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10 rules for investing in a bear market
1. 10 rules for investing in a bear market
Holding your nerve in a bear market requires both sound knowledge and a cool
head. If you can do so, you can both reduce losses and find profitable gems
gathering dust. After all, it's worth remembering that that most revered of all
investment prophets Warren Buffet eyes bear markets with a special gleam in
his eye - for it's at such times that buying opportunities are available with
handsome value in-built into their prices. Here are ten rules from a master
trader to steer by in difficult times...
Flick the switch
You'll never make rational investment decisions if you're mesmerised by the
gyrating prices on your screen. Steel yourself not to look at prices, read market
reports or talk to stockbrokers during trading hours. Markets are not going to
turn for the better just because you will them to. And, as prices have fallen so
far, it matters little if you miss the first inch of their eventual recovery.
Pound the streets
You don't just need a sense of perspective; you need the widest possible
perspective. The best investment opportunities are those you discover by
observation of the workings of the economy in the aftermath of the stock
market collapse. If you can bear it, take the taxi driver litmus test.
Read a good book
History never repeats itself exactly, but you owe it to yourself to be acquainted
with the bear markets of yesteryear. At least if history does then repeat itself
you can't say that you weren't warned. I'd recommend J. K. Galbraith's The
Great Crash, a brief but insightful analysis of 1929 and all that went before and
after.
Avoid collateral damage
In 1987 the real economy emerged from the crash virtually unscathed. Next
time around the world may not be so lucky. It will take time for share price
damage to have its full effect elsewhere. Use this opportunity to pull out of that
house move, sell your granny's Gauguin and ask your boss for an extended
contract.
Dust off the abacus
2. Down and dirty financial analysis has increasingly gone out of vogue. As share
prices fall, so value emerges. But you'll only spot it if you are looking for it. And
this means poring over the numbers, not chasing dreams. You can afford to
keep it simple. Thoroughness will pay greater dividends than sloppy
sophistication.
Beware false prophets
Nobody knows where markets are going - not me, not you, not Abby Cohen at
Goldman Sachs or the anonymous authors of Lex in the Financial Times. Your
view has as much or as little validity as anyone else's. Keep this in mind and,
when your analysis tells you it's time to buy, you'll find you have the requisite
bravery.
Don't shoot the analysts
The backlash against investment bank analysts is in full swing. Don't be
diverted by the spectacle, however enjoyable it might appear. Use the research
available dispassionately. As in all human life, you'll find there's good and bad
there. Just be sure, once you've digested, to formulate your own conclusions.
Rebase to zero
Ignore charts of historic share price performance. How a company was valued
at its peak is no guide to its value today. Those shares that have fallen furthest
may yet have furthest to fall. Start with a blank sheet of paper - no prejudices
or preconceptions - and build an investment argument that reflects today's
reality as you perceive it.
Yield to temptation
Equities are but one tidbit on the investment smorgasbord. One way of
comparing them with other asset classes is through their dividend yield. Seek
out shares whose yields are approaching those on government bonds. Although
unfashionable, this could prove the way back into the market with the least
risk. Just be sure those dividends can be met out of the companies' profits.
Look for leverage
Courage mon brave! When you decide the time has come to invest, be sure to
do so with conviction. Use leverage to your advantage - be prepared to borrow;
consider the use of derivative instruments. You could be a hero of the next bull
market, if only in your granny's eyes.
3. Long put
A long put gives you the right to sell the underlying stock at strike price A. If there were no such thing
as puts, the only way to benefit from a downward movement in the market would be to sell stock
short. The problem with shorting stock is you’re exposed to theoretically unlimited risk if the stock
price rises.
But when you use puts as an alternative to short stock, your risk is limited to the cost of the option
contracts. If the stock goes up (the worst-case scenario) you don’t have to deliver shares as you
would with short stock. You simply allow your puts to expire worthless or sell them to close your
position (if they’re still worth anything).
But be careful, especially with short-term out-of-the-money puts. If you buy too many option contracts,
you are actually increasing your risk. Options may expire worthless and you can lose your entire
investment.
Puts can also be used to help protect the value of stocks you already own. These are
called protective puts.
long put spread
A long put spread gives you the right to sell stock at strike price B and obligates you to buy stock at
strike price A if assigned.
4. This strategy is an alternative to buying a long put. Selling a cheaper put with strike A helps to offset
the cost of the put you buy with strike B. That ultimately limits your risk. The bad news is, to get the
reduction in risk, you’re going to have to sacrifice some potential profit.
Back spread w/puts
NOTE: This graph assumes the strategy was established for a net credit.
This is an interesting and unusual strategy. Essentially, you’re selling an at-the-money short put
spread in order to help pay for the extra out-of-the-money long put at strike A.
