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Spreads VS Selling Puts

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Comparing The Bear Markets Of 2000 to 2003 and 2007 to 2009
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April 18 2011  / Opinion Article

Two Bear Markets Compared

Comparing The Bear Markets of 2000 to 2003 and 2007 to 2009

 

Two Bear Markets Compared

On Friday I sold my SPY puts (which in hindsight with today's (Apr 18 2011) market pullback was a mistake) after I spent Thursday night looking at my charts from the 2000 - 2003 bear market. I felt I much prefer "day trading" the SPY rather than buying when I "guess" the market looks like a pullback might be in order.

A lot of the reason for wanting to stay with trading the SPY on down days comes from my charts from the last two bear markets and what I believe is happening now to the stock markets. Below is the chart of the bear market of 2000 to 2003. I have highlighted in light blue where the majority of investors were during that period. In 1998 to almost the end of 2000, investors were in a buying mood. Even when the market topped in 2000, and began a pullback, investors were told in the fall of 2000 that the bear market was over and the upswing would continue.

 

The NASDAQ though would never recover from the dot com bubble. So even in the fall of 2000 investors were in a buying mood. But the bear market had already started and by the end of 2002 to early 2003 the market bottomed after collapsing 50%. Just as in the bear market of 2007 to 2009, some investors starting buying again in early 2003, but the majority of investors did not buy or "average down" as the saying goes. Instead they waited for the market to start to recover. These buyers then became sellers and it took 32 months for the market to break through all the sellers. But the recovery from the bear of 2000-2003 had a lot going for it, sub-prime mess was just getting started and a lot of investors who lost in the dot com bubble were pumping money into real estate. Debt issues were not discussed, gold was reasonably priced, oil stayed under wraps, bush had tax cuts that certainly helped fuel stock prices and well, it just seemed a better time, didn't it.

Below is the bear market of 2007 to 2009. Once the market broke through all those investors who were selling from the 2000-2003 bear market, in October 2006 you can see how the market set new highs. Buyers after October 2006, picked up shares at pretty lofty levels including right into the fall of 2007 when the market made a new high. The subsequent drop was, by the end of 2007 being labeled as the end to that "mini-bear" market.

Investors loaded up on what they perceived as discounted stocks and indeed analysts everywhere pointed out how inexpensive stocks were. Actually stocks were fairly to fully valued. The market collapsed again, falling 57% before bottoming. Stocks yet again became undervalued but just as before, only a small number of investors were buying.

Starting in March 2010 the S&P has been hitting up against the resistance of the enormous numbers of sellers who have been waiting to get out of their positions from before the latest bear collapse. Just as in the previous bear, (2000-2003 chart above), the number of sellers is enormous and most want out completely. They have had it with stocks after twice being burned. A tremendous number of these investors have not made any money in a decade. They just want as much of their capital back as possible.

So far the S&P has only been in the resistance level for perhaps 13 months and if I take out the period of last summer 2010, when the S&P pulled back more than 15%, it has only been in the resistance range for 9 months. As mentioned, the previous bear recovery through resistance was 32 months. This time the S&P has only been in resistance for 13 months. There is a long time period to go before the market breaks through resistance.

The Headwinds For This Recovery

I am not sure the market can break free and move to a new high, this time before it moves lower. No other market in the past 35 years has had the problems this market faces. The sovereign debt issues are decades away from ever being resolved, high oil prices are crimping the economy, Japan's earthquake, tsunami and nuclear meltdown will have far reaching economic repercussions that the market has not yet experienced. The US housing market just keeps well, falling and unemployment remains a stubborn issue. Economists talk about China like it can save the world. Somehow economists seem to think that they will overnight become a nation of a billion and half consumers, loading up on real estate, furniture, consumer electronics and more. It is utter nonsense. The US GDP in 2009 was 15 Trillion dollars. China was reported to be 5 Trillion. Unemployment even by Chinese statistics puts urban unemployment around 9 to 10 percent and rural unemployment between 20 and 30 percent. The average American income is 48,000 in 2009 versus 4,000 in China. There are so many fundamental economic flaws within China that still must be tackled, that it is just plain silly to think that China will "save the world" from economic disaster.

Meanwhile baby boomers are starting to retire although now many question if they can afford it. Oil is definitely too high and gold and most commodities are double and often triple where they were at the end of the 2003 bear market. A lot of Companies have refinanced at incredibly low interest rates, but a lot of their terrific growth has been through cost cutting and laying off employees. As well, the massive debt loads in all developed countries, not just the United States are on a scale that no one can truly fathom.

Barometer Of Fear

Instead of listening to analysts churn out the daily talk of undervalued stocks and defensive positions, I look at the stock market as a barometer of fear and for the moment, investors are doing their best to subdue their fears. But unless there is significant improvement, particularly in US Housing and Unemployment, than It is only going to take a small spark to get investors "fired up" and into the selling mode again.

Day Trading The Actual Spy Move Is Easier Than Trading The Directional Guess

I sold my spy puts on Friday as I believe that the SPY is better traded by the day rather than my trying to "Guess" when we will move lower. Today (April 18) I day traded the market and earned about 23% return for the day. If I had held my puts from when I bought them on Wednesday last week, I would have made (if I sold at $3.60) 42%. It sounds enormous, but dollar wise, I would have made $1080 on my position from Wednesday versus $932.00 which I made today. You can see the difference is so negligible that it is better to trade when the direction is clear, such as today.

And today was easier to trade than when I made my call on Wednesday. It was easier because the market was already over reacting to the news from Europe and the US downgrade. The whole idea of the SPY put hedge for me, is to build up a cash cushion throughout the year. Last year that cash cushion reached a point by year end that offered 15% protection of my entire stock portfolio. That meant that my portfolio could have fallen 15% and I would have been able to break even for the year thanks to the SPY hedge.

I think that while it is nice to look at charts and try to "gauge" what direction the market may take, in the end the best money is made when the market direction is clear. This morning it was down and there was one additional bounce that was easy to sell. After that the market recovered for the rest of the day. It was an easy day to trade Spy Puts. Easier than buying on a guess and waiting to see if I am right.

The Folly Of Defensive Stocks

I believe the market has for sometime been warning of turmoil ahead and may in fact be unable to break through resistance for a long time to come. The various analysts who are calling this market undervalued in my opinion, wrong. The market has now in general become fairly and on many stocks fully valued. The very concept that an investor can buy "defensive" stocks in case of a stock pullback is, I believe folly. When stocks fall in this market they will all fall. It doesn't matter if that defensive stock instead of falling 40% falls 30%. In the 2000 - 2003 bear Johnson and Johnson fell 38% and in the 2007 to 2009 bear it fell 36%. It's easy to look back now and think "I would have bought it at that level", but ask yourself why so few did. Because of fear. If the sovereign debt issues goes deeper, and it probably will, then even defensive companies will see their earnings tumble. When fear comes back into the market in a panic, no one is buying, and you can tell because stocks are collapsing.

I Believe In Naked Put Selling

I believe it is only through the selling of naked puts and other option strategies that an investor can take advantage of a market like this. I try to sell naked put positions at strikes that I consider undervalued. If there is no premium then I turn to other stocks or simply wait. There are so many stocks that there is no need to chase stocks higher. Through the constant selling of naked puts and the consistent gains in income on all the trades, I am increasing my capital so when stocks do pull back and I am assigned, my actual cost will be far lower than the strike I have sold. By also having capital available at all times,  I can then take advantage of a panic and sell naked puts at much higher premiums as happened in both of the last two bear collapses. For example, when I sold naked puts on Coca Cola starting in October 2008 at the $42 strike, I was in the money within a few weeks of my first sell, I bought and rolled out for enormous premiums as the panic intensified. On one trade alone the puts netted more than 5.00 in actual premium over their true worth. In the end I was assigned on 500 shares and then sold calls and more puts below $40.00. I have found that put selling forces me to look long and hard at a stock to determine its value not only to the market place but for me as I must have a comfort level should I be assigned and in a panic assignments often come fast and often. The key is to stay with smaller positions, don't stray beyond my comfort zone and don't be afraid of missing an opportunity. It is the same strategy with my SPY puts. I keep quantities small and if I believe I am wrong, I sell and re-assess. By keeping positions small I normally can keep losses small and I find rescue strategies easier to implement on smaller quantities of contracts than large ones.

SUMMARY - Skating On Thin Ice

The very fact that only a handful of stocks have even managed to recover to their 2007 highs is a sure warning that it is best to walk lightly and try not to break the thin ice we may all be skating on. The strategy of the cautious bull remains my strategy of choice. It keeps my portfolio fairly liquid and allows for unforeseen opportunities such as today, when I had lots of capital to buy and sell spy puts. Sometimes I prefer liquidity and less profit. 

 

Disclaimer: There are considerable risks involved in all investment strategies. Trade at your own risk.
Stocks, options and investing are risky and can result in considerable losses. None of the strategies, stocks or information discussed or presented are financial advice, trading advice or recommendations. Fullyinformed.com is a private website. Everything presented and discussed are the author's ideas and opinions only.
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