Is winter coming?
Not financial advice. Full disclaimer available here.
A couple of weeks ago, I wrote a post titled on market crashes. Here is an excerpt:
You don't just go short on a hunch in a raging bull market; you wait for a signal to get the odds on your side
Since then, major US indices have had a little tantrum with the Russell in bear market territory last week and the Nasdaq down nearly 20% as well. That's the signal I was waiting for. The more risky end of the market - small caps & high multiple tech - is weak and I am watching whether the blue chips - Dow Jones & S&P 500 - will fail to make new highs in the next couple of weeks.
January has been a bad month for US stocks across the board with the exception of the energy sector, up 19% year to date using the XLE as a proxy. Consider the chart below which points to the leading sectors at various stages of the cycle:
Oops... If you read the chart the same way I do, then we could be in for a volatile 2022.
Is the bull market over? I don't know. The point is: I see a lot of risk in the coming months and I'd be remiss if I did not mention it to readers.
How much risk? How about the Dow at 25,000 by the end of the summer? Well, that could never happen. Really? What about the Dow at 45,000 by 2024 then? Hmm... That's basically a mirror of the last 2 years.
Ignore predictions but do not ignore risk.
Risk goes both ways. If you sell everything because you are worried about a crash, then you might give up a ton of gains. Conversely, if you are fully invested when there is so much uncertainty, then you are asking for trouble.
Stocks make 30% moves all the time, Playboy and Pinterest just did that in less than a month. It's no big deal if you are ready for it. So, let's prepare for a big move while keeping in mind that it might not happen.
The easiest way to thrive in a bear market / crash is to have some cash on the side line. Cash provides stability in a portfolio and optionality to buy assets on the cheap. If you don't have any, you may consider taking down your exposure.
In addition, adventurous investors can make bearish bets by shorting risk-on assets and/or buying risk-off assets. Here are a few classic examples:
buy out-of-the-money puts on financials such as the XLF ETF, that thing can move!
short emerging market or commodity currencies against the dollar (ZAR, AUD...)
buy calls on US-treasury bonds, not sure if this trade still has legs given how low rates already are. I would not do it.
In terms of timing, I think a 6-month maturity is sufficient. Historically, markets tend to be quiet during the summer months. I prefer options over futures but I haven't put on any trade myself so that is all I am going to say for now.
As discussed previously, making money on the short side is a lot more difficult than on the long side. So, I want to give you another trading strategy to express a bullish view which is more aggressive than simply selling puts in a high volatility environment but does mitigate the risk of catching a falling knife.
I'll use Pinterest as an example. The stock closed at $27.33 today and it looks like there was even further selling after hours, ahead of the earnings release tomorrow. I bet you Wall Street will be watching MAU and I'll be watching ARPU. Anyway, volatility is likely to stay high which is good for put sellers.
The April 14th, 2022 contract with the $22.5 strike last traded at $1.5. Investors can sell that put to finance a position and execute a de-risked trade. For every $1.5 of premiums collected, investors can buy 100 shares of Pinterest and place a stop-loss $1.5 below their buy price in case the stock keeps falling.
That's a tight stop, but if premiums spike, the stop widens. Also, there is no need to buy 100 shares. For example, investors can buy 50 shares and place a stop-loss $3 below their buy price. Just be aware that the stock can gap down so a zero-sum exit is not guaranteed. In addition, you still have to be ready to buy however many shares you agreed to under the option contract if the stock price drops below $22.5 (the strike price).
Of course, premiums don't have to be married to a single position. For instance, it's possible to sell puts on Playboy (very volatile) and use the proceeds to buy Nintendo (less volatile) and place a stop-loss there.
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