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Option Tactics In A Bear Market

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By Lynda Schuepp

It ain't over until the fat lady sings. We all are sick of the bleeding and each week we think, "this is the bottom, I'll buy the dip, it's always worked before." It is human nature to want to be long the market not short, but continuing to use strategies that worked two years ago are quite unprofitable. But surely the bottom is near, you say. We've been wishing and hoping that were true since the first major correction in April of last year. One year later, we are down 40% from that low and down 60% from the high set.

Let's compare this bear market to other bear markets. We thought the crash in 1987 was horrendous and the worst most of us have seen in our trading careers. That correction saw the S&P 500 tumble 56%, the Nasdaq declined 58% and the Dow Jones fared the worst at a loss of 70% and only lasted four months, and the worst was over in a month. We have to go back to December of 1974 to see more significant declines. That bear market lasted 2 years and saw the S&P 500 drop 94%, the Dow Jones drop 87% and the Nasdaq fared worst at a decline of 149%! Does history repeat itself? What's different this time?

One only needs to look at the gains in these three indexes up to their highs in March of 2000 to see the problem. I'm afraid Alan's bubble is a reality. If you go back to the lows in December of 1974 to the highs in March of 2000, the Dow rose 1900%, the S&P 2400% and the Nasdaq 9200%! Now I'll admit the Nasdaq is a better reflection of growth companies than the Dow. The times they are a-changing, so it's probably more realistic to compare the growth in the three indexes since the lows back in October of 1987. The Dow rose 600%, the S&P 600% but the Nasdaq rose 1700%, almost triple the other indexes. Therein, lies the problem-what goes up (too far, too fast), comes down to a more reasonable level. The question remains - are we at reasonable levels yet?

As of Friday, the Dow is up 508%, the S&P up 432% and the Nasdaq is up 556% since the October 1987 lows. If we are not in a recession, then these levels are pretty realistic but if we are in a recession, we should see ALL indexes go lower from here.

Last week, I wrote about a longer-term strategy to use in a bear market. Well, it's one week later, the market is lower still and it's time to review our position. To recap from last week, we looked at a bull call spread, being the bottom fishers and optimists that we naturally are. We chose the January calls for reasons explained in the article, going long the 40 strike and short the 45 strike. Last week at the close, we could have put the trade on for $2.30. One week later it would cost $2.30 based on the closing prices on Friday! But the market is down, how can that be? Imagine, the QQQ's dropped from $45 to $41 this week, but our spread actually held. This is why you should hedge your bets in this kind of market! Had you simply gone directional and bought the January 40 calls without selling the 45 strike, you'd be down 25% of your investment. And speaking of investment, on 10 contracts you would have invested over $11,000 if you only bought the 40 calls, but the spread only cost $2300 for 10 contracts. Let's review, invest $2300 in the spread and your loss is zero after the QQQ's went down 8% or invest $11,000 and be down $3000. That's why you need to add this strategy to your arsenal.

The good news is that the perception based on the option prices this week indicate we may finally be near a bottom, but don't expect a rapid turn around.

Nasdaq since October 1987:

Notice how the Nasdaq dropped to its 100-period moving average. Remember this is the 100-MONTH moving average, because this is a monthly chart. Sometimes, you need to step back and look at the big picture. We are very near that average now, the actual number is 1678 and that's only another 10%. We could do that in a week! This average has provide MAJOR support in the past bear markets and will need to be watched.

The moral of the story is keep your losses small and minimize risk in your trades by implementing more conservative strategies in this kind of market.

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