Black Swan Boot Camp: Option Trading Strategies in a Bear Market – Ticker Tape

“I didn’t train to land a plane in the Hudson. I trained to be prepared for moments like this.”—Captain Chelsey B. “Sully” Sullenberger III, pilot of “The Miracle on the Hudson.”

The event we plan for is often the one that doesn’t happen. Whether a crash happens in the market or in your car, no one sees it coming. The crash of 2020 wiped out a lot of market value. And nobody saw it coming. Sure, you can think back now and see somethings that might’ve triggered it—the earliest fears of the novel coronavirus before it hit U.S. soil, an inverted yield curve, or maybe the market was showing cracks.

Forget it. Leave the “whys” to the academics and economists. It’s their job to do the analysis and come up with reports. Traders have a different job to do. We have to get up in the morning, fire up our trading platforms, stare at the flashing numbers, and try to find new potential opportunities.

So, after the crash of 2020, what have we learned that we can use in the future? Let’s go back to basic training and solid if your understanding of the three pillars of trading—psychology, strategy, and money management.

1. Trading Psychology

Check Your Head

Face it, there’s no way to know when the next market crash is going to happen, how long it’ll last, or what will cause it. During a bull market, you might’ve traded only strategies that were designed to make money on the way up. But savvy traders prepare for the worst-case scenarios, so when the market corrects, they keep their heads when others are losing theirs.

• Plan for the loss, not the win. For starters, don’t over leverage. And avoid naked selling strategies. Before placing your next trade, plan for your worst-case loss if things should move swiftly against you. When markets are crashing, you don’t want to have 50% of your capital at stake because you risked it on bullish strategies like long calls and naked puts on a basket of tech stocks.
• What do you do when “go” doesn’t work anymore? When you realize your strategy has stopped working, be prepared to halt what you’re doing. There’s no need to wait until your pain threshold has been pierced. The nice thing is, you have a choice. When the strategy you usually employ goes from two wins in three trades to suddenly losing four out of five, you may need to make some changes to your trading approach.
• Create a decision tree. Have you spent time mapping out a plan by creating a decision tree with possible scenarios, probabilities, and well-thought-out entry and exit strategies? If so, you’re ahead of the game. The markets are known for surprises. Be prepared to tweak your strategies, adjust some parameters, or change up the products you trade.

Unexpected changes usually go hand in hand with increased volatility (vol). That could equate to larger price swings, which in turn could mean higher options premiums. So, when you’re trading in a high-vol environment, you could potentially collect more credit, but it could also mean large potential losses, which is why you have to know which strategies to trade when the markets are crashing.

2. Strategy Selection

Taming the Bear

When trading in a bear market, there are more strategies available than just shorting stocks. Knowing, understanding, and getting comfortable with a few different strategies can better prepare you for that worst-case scenario.

So: practice, practice, and then practice. Fire up your paperMoney® account on the thinkorswim® platform from TD Ameritrade and get comfortable with the different bear market strategies and how they work before you decide to use them. That way, when that next crash comes, you’ll know which strategies might be appropriate to turn to based on your view of the markets and your risk appetite.

High vol typically means higher out-of-the-money (OTM) options prices. You’re getting a higher potential return (credit) for the risk you’re taking. And that means you could potentially take advantage of premiums from short options strategies, which have defined-risk options spreads.

The Crash Strategies

Structure: Sell put; buy lower-strike put of same expiration. Risk: Defined.

Consider looking for an expiration in the short premium of about 30 to 45 days out. Say your target credit for the short put vertical is 30% of the width of the strikes ($0.30 if the strikes are $1 apart). You’d look for an OTM put that has a high probability of expiring worthless, then look at buying a further OTM put to try to get that target credit, typically one or two more strikes OTM. For illustrative purposes only.

Structure: Sell lower-strike put vertical; sell higher-strike call vertical; distance between long and short strikes is the same. Risk: Defined.

