OAP 105: How To Protect Your Portfolio In A Down Market

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The further the markets continue to run higher, the greater the risk that another major market correction or market crash will happen in the near future. After all, as we pointed out in Show #15, the stock market has fallen 9 times at least 30% which is once every 10 years. Right now we're riding a 10-year bull rally that's losing steam fast. So, how do you protect your portfolio in a down market? That's the question and today's show will give you the answer.

Key Points from Today's Show:

  • No two crashes or corrections in the market are the same. 
  • The statistics on market crashes and how often they happen are all generalities until we go through the next event.
  • The only thing we do know is that markets are cyclical: it is impossible to have a market that goes straight up and straight down. 
  • Statistically speaking, we are pushing the boundaries of where we can see another correction occurring. 
  • Black swan events correct markets and keep everyone honest about how they trade and how much risk they take on.

Market Data from 1928:

  • 21 times in history stocks have fallen 20% at least, which is once every four years.
  • 41 times in history stocks have fallen 15%, which is once every two years.
  • 9 times stocks have fallen at least 30%, which is once every 10 years.

Black Swan Safety Plan:

1. Heading into a crash, you need to have a lot of cash. 

  • Anyone with cash heading into a market correction is better off than somebody who is fully allocated. 
  • Cash allows you to be more nimble and more aggressive after a crash.
    Gives you the ability to cover your position and also to expand and add new positions. 

2. Generally, crashes happen in slow motion.

  • Rarely get an entire market that will crash overnight. 
  • Most of the time market crashes happen in stages.
    It is okay give yourself room to wait for the crash to happen and not to over-anticipate its occurrence.
  • As options traders we have time to adjust and move around the crash.

A False Sense of Security:

"Market crashes have a tendency to unfold after the market has lost a 10 or 15% correction and then recovered from those lows." - John Hussman

  • The markets tend to crash, and then bounce back off of that drop almost recovering completely.
  • This creates a false sense of security, drawing traders in to "buy low”.
  • Then the market experiences the actual big crash after the initial dip down.

Market Crash Statistics:

"I counted 24 instances of a drop of at least 10% in the last 30 years. The mean average drop is 17.7% over 11 and a half weeks and the median is 17% over the 8-week period."

  • It takes some time for the markets to realize all of the information and for that information to be disseminated against the masses. 
  • However, individual securities can definitely crash overnight.

What does that mean for options traders?

  • Most trades are around 40 to 45 days out.
  • Might get stung one month heading into a crash situation that you do not know is happening. 
  • However, if you keep trading neutral you can keep adjusting along the way. 
  • As stock traders you do not have that choice; Index trading is really dangerous because it has such a big downside.

3. Stick with the program and don't assume that a bottom is in or not. 

  • You cannot assume that a market bottom is in.
  • Always fun under the assumption that at any time the markets could drop.
  • Still need to maintain a neutral balance, slightly bullish in some areas.
  • Stick with the program, stay neutral, and when the market correction comes you'll have an opportunity to adjust.

4. Scale up position sizes and maintain a balance during a down move.

  • Slowly scale up your position sizes when the market starts to crash.
  • Maintain balance; trade the direction of the market.
  • If you are neutral and the market goes down, add more bearish positions in your portfolio. 

Example: Heading into the market dip that has not yet occurred, your portfolio is totally 100% balance. Meaning, if the market stays right here, you generate the most amount of money possible on your trades. If the market drops 5%, then your portfolio still has its center of profit, its top of it's bell curve, higher than where the market is right now. If the market drops and you've done nothing, then you are naturally bullish just based on the way that the market has moved. If you "buy the dip" and then the market continues to go lower, it digs you into a deeper hole. 

5. Use costless collar for your stock positions.

  • If you have a stock position that you want to maintain in the market, use a costless collar.
  • You want to protect your portfolio without paying the "insurance premium" that it costs to do this.
  • Use covered calls and costless collars to protect your position and reduce cost basis.
  • See show number 30 to learn more.

Option Alpha Podcast Show Notes[FREE Download] Podcast Show Notes & Transcript PDF: No time to read the show notes right now? We've made it incredibly easy for you to save time by giving you instant access to the complete digital version of today's show. Click Here to Download Your FREE Copy

Free Options Trading Courses:

  • Options Basics [20 Videos]: Whether you're a completely new trader or an experienced trader, you'll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.
  • Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an "edge" in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.
  • Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We'll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.
  • Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You'll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.
  • Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we'll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.
  • Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can't seem to get answered, then this section will help you.
  • Portfolio Management [16 Videos]: When I say "portfolio management" some people automatically assume you need a Masters from MIT to understand the concept and strategies - that is NOT the case. And in this module, you'll see why managing your risk trading options is actually quite simple.
  • Trade Adjustments/Hedges [15 Videos]: In this popular module, we'll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we'll help you create an alert system to save time and make it more automatic.
  • Professional Trading [14 Videos]: Honestly, this module isn't just for professional traders; it's for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. This week's question comes from someone who asks:

I have a bear call spread on Tesla, which I sold. The strike prices are 295-300, which means I sold the $295 calls and bought the $300 calls. The reason why I put this trade on was that Tesla was at the top of the Bollinger Bands and that usually means the stock will revert back to mean and in this case, I could clearly see the trend dropping. It looked like it was going to sustain its upward movement, but yesterday unexpectedly some news came out. 

Elon Musk announced more than expected sales on the Teslas and then he announced conversion pack, which can convert any existing traditional car into an electric car. So both these things combined are going to shoot up the stock like no tomorrow. It looks like my trade is going to be a definite loser, but since you recommend that you shouldn't cut your losses, what's your take on this? Should I let the trade go or should I just cut my losses and close the trade?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

PDF Guides & Checklists:

  • The Ultimate Options Strategy Guide [90 Pages]: Our most popular PDF workbook with detailed options strategy pages categorized by market direction. Read the whole guide in less than 15 mins and have it forever to reference.
  • Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.
  • Implied Volatility (IV) Percentile Rank [3 Pages]: A cool, simple visual tool to help you understand how we should be trading based on the current IV rank of any particular stock and the best strategies for each blocked section of IV.
  • Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.
  • When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we'll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.
  • 7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

  • EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.
  • VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.
  • DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we'll discuss why I'm adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.
  • COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.
  • TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.
  • MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.
  • IBB Call Debit Spread (Opening Trade): We'll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.
  • TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly - even still the drop in implied volatility helped generate a $330 profit for us.
  • XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.
  • COH Iron Butterfly (Earnings Trade): Shortly after the market open we close out of our COH earnings trade for about a $160 profit, leaving just 1 leg on to expire worthless.
  • EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.
  • IBM Iron Condor (Earnings Trade): Shortly after the market opened you'll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.
  • SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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About The Author

Kirk Du Plessis

Kirk founded Option Alpha in early 2007 and currently serves as the Head Trader. Formerly an Investment Banker in the Mergers and Acquisitions Group for Deutsche Bank in New York and REIT Analyst for BB&T Capital Markets in Washington D.C., he's a Full-time Options Trader and Real Estate Investor. He's been interviewed on dozens of investing websites/podcasts and he's been seen in Barron’s Magazine, SmartMoney, and various other financial publications. Kirk currently lives in Pennsylvania (USA) with his beautiful wife and two daughters.