Ideally, you want to establish this strategy for a small net credit whenever possible. That way, if you’re
dead wrong and the stock makes a bullish move, you can still make a small profit. However, it may be
necessary to establish it for a small net debit, depending on market conditions, days to expiration and
the distance between strikes B and A.
Ideally, it would be nice to run this strategy using longer-term options to give the stock more time to
move. However, the marketplace isn’t stupid. It knows that to be the case. So the further you go out in
time, the more likely it is that you will have to establish the strategy for a debit.
In addition, the further the strikes are apart, the easier it will be to establish the strategy for a credit.
But as always, there’s a tradeoff. Increasing the distance between strike prices also increases your
risk, because the stock will have to make a bigger move to the downside to avoid a loss.
Notice that the Profit + Loss graph at expiration looks quite ugly. If the stock only makes a small move
to the downside by expiration, you will suffer your maximum loss. However, this is only the risk profile
at expiration.
After the strategy is established, if the stock moves to strike A in the short term, this trade may
actually be profitable if implied volatility increases. But if it hangs around there too long, time decay
will start to hurt the position. You generally need the stock to continue making a bearish move well
past strike A prior to expiration in order for this trade to be profitable
5. Featuring 40 options strategies for bulls, bears, rookies, all-stars and everyone in between
THE OPTIONS STRATEGIES » CASH-SECURED PUT
Sell a put, strike price A
Keep enough cash on hand to buy the stock if the put
is assigned
Generally, the stock price will be above strike A
Rookies and higher
NOTE: Cash-secured puts can be executed by investors at
any level. The Rookie’s Corner suggests other plays more
suited to beginning options traders.
You’re slightly bearish short-term, bullish
long-term.
Strike A minus the premium received for the put.
NOTE: This graph shows profit and loss of long stock and
the short put.
You want the stock price to be just below strike A at
expiration. Remember, the goal here is to wind up
Selling the put obligates you to buy stock at owning the stock.
strike price A if the option is assigned.
Potential profit is limited to the premium received
from selling the put. (If the puts are assigned,
In this instance, you’re selling the put with the potential profit is changed to a “long stock”
intention of buying the stock after the put is position.)
assigned. When running this strategy, you may Potential loss is substantial, but limited to the strike
wish to consider selling the put slightly out-of- price if the stock goes to zero. (If the puts are
the-money. If you do so, you’re hoping that the assigned, potential loss is changed to a “long stock”
position.)
stock will make a bearish move, dip below the
strike price, and stay there. That way the put You must have enough cash to cover the cost of
purchasing the stock at the strike price.
will be assigned and you’ll end up owning the
stock. Naturally, you’ll want the stock to rise in
6. the long-term. NOTE: The premium received from establishing the short
put may be applied to the initial margin requirement.
The premium received for the put you sell will
For this strategy, time decay is your friend. You
lower the cost basis on the stock you want to want the price of the option you sold to approach
buy. If the stock doesn’t make a bearish move zero. That means if you choose to close your
by expiration, you still keep the premium for position prior to expiration, it will be less expensive
to buy it back.
selling the put. That’s sort of nice, because it’s
one of the few instances when you can profit by After the strategy is established, you want implied
being wrong. volatility to decrease. That will decrease the price of
the option you sold, so if you choose to close your
position prior to expiration it will be less expensive
to do so.
Don’t go overboard with the leverage
you can get when selling puts. A general rule of
thumb is this: If you’re used to buying 100
shares of stock per trade, sell one put contract (1
contract = 100 shares). If you’re comfortable
buying 200 shares, sell two put contracts, and so
on.
Use the Profit + Loss Calculator to establish break-even points, evaluate how your strategy might change as
expiration approaches, and analyze the Option Greeks.
Look at stock fundamentals on TradeKing’s research page. The idea is to hold the stock longer-term, so you
need to be comfortable with that.
Don’t have a TradeKing account? Open one today!
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Options involve risk and are not suitable for all investors. For more information, please review
the Characteristics and Risks of Standardized Options brochure before you begin trading
options. Options investors may lose the entire amount of their investment in a relatively short
period of time.
Multiple leg options strategies involve additional risks and multiple commissions, and may result in
complex tax treatments. Please consult your tax adviser. Implied volatility represents the consensus of the
marketplace as to the future level of stock price volatility or the probability of reaching a specific price point.
The Greeks represent the consensus of the marketplace as to how the option will react to changes in certain
variables associated with the pricing of an option contract. There is no guarantee that the forecasts of implied
volatility or the Greeks will be correct.
System response and access times may vary due to market conditions, system performance, and other
factors.
TradeKing provides self-directed investors with discount brokerage services, and does not make
recommendations or offer investment, financial, legal or tax advice. You alone are responsible for evaluating
