Every now and then we see bear markets come along and everything changes.
Bear markets are as natural as breathing. When markets rally they exert a psychological influence over other people and drag them into they market. For example many people see the "easy" money being made and want to join in.
Once everyone is in and there is no one left to buy the peak is in – at this point there is often not a cloud in the sky, it seems the best of all possible worlds.
Peaking is a process and takes some time as the market drags in all the players.
Looking at the market collapses in my trading lifetime we have…
1987 – FTSE peaked around 2450 in July and the initial decline lasted around 5 weeks down to c.2150 (-300 points/-12%). The corrective rally took almost 2 months back to c. 2400 and then the market fell to 1515 in around 3 weeks (-885/-35%). On Black Monday FTSE was down around 15% in a single day.
1999 – 2003 – peak as close as possible to New Year’s Eve (a time of very positive sentiment – the Nikkei saw the same in 1989); so a fall from 6950 to 3277 in March 2003 - -3673 (-53%) in 27 months.
2007 – 2009 – fall from 6754 in July 2007 down to 3460 in March 2009; so a fall of 3296 (-49% in 21 months.)
US markets, measured by the Dow saw something very similar…
1987 – the Dow fell 22.6% in 1 day - Monday October 19th 1987
2000 – 2002 - fall from 11750 (January 2000) to 7197 (October 2002); so a fall of 4553 (-38% in 34 months)
2007 – 2009 – fall from 14195 (October 2007) to 7023 (February 2009); so a fall of 7172 (-51% in 17 months)
You can see from the data above that since 1987 FTSE/Dow have spent around 4 years in bear markets and around 26 years in bull markets.
But, when a bear market bites the rules can change quite dramatically.
Human beings are creatures of habit and this applies equally to our trading approaches. We get used to trading in a certain way and we may not be aware of the risk parameters of what we are doing especially in bear market conditions.
THIS CAN BE EXTREMELY DANGEROUS TO YOUR WEALTH!
This is particularly so if you are trading a strategy which has not been tested in a bear market and/or if you have not personally traded through a bear market.
Having said that there is a big difference if you are day trading a strategy with fairly tight risk control as opposed to something, for example, writing naked out-of-the-money options. The former may cease to perform well but at least losses will be limited by your stop loss to 2% or so of capital. The latter can wipe you out.
In 1987 options writing was all the rage and I remember one newsletter recommending the sale of an out-of-the–money put option at £30 to yield a small percentage gain.
Out of interest I tracked that particular put and at one point it was quoted at £3000 to close. If you had used such a put to secure a 1% return on your capital, a few days later you would have no trading capital left – it would have been wiped out by that single trade.
If you had also sold a similar call yielding 1% then that would have salvaged a 1% gain but that would be very small consolation in the circumstances.
Now in 1987 I had bought puts worth £600 per point in the week before the crash.
£400 of those I sold at a small profit that week looking to re-buy on the Friday. But on Friday a hurricane closed the market (and blew down most of the trees in Hyde Park, I used to walk through this each day from my house in Belgravia to my office in the West End) and so I was left with £200 per point on the day of the Crash, Black Monday October 19th 1987.
I sold those puts that morning for a profit of £20000, not bad, but a fraction of what I could have made if I had held on to the other puts at £400 pounds per point AND if I had held on a few more days.
But that was not the worst of it – I also started selling puts!!
This was a BIG mistake and I was soon under pressure, despite selling some calls 200 points out of the money for 200 points each – in fact liquidity was thin and I only managed to sell 10 lots of these (equal to £100 per point).
Once under pressure I rolled my options over into later months, November and then December.
To manage these positons was a nightmare but I was lucky and FTSE basically went sideways for the rest of 1987 and I got out intact.
OK, that is then and this is now.
I called the 1987 Crash (Perfect Elliott Wave pattern as set out in my book THE WAY TO TRADE), I called for major peaks in 2000 in speeches in both Manchester and New York (standing ovation in Manchester, complete flop in NY!) and in 2006 I wrote the book FINANCIAL CATACLYSM NOW! Predicting the 2007/2009 cataclysm.
So my record has been pretty good.
My view is that we are seeing a potentially major peak in markets right now (October 2017) but if any decline now proves to be a correction then 2018 is the year to worry about.
