Ask Colin

What do you think about trading options in a bear market?

The long and detailed question was:

I would like your comments about the use of options in a bear market. It seems a good time to consider this, because it might be some time before the next bear market, so we might have time to calmly consider the options, so to speak, in preparation.

I raise this, because on your plan you would be essentially out of the market during a bear market, with essentially all funds in cash. This greatly limits the potential to achieve capital gain during a bear market.

However, a strategy of limiting options activity during a bear market to buying put options and using risk management strategies that align well with the risk management utilised in long share trading in a bull market, it seems that one should be able to participate in the market with much the same degree of safety and much the same potential for capital gain as in a bull market.

The strategy would require the investment of less capital in proportion to the leverage, so most of one’s capital would remain in cash during the bear market.

There would be a significant difference in the nature of the analysis of the market, looking for both technical and fundamental indicators of a potentially falling share price, and also technically different considerations such as option pricing factors. Provided these technical aspects were mastered (and, I suggest, complex options strategies avoided), I expect the strategy should be well worth pursuing.

Finally, the current bull market provides a good opportunity to paper trade options, practicing and testing most of the the technical aspects. As for practicing and testing the fundamentals of a bear market, one should be able to start examining the negative fundamentals of some stock while still in a bull market.

Your question is very similar to the one in Ask Colin under Bear Market Strategy - Why don't you use a bear fund to trade bear markets rather than standing aside in cash?

 

The big difference is that the question in Ask Colin was what I do or I don’t do, whereas you are asking about a trading strategy in a bear market which you might follow.

 

When you say “on your plan you would be essentially out of the market during a bear market, with essentially all funds in cash. This greatly limits the potential to achieve capital gain during a bear market.” You are focusing on the capital gain part of the investment return, which over the long term is the minor element of return – the compounding of dividends being by far the greater element in the return from investing. Capital gain comes from changes in the share price or derivative of the share price. That is not buying part ownership of a business, which is the investing activity, it is a trading activity. Investment returns come from the stream of earnings from a business that are paid to owners as dividends and franking credits or reinvested in the business to create greater dividends and franking credits in the future. This potential will tend to raise the share price, which is properly seen as the current value of all future dividends.

 

Investing, which  is what I do and my investment plan describes, is a different mindset to trading. The investing mindset is that of an owner of the business I invest in. While the business itself might legitimately hedge some risks – currencies, interest rates, commodities – trying to make a capital gain by trading options in a bear market is not investing, it is trading. There is nothing wrong with that per se, but it is not what I do. So, I have no practical experience in it and could not intelligently comment on what strategies you might use and their pros and cons.   

Keywords: