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Leveraging A Market Crash To Fill Your Wallet

By Chris Rowe May 10, 2022 Facebook Logo Twitter Logo Email Logo LinkedIn Logo

The market’s falling apart, right on schedule

We are in a bear market. I’m guessing you’ve taken advantage, using one of the many strategies that I’ve been shouting about from the rooftops. 

I’ve been suggesting bearish trades, I’ve explained why cash can be a great investment in times like these, and I’ve talked about commodities being the only place to buy.

That’s all true. But the best way to take advantage of the market going down is with Put options.

The best way to position yourself to profit is from the simple fact that markets have become less fearful, is by selling (short) options.  

You see, options contracts are basically a form of insurance. They get more expensive when there’s more fear and anticipation of price volatility.

So, when people are overly-fearful, it makes sense to be the seller of options to others because you’d be selling at high prices, and options prices tend to come back to normal very swiftly after a spike in fear hits the market. 

But if you sell short options, you could end up with a big loss if things don’t go according to “plan.”  

Instead of simply selling options short, you can benefit in similar ways, just by adding one additional step to your short-option position, a step that:

    1. Caps your loss (ensures a predefined maximum loss, making it easy to manage your risk).  
    2. Adds an opportunity for added profit, from time passing or fear subsiding.  

A short option can be a directional bet or it can be a bet that fear will subside. But if you add one more step and convert that short option into a spread, you’re increasing the directional component and reducing your risk dramatically.  

Let me explain.

Channel Trading

Markets often trade within channels when they are in bull or bear markets. The tops and bottoms of the channel act like support and resistance levels. 

We’re seeing many stocks and indices trading within descending channels right now. Take a look at iShares Russell 2000 ETF (IWM).

(Click any image to enlarge.)

The downtrend is undeniable. And I’m sure you’re already picturing how you can build a strategy around trading the market when it hits the top of the channel and the bottom of the channel.

You can also trade on breakouts from the channel. 

Let’s go over why I think the bear put spread is such an effective strategy for bearish trades within a descending channel.

The Bear Put Spread

One of the biggest reasons I like the bear put spread for bearish trades is the defined risk. 

Your risk is limited to the cost of the spread. That’s it. If instead you short the stock, your risk is unlimited.

I won’t go into a deep explanation of how stock options work, but when you buy an option your risk is limited to what you paid for it. 

Another reason I like the bear put spread is the leverage. If you’re willing to take the risk in a bearish position, you should get a real bang for your buck if it works out for you.

And since the market tends to move fast in bear markets, you want a trade that can benefit from that quick time frame.

For this reason, I like to look at options with a shorter time-frame when it comes to channel trading. As long as there is enough liquidity, you can trade options with about two to three weeks left until expiration. 

Here, let me show you.

I’m going to use the May 27 weekly options on IWM. So, there are only 17 days left until expiration.

We’re going to:

Buy the May 27, weekly 180 Put, cost $8.27

Sell the May 27, weekly 170 Put, cost $3.80

$8.27 - $3.80 = $4.47 total cost

First, the exciting part:  There’s a 10-point difference between the two strike prices.  Therefore we know that the maximum high price that the spread can go to is 10.  And buying it at $4.47 puts us in the position to more than double our money. 

Second, the super cool part:  Since we’d own the 180 put and IWM was at $174.90 in this example, even if the stock market goes nowhere for 17 days, this put will go to $5.10, a bit more than a 10% gain.  

Third, the genius part:  IWM can go in the unintended direction - UP - and we are still profitable until the IWM goes up above $175.53 (again, it’s at $174.90 at the time of this writing). 

Selling the 170 Put does more than just lower the cost of the 180 Put by $3.80 so your total risk is $4.47.

It allows you to take advantage of the time erosion of options. I’ll explain that in a moment.

You don’t need to hold the spread to expiration. You can sell it anytime between now and May 27th. 

But the easiest way to see your breakeven level is to calculate where IWM’s price needs to be at expiration in order for your trade to make back what you spent on it.

Since you spent $4.47 to buy the spread, breakeven will be $4.47 below the strike price of the Put option you purchased—$180.

$180 - $4.47 = $175.53. That’s your breakeven point. 

Where is IWM trading right now? $174.90.

You’re already past breakeven right now by $0.63. IWM could even go up a little in price and you would still be profitable. IWM could stay right at $174.90 until expiration and you would make 14% on this trade.

Since you sold the May 170 Put, your profit potential is limited to the $10 between 170 and 180 minus what you paid for the spread.

$10 - $4.47 = $5.53 in profit potential. That’s a 124% profit potential if IWM is at or below $170 at expiration. That’s pretty damn good.

Let’s say we take a $100,000 account size as an example. If we take 3% of that, we get $3,000. So, you could do six or seven of these trades—or ones just like it.

With that kind of leverage, you can make some very good money on downward swings without risking too much.

That’s leveraging a market crash with a limited risk.

Now, back to taking advantage of the time erosion. Part of the reason why this spread costs less than the $5.10 of intrinsic value that the May 180 Put currently holds is that implied volatility is going up as the market drops.

Implied volatility inflates the value of options when it goes up. In particular, it inflates out-of-the-money options—like the May 170 Put—versus in-the-money options—like the May 180 Put. 

So, even though the May 170 Put has a lower price than the 180 Put, the 170 Put is, relatively speaking, overvalued compared to the 180 Put.

That is what allows you to already be past breakeven on this trade at entry.

And to top it all off, time erosion will cause the 170 Put to lose value at a faster rate than 180 Put. That’s exactly what we want to happen. We want the option we own to hold its value, and for the 170 Put to lose value. That will make the spread go up in price faster.

Here’s another example:

If we use different strike prices (and this one was taken just this morning, the following day), we have different outcomes. 

This one you can buy for $2.61 and the highest it can go is $5.00. 

The coolest thing ever:  This position will go to $4.94, even if IWM goes NOWHERE!

Conclusion

You can take advantage of a downtrend much better with options than with any inverse ETF, or by taking a short stock position. When you isolate a market in a descending channel, you can place short-term Bear Put spread trades inside the channel to take advantage of the quick price movements.

Advanced traders like Wall Street money managers know this. They love taking advantage of retail investors that don’t really understand the ins-and-outs of options.

But here at True Market Insiders, we provide the knowledge you need so that you can trade just like the most sophisticated traders on Wall Street.

Bear market = happy traders.

Chris Rowe

CEO and Founder, True Market Insiders

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