From the January 01, 2011 issue of Futures Magazine • Subscribe!

Avoid losing your shorts amid bear market

Question: How can you avoid losing your shorts when dramatic upward spikes occur amid bear markets?

Answer: A bear-biased put ratio condor

Last month we wrote about ratio condors (unbalanced condor) and how they can allow you to maintain a bullish position while protecting yourself against a dramatic downward spike. It can work in the reverse, which may be more valuable as bear markets often include dramatic upward spikes.

The ferociousness of a bear market rally is legendary. Many investors believe we are currently in the claws of a grizzly market; however, because of the often sharp and swift reversals associated with bear markets, even the best bear tracking trend traders will find it grueling to maintain a short stock position.

The crash during the Great Depression still holds the title for the most notorious bear market of all time, but surprisingly, it had just as many advances as declines (see “Being right is not enough”). And the recent 2008 bear market perhaps was scarier for bears. On four separate occasions during the fourth quarter of 2008 the Dow Jones Industrial Average had a 1,000-plus point upward reversal within two days. The temporary rebounds often were more swift and severe than the declines. Many traders floundered as they watched their profits temporarily evaporate, particularly in the pre-listed options era.

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Prior to listed option trading, there would have been many terrifying moments in a bear’s life, even though the Dow eventually lost 89.2% of its value (381.17 High – 41.22 Low). Fortunately, we now are sophisticated enough to play chess (options) instead of checkers (stocks). We now can set up a bearish position without the worry of loss should the markets move unexpectedly.

Many analysts believe the second shoe is still to drop in the financial crisis of 2008 and that equity markets are due a more serious downward leg. If you are not one of them, you can certainly remember the two market crashes of the last decade and put yourself in the shoes of a confident bear.

Instead of putting a lot of capital at risk with a long straddle, we will elect to sell an in-the-money (ITM) put spread to subsidize the purchase of twice as many at-the-money (ATM) put spreads. We notice that the DJX 114–112 put spread (roughly 11,400 Ð 11,200) is trading at $1.20 ($3.02 - $1.82). By selling this spread, we can purchase twice as many of the 111Ð109 put spreads, which are trading for $0.57 ($1.43 - $0.86) per share. The math looks as follows and yields a net $60 credit if we do 10 contracts:

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Depending on your broker, this even may be enough to cover your commissions on this “unbalanced condor sale.”

Now, with 21 days remaining until expiration, we sit and wait, and we even can sleep soundly. We no longer have nightmares because we are safe no matter which way the market moves.

If the market moves lower by 200 Dow points (roughly $2 in the DJX), we make our maximum amount of $2,000.

What if we are chasing a bear into the woods and run into an injured bull? We still are safe. If the market runs higher by roughly 300 Dow points (like the day we wrote this), then both put spreads will expire worthless and we will keep our $60 credit (minus commissions).

If you have a fair amount of time until expiration and a bearish opinion, you still can place a trade without having to worry about stepping on a bear trap. With a statistically calculated estimated range based on 23% implied volatility of $6.43 (or 643 Dow points), you can feel comfortable that your position will not hurt you unless the market fails to move between now and expiration. If you had purchased a straddle for a debit (by buying the ATM call and the ATM put), you would have been hurt more because it was trading for $3.19 (or $3,190 for 10 contracts). Obviously the unbalanced condor sale is a far superior strategy for those wanting to sleep soundly at night without worrying about time decay and volatility collapse.


Edward LaPorte is an advisor to Random Walk, which designs options education material at RandomWalkTrading.com.

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