

Bloomberg just announced the Senate will vote tonight on the Bailout. If you are interested in an article that expresses why I personally think the proposal is a bad idea -- read this. Regardless, with the imminent volatility ahead, today would be a good day to set up a Strangle (no pun intended!) Here is how the setup will work.

I'm going to choose CME because its price will be directly effected by tonight's vote, and it also made a large, $70 move on monday during the first vote -- let's expect history to repeat itself.

The strangle is simple -- let's not overcomplicate it. Basically you are placing 2 simultaneous trades, one for either direction of market movement. A slightly out of the money Call and Put are purchased with the same expiration date and underlying asset. CME is currently trading at $390 as I write this, so I will be purchasing the $400 Call and the $380 Put. When I wake up tomorrow and find out which way the market is headed, I'll close the "wrong" position for whatever is left of it, and go to the bank on the profitable one.

DANGER: The significant problem here is that the Market Makers know that huge volatility is ahead and they are inflating the options right now. You can see this inflation in several areas: the size of the spread is $2 or more right now, Implied Volatility is well over 70, and the Delta for these OTM options is below 50. The question is, will the move be significant enough to still be profitable -- this is why they make virtual accounts, to test our skills!