The pullback is here! Glory Hallelujah and an Amen. It’s been much-anticipated, much-needed, and is incredibly healthy.
That’s right. H-E-A-L-T-H-Y.
Nasty? Yes. Volatile? Undoubtedly. Loss Generating? In the short run, yup.
But, ultimately, it’s necessary for a more sustainable trend. If you think a 5% puke is ugly, imagine what it would have been if the Nasdaq melted higher for another ten straight days.
Today I’m going to show you how to take this lemon and make lemonade.
Times like these are tailor-made for the Fade the Fear system we teach in our Bear Market Survival Guide. Conditions for its deployment don’t come around very often, but when they do, it’s a wonderful little trade. If you can keep your wits about you, that is.
Fading fear takes guts. But if anyone has the intestinal fortitude to do it, it’s #teamtackle. Let’s review the steps of the system.
The setup is straightforward. We’re looking for an oversold stock with high implied volatility. If the oversold setup occurs in an uptrend, then it’s even better. That tells us the dip is likely to be bought, and the wind is at our back.
I’m using the Nasdaq-100 ETF as the underlying for today’s example because it’s a perfect proxy for the bloodbath in tech stocks. You could substitute it with MSFT, AAPL, or most of the other big-cap tech names. They all have similar patterns.
QQQ is down almost 5% as I type this. Volume is through the roof, and the children are running scared. The setup will sweeten if we can get a second or third down day, but we’ve seen enough bloodletting today to hit short-term oversold conditions.
On the fear front, the VIX is running like a scalded chimp. At the highs, it was at 32. Even with today’s excitement, the 20-day actual volatility in the S&P 500 is still only 15%. That’s a very hefty premium, and it suggests options premiums are really expensive.
Ripe for the sellin’, in other words.
As with any strategy, timing the entry is crucial. Even though you have a larger margin of error with the Fade the Fear system, it’s still advantageous to enter at the optimal time. No one wants to wade through a loss before turning profitable.
As we’ll outline below, we’re going to be entering bull put spreads. These are positive delta plays best deployed at the end of the pullback. Thus, we need some confirmation that buyers are emerging, and the selloff is done.
The two most common triggers are waiting for a break of the previous day’s high or a breach of intraday resistance. In the former case, you need more than a single down day. As ugly as today’s drop is, we don’t yet have evidence of bulls returning. Perhaps the bloodletting continues for a second or third day before all is said and done. It’s too soon to tell.
Whenever the bounce does come, look for the intraday trend to turn higher or price to eclipse a previous day’s high before entering.
The strategy selection is obvious. Implied volatility is high, so we’re certainly not buying options. And, our bullish bias has necessarily downshifted because of the nasty drop. If my bias is +1 and implied volatility is elevated, then bull puts are the way to go.
I’d be looking out a month to October, and going as far out-of-the-money as I can and still pick up a 10% to 15% ROI.
With QQQ at $288, you can sell an Oct $244/$239 bull put spread for nearly 60 cents. It boasts an 86% probability of profit and generates a 13.6% return. Better yet, if we’re lucky enough to get another 5% whack in QQQ, then you’ll be looking at the strikes in the low $230s or high $220 range.
If you want to increase your odds of success, you can use the scaling-in technique. If you’re able to do 2 or 3 contracts, you might enter half or one-third at the trigger but wait to add the rest if the pullback persists, and you can get a higher credit.
For a stop loss, you could use the short strike put or $244 in this example. For a target, either ride to expiration or close when you capture 80% of the max gain.
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