Week 23: Bear markets are hard to trade, even when you're bearish
Sell early and carry a wide stop
Hi. Welcome back to Fifty Trades in Fifty Weeks!
This is Week 23: Bear markets are hard to trade, even when you're bearish
50in50 uses the case study method to go through one real-time trade in detail, about once per week. This Substack is targeted at traders with 0 to 5 years of experience, but I hope that pros will find it valuable too. For a full description of what this is (and who I am), see here.
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Update on previous trades
Here are some updates on past 50in50 trades:
Last week’s META trade was a loser, even though META went straight down from inception. In real life, the trade was fine because the stock bounced off $155 twice and there was some ability to trade around the gamma. But the specific strategy laid out here lost money as there was no flexibility.
The XME trade is nice so far. Up around 7%.
The GBTC trade was good. Took profit at $14.80 (Friday close, as per the plan).
ARKK is boring.
RBLX is still substantially outperforming CVNA.
That’s it! Full spreadsheet with all the results in Week 30.
Now, let’s talk about selling into bear market rallies.
Bear markets are hard to trade, even when you're bearish
Bear markets are hard to trade for a bunch of reasons:
Volatility is higher in bear markets. The volatility of volatility (vol of vol) is also higher. Therefore, the market switches between regimes faster. For example, stocks were cratering and VIX was 35 in May and again in June… Now we’re grinding higher and the VIX is 22. Those are two completely different trading regimes in the space of two months. To give you a sense of the difference, here is the average daily range of S&P futures vs. the level of VIX the day before.
S&P futures % daily range vs. prior day level of VIX (2017 to now)
You can estimate from that chart that at the lows in stocks (the highs in VIX) in June, daily S&P ranges were in the 3%-5% area while now they are closer to 1%-2%. That’s a totally different regime that requires different position sizes and a different trading approach. In a bull market, volatility doesn’t change that quickly. In bear markets, you need to be good at real-time vol-adjustment.
Quite often, the exact moment you want to add to your shorts is the moment you should be taking profit. The most fun trade in the world is when you catch the right side of a bear market selloff and ride it down while adding. Unfortunately, this doesn’t happen very often because stocks are in a bull market most of the time, and even when they’re not, this trade requires perfect timing.
Bear market rallies are fast and soul-destroying and go farther than most people think is possible. When stocks are oversold, and everyone is bearish, the rips higher can be insane. There were solid 25% rallies in 2001 and 2008, even as it seemed pretty obvious that the world was ending. There does not have to be any fundamental catalyst for a bear market rally. It just happens when it’s ready to happen.
I provide this intro as a warning because this piece is about selling the current rally in stocks.
Selling a bear market rally
Selling the hole in a bear market is fun when it works, but it barely ever works. Pyramiding into short equity trades is soooooooooooooooooooo much fun when it works. But it’s high payoff, low EV most of the time.
Most of the successful short equity index trades that I have executed involved self-restraint to wait for the right entry, courage to pull the trigger, a willingness to trade with a wide stop, and the patience and discipline of Ernest Shackleton to avoid adding on the way down and hold on until the target was reached.
Before I get into how to sell the rally in a bear market, let me first provide my bearish rationale. My view is not all that unique or creative; many market observers hold a similar bearish view. The thing is, that’s fine. It’s easy to talk about why you are bearish, the hard part is making money. For example, one of the biggest permabears in the world, who has been bearish every year since at least 2010 as per these sorts of comments…
… Is down 3.4% on the year for 2022!
Whenever you see some kudos like “the man who called the 2008 crash” or some such nonsense… Try to find out whether that person made money. There is a very good chance they did not. You will see many prognosticators make aggressive directional forecasts but most of those forecasts involve an unlimited time horizon and no stop loss. That’s a much easier game to play vs. trying to make money in real life.
Anyway, I’m generally bearish stocks because:
The Fed will keep policy tight right into 2023 as they follow lagging indicators like CPI and US Unemployment.
Quantitative Tightening (QT) has just begun and will double in September. Fed balance sheet growth or shrinkage has been a pretty good univariate model for forecasting stock prices since 2008.
The Fed is tightening into a significant global growth slowdown with Europe and China weakening at the same time as the US stalls.
Valuations are high and bear markets normally end with cheap, not high valuations.
VIX has never gone to panic levels yet in this bear market; it keeps topping around 35. Bear markets usually climax with a blow-up in the VIX.
The period from August to October in mid-term years is seasonally weak. Here is a chart:
There are some other reasons to be bearish, but that is the basic gist. Before we continue, a brief word from our sponsor.
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Courage, patience, and discipline
Selling bear market rallies takes courage, patience, and discipline. First, let’s talk about the courage part. It takes no brains or courage to sell into a collapsing market because that’s what every trader’s instinct is likely to be. On the other hand, when S&Ps bounce hard off 3650 and start climbing the wall of worry every day, it’s strangely difficult to sell the rally at 4125.
