When considering investing in bear markets most think of hedge funds, shorting stock, or put options. But there are other ways to invest and profit in down markets.
It is theoretically possible to buy a stock, have the price fall 36% in 18 months and still double the investment. It is also possible to have the share price slide 70% and the still walk away with the original investment. This is how it can be done.
Picking the Right Stock
First, the investor needs to pick a stock that has very high expectations. Blue chip stocks are not adequate for this type of strategy. The investor will want companies that are looking forward to some big event such as an FDA approval that can make prices rise or fall quickly.
A simple way to find these types of stock is to screen for option-able stocks with the highest amount of Implied Volatility. Options derive their value based on past performance (historical volatility) or anticipated performance (implied volatility).
Buying the Stock, Selling the Anticipation
- First, buy the stock.
- Next, sell the rights to the stock.
Why should one sell the rights to a stock if there are such great expectations? Could he or she not make much more by merely holding the stock?
Options on these stocks are very expensive since rumor, FDA approval, earnings, or some other event is creating a buzz. Once the cat is out of the bag, the implied volatility will drop. This is the investors profit. For instance, a stock might be awaiting FDA approval for some vaccine. Anticipation is mounting and investors are getting euphoric with what may happen once the drug is approved. One of two things might happen:
- The drug is approved and the stock soars. Now that the stock price is well along, the implied volatility goes down since the event has passed. The option value may increase overall but the ‘speculation’ portion of the contract decreases.
- The drug is rejected and the stock drops. Investors are disillusioned, disgruntled, and no longer optimistic. The overall Call options value goes down and so does the implied volatility portion that was so high surrounding the FDA decision.
Either way, once the event has passed and anticipation becomes reality, implied volatility drops.
Example of FDA Decisions
Let’s say XYZ is awaiting an FDA decision on September 16th for its weight loss drug. If approved this could be big money. Similarly, it could be a huge setback if declined. How can an investor use the high priced Call options to his or her advantage?
First, they need purchase 100 shares of XYZ for illustrative purposes. The price of XYZ is 3.91. Next they sell January 2021 Call options with a strike price of $2.50. The bid/ask is at 2.50/2.85 with the last sale going through at 2.75. The assumption is that they get the same price as the last sale.
- Purchase 100 shares XYZ = $391
- Sold 1 Call option expiring Jan 2012, $2.50 strike = $275 income
The net cost is $1.16.That means that if on January 2021 the stock fell from almost $4 today all the way down to $1.16 the investor would still break even. To put that another way, share prices can fall 70% over the next 18 months and they still retain 100 percent of the original investment. Few other investment can offer that.
What is the upside? If the stock price is at or above $2.50 the investor turns 116% profit. Again, the stock can fall 36% over 18 months and they more than double the investment.
XYZ Comparison Chart of Buying Shares versus Covered Calls
Prudent investors can see the difference in profitability of selling covered Calls in the chart attached. Even if the share price spikes up to 5.00 per share, the ‘buy and holder’ only realizes 28% profit while the person who sold covered calls has made 115% since the share price was at $2.50.
But isn’t the downside that the investor cannot sell early and is forced to hold until January 2021? What if the stock went up or down wildly and they wanted to cash in early?
Getting Out of Covered Calls Early and Profitably
To get out of such a position, they merely buy back the call options and sell the stock. No matter what the FDA decision, the investor should be in a profitable position in a very short period of time.
Below is a scenario where the stock still has a high implied volatility of 80% despite the major event passing. The assumption is that implied volatility dropped somewhat, but is still very high. The net profit will be the difference between selling the stock and buying back the Calls and then subtracting the original investment of $1.16 per share. The scenario will assume 3 months have passed.
- Look to attached diagram or picture for chart in question
In three months time the investor can still make about 68% gain if the stock doesn’t move but the implied volatility drops once the event passes. If the IV is less than 80% the profits could be much greater than this. Once the FDA decision comes out the stock should react one way or the other with a large drop in IV.
In mid-September the review board that makes recommendations to the FDA voted against the use of the weight loss drug. In a few days the share price of XYZ slammed down from $7 per share to just over $2.00 per share. While some lost almost 70% in the blink of an eye (and you truly have my sympathy), those who followed the above system are still in a profit position with the same stock.
The break-even point is just above a dollar. This means the investor of this system can either sell out early for a profit, or wait to see if share prices will bounce back slightly by January.
Buying Stocks in Bear Markets
In bad markets there are few good investment opportunities. By picking stocks where one can recoup the original investment despite a share price fall of 70% in 18 months, or doubling their money while the stock falls 36%, and further having the opportunity to cash in as soon as the implied volatility hype surrounding the FDA decision cools… is one of the safest methods of investing that most analysts can think of.