Last update: August 2021

One of the systems introduced in the Bear Market Survival Guide is called “Fade the Fear”. And with the epic levels of panic seizing the Street, the time is ripe for its deployment. After a brief review, I’ll provide an example of how you might use it right now.

The basic idea behind the system is that there are times when fear is overblown, and the market won’t fall as much as expected. To capitalize, we can scale-in to bull put spreads and profit on the eventual snap-back in prices and drop in implied volatility.

First, allow me to provide some evidence that fear is indeed excessive.

Exhibit One: The VIX

The one thing lacking during the market swoon has been a blow-off move in the CBOE Volatility Index (VIX). Given the relentlessness of the selling, I’m surprised it took so long. But, on Friday we finally saw panic-level readings on the VIX with the spike to 35. While it could move higher, prior readings around these levels have usually signaled short-term capitulation (and thus a market bottom) is nigh.

Exhibit Two: CBOE Put/Call Ratio

Alongside Friday’s VIX ramp, we witnessed extreme demand for put options. The equity-only put/call ratio saw its highest reading in two years on Friday, jumping to 1.12. That means 1.12 puts traded for every 1 call.

Exhibit Three: The worst Christmas Eve trading session in history

Monday’s beatdown officially marked the worst sell-off we’ve ever witnessed on the day before Christmas. Furthermore, we’re on track for the worst December in history as well. It doesn’t get much more extreme than that.

Thus far, the fear has been justified and the expectation of large moves has been both met and exceeded. But there comes a point in which the panic pendulum has swung too far. I think we’re there.

Our forecast is that implied volatility is too high and thus option premiums are too expensive. The other way to say this is that the market won’t fall as much as OTM puts are predicting. Thus, we want to “fade” or bet against the fear by selling these pumped-up put options. To define our risk, we use bull put spreads instead of naked options.

We’ll use SPX Index options in our example today, though any Index or ETF will suffice. With SPX at $2,380, suppose we sold a January $2150/$2140 bull put for $1.15. Consider it a bet that we won’t fall another 10% from here. Said another way, we will win if the S&P 500’s current 20% decline doesn’t grow into a 30% drop by January 18th, 2019.

Adopting the scaling-in technique might mean we enter three tiers like so:

• Tier One: Sell Jan $2150/$2140 bull put @ $1.15 (1/3rd size)
• Tier Two: Sell Jan $2150/$2140 bull put @ $1.73 (1/3rd size)
• Tier Three: Sell Jan $2150$2140 bull put @ $2.30 (1/3rd size)

You can adjust the timing on tiers two and three. These are just opened at 150% and 200% of the original premium received.

Timing the Entry

In deciding when to pull the trigger we use the same technique deployed with any bullish trade. Namely, a break of the prior day’s high or intraday resistance. This provides some evidence that buyers are emerging and the bounce-back has begun. One nice thing about the current downdraft has been its consistency. Most indexes have fallen very consistently with few false bounce attempts. Ideally, this would have prevented us from fading the fear prematurely.

It remains to be seen if this morning’s (Wednesday) up-gap can go the distance, but thus far we haven’t broken a prior day’s high.

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