This is a strange quirk of human nature. We love a bargain on Amazon Prime Day and we desperately want to sell our used car for top dollar… But we feel more comfortable buying SPX (and USDJPY) at the highs and selling it on the lows. Avoiding this sort of reflex to buy high and sell low is the number one way to avoid sucking wind as a trader and investor.
The two main reasons investors perform poorly are 1) transaction costs and 2) selling low and buying high. Check out this mindblowing chart from JPAM:
Anyway, it takes courage to sell the rally. That courage is abetted by analysis that convinces you that you are not just peeing in the wind, but instead taking a calculated shot in an attempt to determine when the direction of the wind is about to change. The simplest way to do this is to use some basic technical analysis.
Assuming you are not already short at bad levels, you want to wait as long as possible to sell the rally. There is tension, though, because if you wait too long, you miss it. One way I deal with this is to sell a bit early and use a wide stop.
The SPX chart right now looks like this:
SPX hourly back to November 2021
That’s a lot of blue lines lol! The purpose of the blue lines is to show points where I think there is likely to be meaningful resistance. As you can see by the three highs in late May, there looks to be a band of resistance right here 4160/4200. Then, the big papa resistance is 4300 where you had a triple top in April/May. Above that, you have the 4355 level (top of gap down in late May and old support) and then the huge trendline that comes down right at 4350.
So my strategy in a setup like this is to sell early and use a wide stop. There is a cost to selling early, but there’s also a cost to missing it and then hitting a bid at 3900 cuz of FOMO! The main cost to selling early is that you can’t lever up very much. If you’re selling here with a 4366 stop loss, your position is not going to be very big.
But everything is always about tradeoffs. Here, it’s better to sell ahead of the first batch of resistance, with a stop above the last batch of resistance, and give yourself the best odds of 1) catching it before it turns and 2) surviving the overshoot if there is one.
The more aggressive strategy would be to sell here (4125) and stop above the first layer of resistance (4225, for example). This gives you much more leverage but less staying power. It’s always about tradeoffs. Leverage vs. staying power. Always a tradeoff.
Specific tactics for this trade
My view here is that stocks roll over and trade back to the lows by September or October. It’s a three-month view, and I don’t think we collapse in a disorderly fashion. I think we go back to 3600/3700 and at that point, I will want to cover.
In S&Ps that means I go short at 4125 with a stop at 4366. If we are using SPY (the S&P 500 ETF), we could go short at 412.50 with a stop at 436.60 and then look at selling some puts to make the risk/reward a bit better.
Selling S&P puts against short positions is often a good idea if you are not looking for a stock market collapse. S&P puts tend to be expensive, and selling SPX puts has produced abnormal returns over almost all extended time periods primarily because a) natural demand for SPX puts as insurance almost always exceeds natural supply and b) it’s very hard to manage naked equity puts when you’re wrong. Stocks go up slow and down fast.
As discussed in previous 50in50 episodes, if I’m comparing cash to options positions (or cash to a mix of cash and options,) I always plot the possible P&Ls in Excel. It’s the easiest way to easily and quickly understand the payout profile of each strategy.
In this case, I think we go to 3700, so I’ll take a look at selling the October 3600, 3700, or 3800 puts ($360, $370, and $380 in SPY) to see how the P&L changes.
Here is the result:
P&L of short cash SPY, and short cash SPY + sell a put
Since my plan is to cover around 3700 anyway, and I don’t think we are going there in a straight line overnight… Selling the 370 put makes sense. The 380 put isn’t terrible to sell, but that cuts off a bit too much of my P&L. The 360 put is similar to the 370, but since I plan to get out down there somewhere anyway, it honestly doesn’t make much difference.
A few things to consider:
If we get stopped out, we need to buy back the option. Presumably, it will be much cheaper, but depending on how quickly the stop-out happens, we are not going to collect the full premium sold in that case.
If stocks collapse right now and go straight to 3700, I’m going to wish I didn’t sell the put. That’s life. Once you have your view, you structure your trade around that view. Not around the path of least regret.
When SPX goes to 3900 next week, you’ll be tempted to sell into that downward momentum. This is usually a recipe for a worse average and big frustration when it rallies back to 4100 and you cut the regrettable decision to add.
That chart looks like it could be the new, modern logo for an NHL hockey team.
Selling rallies in a bear market is better than selling the hole. The best way to execute swing trades in stocks in a bear market is to wait for a rally into converging resistance, sell early as resistance nears, and put your stop loss on the far side of the next layer of tops.
This approach maximizes expected value but it does not maximize returns because the wide stop requires you to use less leverage. But: less leverage means a greater chance of survival and with the high volatility and high vol-of-vol in bear markets, the early and wide strategy is best.
Note that this is a 3-month view and there are more nimble and high-leverage ways to sell the rally in stonks. This is a swing trade methodology looking for a retest of the lows sometime before Halloween.
We go short SPY at 412.50 with a stop loss at 436.60 and sell an October 370 put to generate a bit better risk/reward. Target 3700.
That's it for today. Thanks for reading.
Trade at your own risk. Be smart. Have fun. Call your mom.
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