Saturday, October 30, 2010

How and when to be Bearish

If you want to be bearish there are various options for you. First of all, you have to determine your time frame and when to be bearish. ALthough you can trade breakdowns for the short term if you can buy it back before the trend reverses back to the upside, many breakouts in the long run actually end up below where they started.
So a more intelligent idea if you are not very quick and nimble is to sell high and buy back low. One way to do this is to identify breakouts that have reached their target, but this is more of a contrarian approach and is difficult to do if you go short stock as opposed to writing calls or buying puts.

Another thing to do is look at the market. The slow stochastic indicates when the momentum to the upside or downside is no longer sustainable for a long time. It will tell you when stocks are oversold and overbought. It's still a little difficult as overbought stocks can still go higher longer than you would expect because all the dumb money follows always too late.

If you are going to go with this you can buy puts on the market that are cheap and out of the money and you can keep mostly cash. This way you can't get burned too bad, and if the market continues higher, you only lose the small premium. If you are right and after stocks are overbought they gradually move towards oversold, your out of the money put will become in the money and you can earn a lot of money fast. They're considered more of a long shot to expire in the money, but you will sell them before they expire, and you only buy them when the market is overbought. If conditions continue to remain overbought, it's fine, but eventually it will reverse and when it does, unless it's a new bull market the stocks will trade lower and lower. The more it's overbought the more it can sell off. The overbought/oversold conditions of the market generally are not factored into the price of an option premium.

The good thing about this is when stocks rally, the VIX drops, and as the volitility drops, the options become cheaper. So being bearish by buying put options is a good thing if you can spot the right time because you also gain volitility in general.

The Slow Stoch can be measured in different timelines. While you may have a minute chart overbought, the weekly could be oversold. It's important to be aware of several different timelines. Although what goes up must come down, you shouldn't bet the house on it. Just a small 2% position in an OTM put is plenty as if you are right, you stand to make a lot, and if you are wrong, it won't hurt you as long as you keep the position small.

Another thing to note about the slow stoch is whether it is showing an uptrend or a downtrend and whether the stocks agree with it. If the slow stochastic shows a downtrend while stocks show an uptrend this means the move is not to be trusted, and the evidence is that there will be a reversal. So look for false moves and short after overbought conditions are met.

Right now we are overbought on a weekly chart, but on a monthly and daily chart we are not oversold or overbought. This represents a difficult market to be short.

The RSI is also a good indicator of overbought vs oversold. However, the RSI is not yet overbought. It is however close on monthly, daily, and weekly.

This is a signal that any longs better be very careful. Any bears must also not get carried away. There really is no clear sell signal, however it is very close, and if you had to be one it would be defensively short. The highs for the year also should act as resistance. We may surpass them breifly, but unless we see it find support at the highs of the year and continue to break higher gradually without the slow stochastic and RSI going overbought, you must tread carefully.

Although a small retracement followed by new highs is a base, if the base is too deep (like 20% or more) it is less trustworthy because it requires that stocks get overbought and continue to remain overbought which isn't likely. A lot of the deep bases are false breakouts. From april to July S&P declined just under 20%, but RSI is clearly nearing overbought and it's still possible new highs will not be broken.

This means you should prepare to get short.

Like I said before, you want to use OTM put option. So you would want to buy ontracts 3 months past the point you want to sell it. So it's almost November. If we assume we buy puts in November with a 2 month holding period (3 to be safe) that would take us to Februrary. Leave 3 more months and May or later is when out contracts should expire. So we will buy June 2011 SPY contracts at maybe a strike price of 116. These will cost about $8 per share or $800 per contract of 100 shares.

Based on what options with the same strike price are worth 3 months out, if we are wrong and the SPY remains at the same price, we can see that it will drop to 4.50 a nearly 45% drop. If however, the SPY drops 10 points, the option would be worth $10 intrinsic value, plus we would still have the time value remaining. However, gaining $2 and risking $4 does not seem like a very good bet. So we can see why it's tough to be short the overall market, and if you're going to own OTM puts you have to be right either a high percentage of the time, or you need to expect a big decline when you are right. Options are often met for short term trading of individual stocks.

Option trading can be difficult and being bearish can be difficult.

No comments:

Post a Comment