Look for expiration in the short premium that’s about 30 to 45 days out to balance growing positive time decay with high extrinsic value. Higher vol may allow you to find further OTM calls and puts that have a high probability of expiring worthless but with a relatively high premium. Create an iron condor by buying further OTM options, maybe one or two strikes out. For illustrative purposes only.

Structure: Sell call; buy higher-strike call of the same expiration. Risk: Defined.

Consider looking for expiration that’s about 30 to 45 days out. Look for an OTM call that has a high probability of expiring worthless, then look at buying a further OTM call to try to get target credit, typically one or two more strikes OTM. You could take advantage of flatter vol skew on upside strikes. For illustrative purposes only.

Structure: Buy one call; sell three higher-strike calls; buy two higher-strike calls; strikes equidistant. Risk: Defined.

This strategy combines a short OTM call vertical and a long at-the-money or slight OTM call butterfly (“fly”). This should be a credit spread; the credit from the short vertical offsets the debit of the fly. This is not aggressively bearish, as the max profit is achieved if the stock is at the short strike of the embedded fly. But if you do an unbalanced call fly for credit, it shouldn’t lose money if the stock drops and the entire position expires worthless. For illustrative purposes only.

3. Trade Management

Prepare To Be Prepared

What you practice now may save you later. You wouldn’t start a business without a formal written plan. The same goes for trading. Traders and investors who know the ropes approach the market for what it is—a business venture with a focus on limiting your portfolio’s potential losses. Yup, it’s not just about potential profits. It’s understanding how much you can lose that counts. Here’s what you need to detail in your trading plan.

Be reasonable with risk. Decide how much you’re willing to risk on each trade and size your positions so it’s nearly impossible to lose more than that. (Hint: think maybe 5%, not 50%.) And whatever the percentage is, base it on the net amount in your account, not what you started with. In other words, if you start with a $500 risk on a $10,000 account, and you lose it on your first trade, your 5% maximum risk is $475 on $9,500.

Position sizing. Once you figure out your risk per trade, you can calculate the position size that works for your profit and loss. This is why defined-risk strategies tend to work better for position sizing. Don’t go beyond that risk level, regardless of where vol is. Think about your entire portfolio and consider spreading that fixed amount of risk (a cap on the percentage of your account value) over more markets, sectors, and/or asset classes. And remember, when you’re trading any of the defined-risk credit spreads when vol is high, you’re likely already getting a bump in your average potential return versus max loss. So maybe dialing back your size a bit isn’t such a bad idea.

Entries and exits. When and where you get in and out of trades speaks plenty about how you manage trades. There are many ways to do this, and it’s really a matter of personal choice. But generally, you’ll exit if: (1) you hit your max threshold of risk (e.g., 5%), or (2) if you look at charts, you may base your entry and exit points on breakouts from support/resistance levels (see figure 1).

To confirm the breakouts, you could look at charts of different time frames. For example, if you typically look at a daily chart, try looking at a longer time frame to see if the overall trend is the same. Then look at a shorter time frame such as an hourly chart (see figure 2) to zero in on the entry or exit.

Changes and changing plans. When it comes to the markets, never take anything for granted. Keep a close eye on conditions to decide when it may be safe to revert back to your “normal market” strategy. Position your strategy so you aren’t exposing yourself to risk when the market sells off. When vol is high, trade smaller and adjust your stops. With higher volatility comes wider daily swings. If you’re used to trading 1% swings in a day and suddenly they’re 5%, you’ll be whipsawed out of your trade every time and take more losses than normal. Decrease your position size so you can let your higher-vol trades breathe a little.

So, what’ve we learned from all this? The next time the whole world gets stressed and the markets start crashing, you may be better prepared to pivot your strategy sooner and roll with the punches because you prepared for the worst that was to come. You can hope that day never appears, but if you trade long enough, you’ll see it. And when you do, perhaps you’ll embrace your fear, know you got this, and keep on trading.