Until stock markets sound the “all clear” signal and we can get back to our regularly scheduled bull market, we have to operate with a different set of rules in order to protect our capital — both money and mind. Corrective or Bear Markets require a different set of tools. And it’s not just knowing that the odds more favor short direction plays versus long direction plays, it’s knowing that you have to manage open risk differently. You have to structure trades differently. And you have to operate in shorter time frames.
Down markets can be incredibly profitable for nimble traders. In fact, in my 20-year career, my most profitable years ever were 2000 and 2001 when we were on the backside of the Spring 2000 “dot com” bubble where NASDAQ dropped a dramatic 78%!!
However, in a down market one doesn’t simply flip the rules upside down. We don’t transition from the bull market “buy and hold” mentality into a “short and hold” mentality. Anyone who’s ever attempted to short a stock like $NFLX which fell over 75% in 2011 knows that holding on to a long term short is an exercise in extreme pain (just ask Bill Ackman how his Herbalife $HLF short went?).
No. We must be more nimble. More tactical. More aggressive in taking profits, while being more mindful of our risks.
Since we got bearish here at All Star Charts in early October, we’ve been picking our spots getting short stocks we deem to be some of the weakest in the market. We’ve shorted when key support levels have been broken, and we’ve entered short on bounces that offered us better prices. But in all cases, we’ve done so while protecting our capital. We haven’t put on any trades with unlimited or excessive risk, which has been achieved both through defined risk positions as well as position sizing — the two things we can control in an otherwise chaotic period for the markets.
However, I feel I need to address a subtle mind shift that needs to be present for options traders to succeed that is especially important in corrective and/or bear markets. This has been spurred on by a handful of emails I’ve received recently from All Star Options subscribers who find themselves holding positions that were once profitable but now are not and they are nearing November expiration. We need to address the idea of aggressively taking profits in defined risk spreads.
We put on a number of Bear Call Spreads this October. This is a bearish spread entered for a credit that is short a near-the-money call option and long an out-of-the-money call option for protection. The most you can lose in this trade is the difference between the strikes minus the credit you received at trade initiation. For example, if I was short the XYZ 50/55 bear call spread for which I received a $1.50 credit when I put the trade on, this means the most I could lose (if XYZ closed above $55 at expiration) is $3.50 ($5 – $1.50).
This is a defined risk spread. We cannot lose more than $3.50. This is a vitally important piece of information which gives us strength. It allows us to size our position such that if we were to take the maximum loss, we can still restrict that dollar loss to an acceptable percentage of our portfolio. Another example: Lets say I’m working with $100K in capital and I don’t want to risk more than 1% of my capital on any one play. 1% of $100K is $1,000. This means I must limit the size of this trade to no more than 3 contracts (Ok, that would mean I’m risking $1,050 — close enough).
So now that we’ve got this options spread on, we need to adopt a management mindset that is quite different than the mindset common for most stocks and futures traders where the popular phrase “cut your losers short and let your winners ride” is both widely accepted and solid advice for most players. With defined risk spreads, this common wisdom gets somewhat reversed. When a trade goes against us, there is no reason to panic provided we sized our position properly. We accepted the risk up front. In most cases, there’s nothing to do. The beauty of the way the trade is structured is that the risk/reward ratios in a losing defined risk spread actually work in our favor because as we go down in the trade, this means there is less we can lose going forward — but the more we can win if the stock reverses. Using the above example, if that spread we sold for $1.50 is now trading at $4.00, this means we can only lose one more dollar from here (most the spread can cost is $5.00). This also means that we now have the potential to “earn” $4.00 from here if the stock were to reverse and all of our options were to expire worthless. This means we’re now risking $1 to potentially make $4. I like that.
But I really want to focus your attention on how to manage winning trades and the need to aggressively take profits.
While the risk/reward ratios in a bear call spread favor us in a position going against us, they work to our disadvantage when our trade is actually working. The most we can can hope to win in a credit spread is the actual credit received. If all the options expire out of the money, then we get to keep the credit we collected at initiation. That’s it. So, when that same spread that we sold for $1.50 is now trading at 50 cents, the most we can win from here is that remaining 50 cents. But we’re risking $4.50 to get there. I don’t like that ratio. This means we need to be aggressive in harvesting profits.
My general rule of thumb with bear call spreads is to close the trade when I can do so for half of the credit I received at initiation. So in this case where I collected $1.50 when I entered the spread, I’ll look to buy it back to close at 75 cents. I want to take the “easy” part of the trade and let somebody else sweat out the last of the premium.
This is especially important in our current trading environment where we can expect whipsaws in price action both up and down. When we have profits, we need to seek to take them ASAP because markets can reverse on a dime, as we’ve already seen in the past fews weeks. We’ve had a number of November bear call spreads initiated in October hit our profit target and we moved on. But if we didn’t take our profits according to our plan, we’d still be holding these spreads now and many of them would be showing us losses right now! And I know this happened to a few of our subscribers because they are emailing me asking me what to do next? They didn’t take their profits and now they are sitting on open losses.
This powerful bounce we’ve seen in stocks over the past two weeks — which is totally expected in corrective/bearish market environments — hopefully has driven home the point that we need to be aggressive in taking profits. This is not the environment to be greedy. This is the environment to be nimble, tactical, and quick.
A best practice that I adhere to — especially since I have no intention of staring at my screens all day, obsessing over every tick in the market — is to leave good-till-canceled limit orders in the market to close at my profit target. This helps eliminate my fear & greed emotions and just gets me out according to my plan.
Make this your best practice as well. I promise you’ll see better results over the long run.