Since the market has decided to remain pretty chaotic this week I thought we would continue talking about issues that arise from market action like we have seen this week and last and talk about proposed solutions. For those who have not been watching the markets in the last two weeks or for those that may read this many moons from now, the market plummetted over 11% last week and has had its worst drawdown since the 2008 crash. Now we are going to be spitting some truth this week and it starts right here! How many of you that are reading this blog were surprised by last week’s market movement? If you were, raise your hand? I’m betting there are a tonne of people with there hands aloft if they are indeed honest with themselves. It’s ok to be blindsided by the market once or twice but we do need to learn to respect the process of trading and get ourselves prepared which is what we discussed in last week’s blog. However, I feel a deeper dive into the issues that pop up during a downswing like that need to be addressed so that history, at least the bad parts, don’t repeat themselves in the future.

Now, I am not going to profess to know when this market will down again because that in my humble opinion is foolhardy and a waste of time. Instead, we will try to put ourselves in a position that even if the market works against us that we can either profit from it or at least minimize the negative effects of it. We talked about specific tips last week of how to be more in tune with the markets and generally be able to identify when a market might be moving. Let me say this, we are not trying to predict market movement but we are trying to get in tune with it so that our REACTIONS are better timed. That was last week’s theme, this week I want to talk about a different scenario. Let’s say you were surprised by the markets last week and you happen to be woefully unprepared to deal with its effects, you know like when the horse gets out of the barn, is there something you can do “in the moment” that may help reduce the risk of the adverse moves? There is and we will discuss.

Before we talk about what to do in the crisis moment, we must define what the issue or problem is during these moments. First, the issue is the swift decline in stock price whilst we are sitting with most likely a rather large bullish delta as the markets had done nothing but go straight up for a matter of months and this is naturally what a bullish trader would want. However, this is the surface issue but not the real issue in my estimation. You see if one has a bullish delta and a grasp of the options arena then one could add bearish trades to neutralize the delta and perhaps even turn it negative if one were so inclined. This is true but this is also where the real issue rears its ugly head. The real issue as I see it is the volatility spike! This spike makes putting on bearish options trades very expensive as the volatility explodes when the market hits freefall. You see that easy fix I outlined above now becomes a problem as you will need to spend like crazy to get the protection you desire, it’s like calling the insurance company as your house is in flames, the coverage is going to cost you more no doubt about it. So we have defined this issue and naturally, we need to figure out what to do about it?

Well, if you understand how volatility works then you will know that those awesome protective puts that you so badly covet are many times the price that they were the week before and they have a unique challenge even if you have the capital to buy them? That challenge is the loss of volatility! You see there is a phenomenon in the markets that is almost as certain as the sun rising in the east and setting in the west and that is that high volatility is always followed by lower volatility periods and vice versa. So what this means is that those straight put options that you are paying for are at some point are going to plummet in value and unless you have expert level timing can end up costing you a bundle when the current market carnage is over. So what do we do? I’m glad you asked.

When in the heat of the moment and things are falling faster than Justin Trudeau’s approval rating then you need to have a few things in your arsenal that can help slow the damage. Make no mistake, this is not a cure-all to all the bullish ails but it may help stem the tide. The first way to offset the issue of high volatility is to use instruments that are less or unaffected by increased volatility. I am specifically referring to the futures contracts. There are mini future and micro future contracts that are unaffected by volatility like options are, however, there is a problem with these as well and that is the leverage part of these contracts. With these contracts, you control a large amount of the underlying for a little bit of money. This means that if you are wrong and don’t use very good money management strategies and techniques you could find yourself in a whole heap of trouble! These are not for beginners and since this is a rookie blog we are going to discuss something that is more suited for beginners, although not as effective and that is spread trades. A spread trade, and there are many different kinds involve buying and selling options and therefore the effect of the volatility is somewhat offset. If one is trying to hedge in the heat of battle then looking at ratio spreads and debit spreads is a place to start.

So, if the horse does get out of the barn and you have learned and practiced how to use these techniques then you may just be able to wrangle that horsey back in the barn without too much trouble.

If you are unfamiliar with these techniques and want to hear more about how to use them then check out this week’s Cash Flow Club as we are going to dive into these subjects and techniques more so that we can be ready for the next time the market decides to throw a curveball our way.

Trade Well and Be Happy,

Coach Holmes