I’m Adjusting My Tactics To Win The Battle. Are You?

This is the fastest bear market in history. A bear market is official when the price of the Dow Jones Industrial Average falls 20% below its high. On average, it’s taken 164 days for a market to fall that much. This time, it happened in just 16 days.

Source: USA Today

The immediate cause of the decline is the coronavirus, but now the stock market is pricing in a recession. That means we shouldn’t expect an immediate rebound.

The average bear market loses 28%… unless it’s associated with a recession. Then the average loss jumps to 37%. On average, recession-related bears last about 18 months, more than twice the average for bear markets that occur while the economy is growing (usually 7.5 months). An average recession bear market would the S&P 500 to 2,100 and would last until next summer.

But the speed of the decline makes this market anything but average. One indication of the unique nature of this market is the number of options contracts that are listed.

Typically, when a stock makes a large move, we see exchanges add contracts. In the past month, the number of contracts exploded from about 220,000 to more than 370,000. Counter-intuitively, more options contracts mean there is more risk since the expansion in options is caused by a jump in volatility.

How We Win The Battle

In this market environment, I am preparing for anything, and that means I am adapting. I’m not changing my strategy. I’m adapting my tactics.

In military terms, the strategy might be as simple as “win the battle.” The tactics could be to engage the enemy at a specific time and place. My strategy will still be to win the battle, but I am changing how I engage the enemy, so to speak.

The biggest tactical change I am making is to my award-winning Income Trader Volatility (ITV) indicator. If you aren’t familiar with ITV, it’s an indicator I created to identify the ideal time to sell options. It’s the same indicator we’ve used over at my premium Income Trader service since 2013.

ITV is similar to VIX, which is a widely followed sentiment indicator. VIX is often called the “fear” index because it moves higher as prices fall and fear rises. VIX was my inspiration for ITV. I saw the usefulness of VIX, but I noticed it wasn’t very tradable.

To fix that, I created an indicator that applies to individual stocks. Then, I added a moving average (MA) to act as our trading signal. Below, I’ve included an example of what my ITV indicator normally looks like. In the top panel is the stock’s weekly price action, and in the bottom panel is the stock’s ITV (grey solid line) and the ITV’s 20-week moving average (green dashed line).

ITV measures volatility. When ITV is above its MA, the level of volatility is above average. This is simply the definition of above-average volatility.

Now, volatility is a factor in the price of an option. It is usually the most important factor in the options pricing model. This indicates the best time to sell an option is when volatility is higher than average and declining. Because it’s impossible to know exactly when volatility peaked in real time, the best time to sell an option is when volatility drops below its moving average. This will capture a high premium with a margin of safety.

That’s a brief look at ITV.

Now, let’s take a closer look at one of the more specific aspects of ITV — the timeframe. Normally, I use weekly periods to calculate ITV. In the upper section of each chart, you would normally see the stock’s weekly price movement; in the bottom section, you’d see the stock’s ITV (grey solid line) and the ITV’s 20-week moving average (green dashed line). These charts usually show several previous signals and help me evaluate how successful signals were in the past.

But lately, the market’s movements have been erratic and fast… too much so for our normal ITV timeframe based on weekly periods.

To solve this problem, I’m adjusting our timeframe to keep pace with the market. Instead of the weekly periods, my ITV indicator is now using 60-minute periods. This should allow us to identify and capture these faster price swings at the ideal time.

I’ve tested various timeframes and found similar success with all of them. That was one of the original reasons I had confidence in the ITV indicator.

The Bottom Line

If you’ve been trading options, then you need to take a look at adjusting your tactics in this environment.

I’ve been using this indicator in Income Trader since 2013, and more than 91% of my trades have been winners. Each individual year has been a winner, and statistical testing shows that it is impossible for this be a random occurrence. ITV identifies a real market behavior that has held up over time, through upturns and downturns. There’s no reason for that to change now.

If you’ve been selling puts on your own, then I want you to know that I am here for guidance if you need it. My subscribers and I have built a wonderful community over the years, and I’m making it a priority to make these adjustments in order to identify more trading opportunities as safely as possible. To learn how you can join us, go here now.