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There's an old adage that goes, "The bulls climb up the stairs, and the bears fall out the window."
Basically, stocks fall faster than they rise - and that statement has never rung more true.
The Dow was climbing to new highs all year long. And then, Monday, Feb. 24, hit and erased every single one of those gains all in one day.
People are scared - and fear grows like wildfire. As wealth dissipates, fear increases, and a vicious circle ensues...
But there's a way to measure the fear in this market and use it to your advantage - to make money on the free fall.
While investors are moving their money around in a desperate cry for help, smart traders are grabbing cash like it's floating in an arcade's wind booth.
And now, it's your turn.
Use the Bear Call Spread to Take Profits in a Falling Market
There's an options strategy I love for a market just like this - a market when fear is peaking.
Just look at the Chicago Board Options Exchange's CBOE Volatility Index (SVIX), also called the "fear index." The VIX is an averaged implied volatility (IV) of at-the-money S&P 500 index options.
As you can see in the above VIX chart, fear hasn't been this high since October's U.S.-China trade war.
But here's the thing about fear - it comes and goes. That much is evident in the chart above. Eventually, the fear will subside.
But before that happens, you can take advantage of the trading environment that this fear is setting up. Stocks are tanking, bears have fallen out the window, bulls will take time to rise, and options are expensive.
The strategy is simple...
Sell expensive credit spreads far away from the price action and beyond reach of a short-term recovery.
Here's what I mean...
Twilio Inc. (NYSE: TWLO), along with the rest of the market, has succumbed to the coronavirus-inspired correction.
It tanked below its 200-day moving average (brown line) and below its 50-day moving average (purple line). Additionally, it breached strong support at $120 and $115.
All of these levels are now resistance... strong resistance that will impede any bullish recovery. Additionally, TWLO options are now very expensive.
This elevated IV will allow us to sell a credit spread at or above these strong resistance levels and make a tidy, high-probability profit.
To review, implied volatility is derived from an option's price and shows what the market implies about the stock's volatility in the future. Basically, implied volatility is the real-time estimation of an asset's price as it trades, and it falls when the options market shows an upward trend.
Before this trade could get into any trouble, the stock would have to make a short-term, very strong bull run - a highly unlikely move, given the current market.
A bearish credit spread, also called a bear call spread, is constructed with two moves: selling a short-term call and buying a call with a higher strike price, typically five or more points apart, like the one below:
Now, opening this spread doesn't cost you any money. In fact, it gives you a credit!
Simply subtract the price of the call you're buying from the price of the call you're selling, and there you have it. Your account has been credited $100.
As long as the stock stays below $120 for the next 16 days, you can take this high-probability profit to the bank!
Here are the four steps to selling a bearish credit spread:
- Find stocks that have dropped hard below support and preferably the 50-day and 200-day moving averages.
- If you have two or more resistance levels (including moving averages), sell a bearish spread above as many resistance levels as possible. More is better.
- Receive at least 1% of credit for each day in the trade. In the example above, we will receive 25% for 16 days of time in the trade, fitting this rule.
- If the stock closes above your short strike, close (buy back) the spread for a small loss.
It doesn't matter if the market is heading up, down, or sideways. There's always profit potential there - if you know where to look.
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About the Author
Tom Gentile, options trading specialist for Money Map Press, is widely known as America's No. 1 Pattern Trader thanks to his nearly 30 years of experience spotting lucrative patterns in options trading. Tom has taught over 300,000 traders his option trading secrets in a variety of settings, including seminars and workshops. He's also a bestselling author of eight books and training courses.