The last couple of days have shown us some red candles before having a solid bounceback. For all the mega-bulls this is great news and as it seems it is mostly expected as it appears the market will never go down again. It is not surprising that a lot of folks feel this way, especially if you have never really traded through some challenging market conditions. I can’t count the number of times I have heard “should I buy the dip” this week, lol. This kind of complacency can be very dangerous and it happens to the vast majority of traders when they begin or whenever the lessons of the past are forgotten. This week’s blog is going to reference what happens when our primary defensive strategy becomes problematic when instead of having a nice orderly pullback the market gets a bit more frisky.
Let’s begin with the part of the market that can sometimes tell us if we are in for a solid beatdown or just a little rest period before resuming the current direction. I am referring to the VIX, the market fear gauge. The VIX can give us a hint as to whether things have the potential to get really ugly or whether we are just looking at a nice steady pullback. Take a look at the chart below and you will see that the last couple of days in the VIX were not of great magnitude but just a couple of green candles that brought the level of the VIX back up to an old consolidation range. Usually when we see large spikes in the VIX we can expect bigger issues with market pullbacks and in this case we just didnt get those massive spikes this time around. If you look back in early March you will see where the VIX exploded and continued with large candles for several sessions. This blast in the VIX lead to a decline of around five percent in three sessions. So even though the number of down sessions wasn’t huge the fall was more proliferic. This is just a small example of how the volaility in the markets can be affected when the markets starts to decline. It is this increase in volatility that can wreak havoc on our plans for defending our accounts.
When most experienced traders think about defending positions they tend to gravitate towards using options, specifically put options. Put options give traders the right to sell their equities at a specific price for a specific period of time and this helps protect against downside movement. This is typically a solid strategy to protect from downside movement…unless that movement gets too intense. The best example of this comes from March of 2020 when the market cratered on the Corona virus problem. With a massive spike in the VIX these primary defensive structures became problematic in the fact that they became so expensive to buy that the likelihood of profitting from them was reduced to almost zero. You see these spikes in volatilty have a devasting affect on option buyers and that is especially true for put buyers wanting protection. Think of it this way…an insurance company that ensures against typhoons sees the weather reports and it is expected that a typhoon is going to hit land any moment and you now want to buy insurance…. as you can guess the premiums would be though the roof and it may get so expensive that one would be better off insuing one’s self.
So what is one left to do when something like this comes along? Well, every good trader should have a back up plan just in case this market condition comes along again and believe you me it will happen again it is just a matter of time. So, if puts are our primary defensive strategy and that becomes problematic perhaps we can jump the fence and look at the other side of the options market? Instead of buying a put that is too expensive maybe we could sell something and collect on those fat premiums instead of paying them. Also, instead of looking at puts there is another side to the options chain and that would be the call side. If we sell an option instead of purchasing one then we have an obligation to buy an equity at a specific price for a specific length of time and in this case we would get paid to obligate ourselves to buy a stock. What if we obligated ourselves to buy a call at a price below the current price and get paid to buy the stock at a deal or just collecting enough premium to offset any damage that might be occuring if we already owned the stock.
This secondary strategy flips the script on the volatility problem and puts us in a more favorable position. This strategy may not work quite as well with the garden variety small, short-lived pullback but could work out much better if the decline gets a little wild. This strategy is called an In the Money Covered Call. This is a tool that every good trader should have in their toolbox just in case things go wild.
In the coming blog posts we will explore this strategy in more detail but the takeaway from this week’s blog is that one needs to have secondary defensive strategies available for all different market conditions if one expects to be a champion!
Coach “Old Money” Holmes