I have always had concern for fellow traders and my purpose in writing this piece is to help traders avoid the sort of decimation than can occur once markets start to fall sharply.
Let me illustrate how a market crash could wipe you out in 2 easy stages…
I will assume you write puts and calls shortly after expiry on the third Friday of every month.
FTSE was around 7230 at expiry (10:15 am) on Friday 15 September. Let’s assume you sell both October puts and calls to raise 2%...
I will assume capital of £100,000 so you would need to sell options worth £2000 and to this you might pick the 7000 puts and sell for around 40 and the 7500 calls and sell these for around 10. You would need to sell at £40 pp to obtain £2000 of option premium (40 +10 = 50 x £40 = £2000).
As long as these expire between 7000 and 7500 you would be fine.
You could expand this range to 6750 – 7750 by selling more options at strike prices further out-of-the-money but then you would need to at least double the size of your positions.
I would stress this is just an example and the prices you obtain will vary with volatility and market action – ie each month is liable to give you different results and thus you may well choose different strike prices.
You may also decide to wait until the following week to sell as price action immediately following expiry can be more volatile.
In 1987 the Dow fell over 20% in one day.
A good rule of thumb is to expect an event at least twice as bad as any seen before.
However we will ignore this and instead got for a 10% decline over the course of 1 week.
On FTSE this would mean a 700 decline (or rally) in one week. Whichever range you chose your well out-of-the-money options would now be well in-the-money but we will assume you plan to roll-over once the option is near-the–money – say 50 to 100 points away.
But bear markets are unpredictable (actually so are all markets but bear markets are a lot worse) and your carefully laid plans may be in tatters as the market gaps right through the strike price.
But let’s assume you are able to execute your plan.
But volatility has increased substantially (volatility can be seen as your friend but it cannot be trusted!) and you end up having to pay 10X to close the option under pressure.
OK, no big deal you are down 8% at that point (10% to close – 2% taken at inception), just 4 months of profits (and if you have been doing this for any length of time you should have a fair bit of profit in hand).
What you should do is get the fuck out!
But you don’t, you follow the plan. You roll-over into November or December options – selling both puts and calls in sufficient number to cover the 10%. These are liable to be nearer the money than your previous positions and/or you may have to sell in greater size.
You relax, confident that all will come good and that you haven’t really lost any money – all will come good once your new option expire in 6 weeks or so.
WRONG – you have lost that money you are just hoping your new positions will make it good.
But this is a bear market and it takes a second chunk out of your positions and you again face paying 10x to close one side of your new position – you are now down around 90% - in fact your broker is demanding more margin to allow you to maintain your positions – if you are lucky the broker may have stepped in before it gets that bad but if it happens quickly there may not be time for that.
Now this may seem alarmist but I have seen this happen and whereas there may be systems suggesting selling out-of-the-money options before a bear market hits I have never seen one after a bear market has passed through.
Now a few general points…
1. As far as I am aware there are only 4 ways of mitigating disaster if out-of-the-money options come under pressure…
a. You close the position (and this would be my recommendation)
b. You roll-over opening yourself to the scenario above.
c. You buy other options to mitigate total disaster
d. You buy/sell futures/spreadbets to cover the exposure but these are very hard to manage.
2. Having said that I do not know everything and maybe there is another way I am unaware of.
3. If you have the help of active and/or experienced traders they may be able to guide you through the bear market and keep you safe, for example you might sell puts in a bull market and only calls in a bear market. But as markets are essentially unpredictable this is not a recommended option.
4. The scenario I have outlined above is one of many. The reality may not be as damaging or it may be MUCH, MUCH worse. In my experience the market can do virtually anything and will do so over time. If there is a risk in your strategy then the market will exploit that risk at some point – it may take 12 months to do so, or it may take 12 years.
5. The last bear market in 2007/2009 is now over 8 years ago. My indicators suggest another is very close but I may be wrong. However I am really talking about risk here. Volatility is unusually low (in fact in the US it has never been so low) which gives you less bang for your buck when selling options at whatever strike and markets always swing from extreme to extreme. Similarly market strategies that expose the user to large moves have periods where they work very well, and other periods where they don’t!
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This piece has been written by John Piper, an experienced trader and analyst with 30 + years of experience. John runs the BIG CALL service looking for the major moves in markets including the next bear market.