After the strongest bull run in the history of the markets, it took just six trading sessions for stocks to go from all-time highs into correction territory, obliterating four months of gains.
The swift downturn caught many traders by surprise, but I was not one of them. For the past few weeks, I have been telling anyone who would listen that stocks were grossly overvalued and that a sell-off was coming.
In fact, markets were as overbought as they had been in the past five years.
As the coronavirus began popping up across the globe with the number of cases spiking and the death toll steadily rising, stocks quickly reversed course and went screaming lower.
Again, the force of this sell-off was not shocking. There were a number of charts predicting that something like this would happen — like a diverging RSI or the extremely high level of stocks trading above their 200-day moving average.
Now stocks have swung from being overbought to being oversold. And I’m sure there are some brave souls out there who are itching to go long.
But there might be a better way to take advantage of current market conditions with less risk…
Following a big drop in the market, two things tend to happen.
The first is that volatility tends to remain elevated. Below is a chart of the CBOE Volatility Index (VIX), which measures the stock market’s expectation of volatility based on S&P 500 index options. It is a barometer of whether traders are greedy (low VIX) or fearful (high VIX).
As you can see in the chart below, the VIX is significantly higher than at any point in the past year.
The second thing that happens after a big sell-off is that the odds of sideways market movement increase.
While many traders like to make things more complicated, there are essentially two market phases: a trending phase and a congestion phase.
In a trending phase, the market (or individual stock) moves in one direction or the other. That’s why I also refer to this as a “directional phase.”
In a congestion phase, the market (or individual stock) bounces around but moves sideways without a sustained advance or decline.
As a general rule of thumb, the longer the market stays in one phase, the better the odds it will enter the other phase. So, when we have a strong directional move like we saw last week, there is a good chance it will be followed by choppy sideways action. In fact, the best non-directional periods come after a strong directional move.
To sum up, we’ve just experienced a massive move down in the market in which stocks rapidly went from overbought to oversold. This sets us up for a non-directional period in which volatility remains elevated, and the best way to take advantage of this is with credit spreads, specifically bull put spreads.
How Bull Put Spreads Work
With credit spreads, you sell an option that’s more expensive than the option purchased. This generates a premium (i.e., income) upfront, which is the maximum profit for the trade.
The goal when initiating credit spreads is for time to run out so that the premium you collected when you entered the trade is yours to keep.
A bull put spread is created by selling an at-the-money or slightly out-of-the-money put option while at the same time purchasing a cheaper or lower strike price put option. Both options will have the same expiration date, which makes this a vertical spread.
The cheaper put option is purchased for protection in case the underlying asset moves sharply lower after the spread is initiated. While the price you pay for the long put decreases your overall profit potential, the small debit is worth the cost since an unexpected move lower can wipe out several profitable trades.
Since the bull put spread is a credit spread, the end goal is to capture as much of the premium as possible between the time the spread is initiated and the time both options expire.
The maximum profit on a bull put spread is realized if the underlying asset continues to trade at or above the strike price of the put option that was sold prior to the options expiration date. A maximum loss occurs if the underlying asset trades at or below the strike price of the put option that was purchased.
The fact that you know your maximum profit and risk upfront is one of the advantages of credit spreads. The more you know about the trade you’re entering, the better you can plan for potential outcomes.
If the underlying asset trades below the strike price of the put option that was purchased, the loss will still be limited to the difference between the two strike prices minus the net premium that was received for selling the expensive put minus the offset for the put that was purchased.
The breakeven on the bull put spread occurs if the underlying asset trades below the strike price of the option that was sold by the amount of the net credit received when opening the position.
When To Trade Bull Put Spreads
The best time to enter a bull put spread is when the market has just finished breaking down and is likely to enter a congestion phase. After a strong, fast downside correction, bull put spreads can be a great way to generate income without the risk of holding long positions through periods of heightened uncertainty.
When you go long/short a stock or buy a call/put option, you’re trying to guess where the stock is going and how long it will take to get there. Credit spreads are just the opposite: You’re concerned with where the stock is NOT going to go, and that is much easier to predict!
As I just explained, with a bull put spread, you don’t need the underlying stock to make a big move higher. You simply need it to not be below the strike price of the short option at expiration to collect the maximum profit.
Plus, when volatility is high, options are more expensive, which is great for credit spread traders because we’re selling options
In general, I sell credit spreads when implied volatility is moving higher or elevated because it means juicer premiums on the spread, which, in turn, means more money in my pocket.
So, if you believe the market may be bottoming out here or in the near future, bull put spreads will be a great way to squeeze money out of stocks as we enter what is likely to be a choppy sideways period.
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