Being prepared for a bear market takes many forms. In some cases, it can become an obsession.
Some investors always seem to be looking for a market top and forecasting a major decline only days away. While there have been two significant bear markets since 2000, these investors have been mostly wrong for many years.
Investors worried about the next bear market should remember that SPDR S&P 500 (NYSE: SPY) has only suffered three drops of 20% or more since it began trading 20 years ago. There have only been five declines of 20% or more since 1982 in the S&P 500. Bear markets are rare, and always preparing for a rare event can be very costly.
Rather than making investments right now to prepare for the next decline, you could simply make plans for what you will do to protect wealth when the market starts to fall. There are a number of indicators to define a bear market, but I think the simple 10-month moving average (MA) is an effective tool. (See This Chart Shows Where the Bull Market Will End.)
That indicator gave a sell signal less than 7% below the high in 2007, and 7.3% below the high in 2000. I don't know whether the next signal will be that accurate, but I know prices will move below the 10-month MA in a deep bear market.
I believe selling options is an appropriate income strategy in any market environment, but it will become even more important in a bear market.
A put option gives the buyer the right to sell 100 shares of a stock at the option's strike price before the expiration date. Put options go up in value when stock prices fall.
When selling puts, the trader generates immediate income, known as a premium, for taking on the obligation to buy the stock if it falls below the option's strike price before expiration.
Selling put options can provide a disciplined approach to buying stocks as prices fall, something many investors become too paralyzed with fear to do. While prices are rising, it is a good idea to make a list of stocks that would be good buys at lower prices. When SPY falls below the 10-month MA, it would be a good time to sell some holdings and put that cash aside for buys at lower prices. Then sell put options to ensure you buy when prices fall.
Selling puts is also a way to generate income that offsets the losses of a bear market. As an example, consider hypothetical stock ABC trading at $100 a share. You could sell puts 10% below the market price that expire in one month for about $1 a share.
If ABC falls below $90, the put will be exercised and put sellers will buy the stock at $90 a share. With that put sale, the actual cost would be $89 since you have the $1 a share from selling the put to reduce the cost of the stock.
If the price doesn't fall 10% in one month, which will be the outcome most of the time, the put option expires worthless, you keep the $1 per share in income, and you can sell another put option.
This process can be repeated over and over again. If the market drops slowly, the stock price might never be below the strike price at expiration, and that means the options will never be exercised. In that case, you generate monthly income from selling puts.
To recap, selling puts helps investors in two ways during a bear market.
1. They generate immediate income, which offsets losses in other positions.
2. They can be forced to buy high-quality stocks at low prices.
Many investors fail to take advantage of low prices in a bear market, waiting for even lower prices. Selling puts could force you to buy when stocks offer bargains, an action that should be rewarded with large gains in the bull market that inevitably follows a bear market.
This article was originally published at ProfitableTrading.com:
A Bear Market Defense Strategy That Works