Want To Profit In A Bear Market? Here's A Safer Way...
Contrary to popular opinion, conservative options-for-income strategies like covered calls can actually perform quite well during bear markets. Of course, we have to be very careful which stocks we buy. After all, falling stock prices can erode profits quickly. But careful stock selection can go a long way toward avoiding losing trades.
During bear markets, covered call traders also benefit from inflated option prices. Option pricing is highly correlated to volatility. So as volatility picks up in a bear market, the prices we receive for selling options become much more attractive. This helps increase our income as well as the amount of protection for our positions.
However, there is a less traditional options strategy that can capture even more profits as stock prices fall: covered puts.
Covered Puts Explained
Setting up a covered put trade is fairly simple:
-- Sell short shares of stock in 100-lot increments
-- Sell put contracts against these shares (one contract for every 100 shares)
Let's say you sell 100 shares of stock at $50. The stock is trading in the open market at $40. The intrinsic value of this contract would be $10 per share. As the price of a stock trades lower, the value of the put contracts increases.
Since we are the seller of the put contracts, we are giving another party the right (but not the obligation) to sell us stock at a particular price. Put another way, we are obligated to buy stock from the other party at the agreed upon strike price.
We are being compensated for selling this right through the payment we receive when selling the put contract, which is known as the premium.
If the stock trades lower, we will be obligated to buy stock at the strike price as the owner of the put exercises their right to sell to us. But that's OK. In buying the stock, we will cover our short position (and still keep the money we received for selling the put contracts).
This strategy works in exactly the opposite way that covered call trades are executed. With covered puts we sell short the stock first, and then cover (or buy back) our short position when the option contracts are exercised.
But similar to the covered call setup, our profits come directly from the premium we receive for selling option contracts.
Advantages of the Covered Put Options Strategy
The key advantage of the covered put strategy is that it allows traders to safely make money in a bear market.
Aggressive traders often short stocks outright or buy naked put contracts during bear markets. They profit when the stock price trades lower. But during a bear market, stocks can rally sharply as investor sentiment shifts. That can make this approach can very dangerous for novice traders.
If a stock rallies sharply while a trader is short, losses can accumulate quickly. The higher a stock trades, the more losses build. Many traders don't have the discipline to close this type of trade out before the damage becomes significant.
The same can be true for put buyers with one key difference. When buying a put contract, a trader's potential loss is limited to the amount they paid for the put contract. But it's important to note that the full amount could be lost quickly if the stock rallies unexpectedly.
On the other hand, covered put setups carry less risk than either of these approaches. Since we sold the put contracts against our short position, the premium we receive can help to offset some of the losses we might endure if the stock rallies.
At the same time, the statistical properties of the put contract cause its value to decline as we approach the expiration date. This decline is what puts income in our pocket even as most traders are worrying about losses.
Disadvantages of the Covered Put Options Strategy
One of the biggest disadvantages of this strategy is the fact that it cannot be traded in a typical IRA account. This is because the covered put strategy requires investors to sell stocks short. This cannot be used in an IRA account under today's regulatory environment.
Another disadvantage of the covered put approach is the added volatility risk. Price action can be much more volatile during bear markets. And investors often panic at the wrong time, hitting the exits all at once, causing prices to drop rapidly.
Then, after prices hit their lows, institutional managers panic. They tend to worry that they aren't invested enough (grounds for dismissal for many of these managers). So they start to buy. This can cause stock prices to rise rapidly, which can cause significant losses if you are short.
To guard against this risk, always have a set price point where you will exit a stock if it moves against you. For example, let's say you short a stock at $43 and sell the next month $45 puts against the position. You may want to commit to buying back the stock (and closing the put position) immediately if the stock hits $48.
Traders with discipline will be able to get away from positions that are moving against them. Undisciplined traders will stick with a trade and continue to suffer mounting losses. Don't be an undisciplined trader. Write down your exit points and then honor them regardless of your overall bias or expectation. You can always find another trade to enter. But if you lose your trading capital, you could be out of commission for a significant amount of time.
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