How to Save a Bear in a Herd of Bulls

From the dark days of early 2009 to the time of this writing, the S&P 500 index (SPX) has rallied more than 325% in simple returns, not including dividends. Yup, the last 10 years have been a good time for the patient bulls who hung on to their investments. But it hasn’t been a smooth ride—there have been times when the bulls were scared. Threats of a government shutdown in 2011, fears of a European economic crisis in 2014, and Brexit in 2016. You get the picture. Those were times when the perpetually bearish were thinking, “This is it! The great crash of ....”  But it didn’t play out that way. If a crash is when the market has a huge selloff and stays down without rallying back quickly, well, that hasn’t happened. It’s been a tough slog for bears.

A Crash Course

Let’s drill down into some SPX data going back to the financial crisis of 2008, pulled directly from the Charts page of the thinkorswim® platform from TD Ameritrade. This gives you a 10,000-foot view of the SPX chart, so you can better look for sharp drops. The analysis is subjective, of course. But there were times traders will remember when the bulls were a bit more panicky than usual, and when the SPX was dropping big and fast.

Let’s look at how much SPX dropped from the closing price of its relative high the day before it dropped, to the closing price when it seemed to stop dropping and rally back. You might find more, and/or different, bearish events. But here are some that stand out.

On average, SPX dropped about 1.4% per day during these events, and the average overall drop was 13.2% over 11 days. No wonder the bulls got nervous! But the brevity of these events has made it tough for bears who might continue to hold short delta positions in the hope that the market would continue to drop. Sure, the SPX had some big selloffs. But it came roaring back even higher. 

Simply said, there have been more days when the SPX was higher over the past 10 years than days it was lower, despite some significant selloffs. That’s why patience has been a virtue for bulls.

This data also suggests price moves during SPX selloffs are bigger, faster, and shorter. During rallies, price moves are smaller, slower, and longer. The implied volatility (“vol”) skew suggests this, too. Before the most famous (to option traders, anyway) crash of them all—the crash of 1987—implied vols of SPX options weren’t skewed. A call that was 2% out of the money (OTM) had about the same implied vol as a put that was 2% OTM. Black Friday changed all that. It gave option traders a harsh lesson in risk management, and made them aware that big price changes can happen anytime.

Map your moves

The impact on SPX option prices of this “crash lower, grind higher” outlook on the market is significant. Looking at some recent SPX options, the 5% OTM call was trading at half the price of the 5% OTM put. This indicates traders believe the put’s potential profit is larger than the call’s potential profit. As an example, with the SPX at 2,840, the 2695 puts with 50 days to expiration were trading for $11.20, and the 2980 calls with 50 days to expiration were trading for $2.00. Those strikes are roughly equidistant on a percentage basis from the prevailing SPX price. Since the put’s price is over five times greater than the call’s price, it indicates that “the market”—that is, traders collectively—thinks there’s a higher chance of a 5% drop than a 5% rally, and that the potential for a profitable payoff in a drop is bigger than in a rally.

Now, before you start thinking there’s some indicator to warn bulls to hedge, and bears to get short, remember that big selloffs are unpredictable. There’s no telling how much the SPX might drop, or how long it might keep dropping. The strategy shouldn’t be to guess when the selloffs might happen. Rather, if you’re bearish, it’s about positioning your strategy so you can withstand a persistent rally but still profit if and when the selloff occurs. You want to put as many factors as you can in your bearish trade’s favor.

Past performance of any stock or index is no guarantee it’ll deliver similar performance in the future. That means bullish markets might not last as long as they have, and bearish markets might last a lot longer than they have. With that caveat, let’s assume as an example that you are bearish, and you think a market drop in the future might be similar to ones in the past 10 years.

A way to take advantage of the higher prices of OTM puts could be to use them as the short leg of a long put vertical spread, which is long a put at a higher strike and short a put at a lower strike in the same expiration. If you buy a put that’s near the at-the-money (ATM) strike, and sell one that’s further OTM, you’d be buying a put with a lower implied vol (IV), and selling a put with a higher IV (Figure 1). The skew is in your bearish trade’s favor.

Obviously, if the index moves the way you think it will, you want your trade to be profitable. But some trades react more favorably than others. Typically, a long vertical like the one just described would be expected to increase in price if it has fewer days to expiration. That’s because the long ATM put has high positive gamma, which manufactures negative deltas quickly if the index falls. And gamma is higher with fewer days to expiration, all things being equal. A long put vertical with more days to expiration would also likely increase in price if the index falls, but not as much. So, if you think the market might sell off quickly but possibly rebound, a long put vertical with fewer days to expiration could potentially capture higher profit than one with more days. That’s putting the power of positive gamma in your trade’s favor.

The downside? If you want to maintain a bearish position, you may need to roll a vertical with fewer days to expiration to one with more days, which incurs commissions and transaction costs. So, consider balancing the benefits of fewer days to expiration against the extra transaction costs from rolling by using an expiration that might have 30 to 60 days to expiration. A long put vertical in one of those expirations won’t respond as quickly as one that expires in five days, for example, but you won’t have to roll as frequently.

Now, if the index does have what you consider to be a big drop in a short time frame, consider taking smaller profits more quickly before the index bounces back. Don’t wait around to see if the index has another massive ’87-style crash. The risk, of course, is giving up potential profit if the index drops more. But if you believe the index might resume an inexorable grind higher, then it may make sense to take, say, 50% of the max potential profit of the long put vertical when you can. You’ll capture some profit (eliminating the risk of giving up all the profit) even if the index rallies back quickly and the trade turns into a loser. In other words, take the profit the market gives you, before it takes it away. And don’t be greedy. That’s putting the exit strategy in your trade’s favor.

Finally, keep your trade size small. Being a bear in a bull market can be a lesson on how to take losses. Don’t let them destroy your account by trading too big. That way, you can make sure the bull only steps on your bear’s paw, rather than squashes him. And, once in a while, you give the bear a chance to chase the bull around.