How to Trade Options in a Bear Market: Retired Math Teacher

Business Insider2022-07-19

Steve Chen was options trading covered calls and LEAPS options in neutral and bullish markets.This year, he pivoted to bear call spreads because the market became bullish.It allows him to earn ...

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Thalos
2022-07-20
Thalos
Deep read. Not for people hasn't done option before
Jess261
2022-07-20
Jess261
Okay
tigernaut
2022-07-20
tigernaut
[Like]
EHG
2022-07-20
EHG
Like
Ghostwalker
2022-07-20
Ghostwalker
Good
chinks29
2022-07-20
chinks29
Ok

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Steve ChenSteve Chen spent his career as a middle-school math teacher until he retired from the job at the early age of 33 in February 2020.He hadn't initially planned to leave that early. However, after landing his first $5,000 paycheck and seeing what he was left with after all the deductions were made, he realized he needed to find additional income streams.One key takeaway he had after reading examples of others retiring early was that investing every month was a key factor in growing wealth. So he opened a brokerage account and began by simply investing in companies he was familiar with and broad-market exchange-traded funds such as Vanguard 500 (VOO), which tracks the S&P 500.As Chen became more familiar with investing by watching YouTube videos and reading blogs, he began to explore options trading, which took off for him in 2020.By 2021, between his retirement and brokerage accounts, he had a net profit of $76,925.88 from options trading, according to records viewed by Insider. Chen estimates that about 5% came from dividends paid by the underlying stocks he had call options on, 10% from capital gains from selling the call options, and the remainder came from premiums.He's now the founder of Call To Leap, a website that teaches financial education around saving and investing, including options trading, for a fee.Throughout 2020 and 2021, Chen mainly focused on selling covered calls, an options trade where he purchased shares of a stock and then sold a contract that gave the rights to another trader to purchase those shares at a certain price by a certain date. In exchange, he received a premium for that contract. Most of the time, Chen's shares weren't purchased away. This strategy not only allowed him to own stocks that appreciated over time, but also collect a fee on the call option.He was also purchasing LEAPS, longer-term options contracts of one year or more that gave him the right to purchase shares away from another trader.Covered calls were more profitable when the stock market was trending either neutral or bullish because the value of the underlying stock was increasing. Chen could put his shares to work by collecting premiums and if sold, also collecting capital gains.LEAPS were highly profitable for him during the bull market that engulfed most of 2020 and 2021 because they enabled him to hold the rights to purchase shares at a designated price in the future. Since share prices were rising rapidly and faster than the contract decayed, he often didn't buy the shares but resold that contract at a higher value for a profit.This year, stock investors haven't been as bullish. Year-to-date, the S&P 500 has tumbled by about 19% and the Dow by about 14%.Chen told Insider he noticed the downtrend on January 18, after the support line in the S&P 500's technical chart broke, indicating a reversal pattern to a downward trend. He was also aware that the Federal Reserve was planning on raising interest rates to combat rising inflation. This meant that the downward trend could be strung out.These two factors led him to pivot his options strategy to set up what's known as bear call spreads. This is an advanced options trade that is more ideal in a bear market because it allows a trader to profit from a falling stock price and the time decay of the contract without the risk of incurring unrealized losses due to the falling price of the underlying stock. This is because Chen doesn't need to actually buy the shares he's placing under contract.Chen says the strategy isn't for everybody. This approach is for traders who have already been options trading in bullish and neutral markets and want to pivot to doing it in a bear market. Additionally, users often won't have access to this option in their brokerage account if they haven't been trading more basic options.Setting up bear call spreadsSetting up a bear call spread requires two main steps.First, Chen needs to buy an out-of-the-money call option, which will act as a proxy for the shares he plans to sell under contract. He needs to do this because brokerages often won't allow traders to sell a call option contract unless they can cover themselves. Since Chen doesn't want to buy the actual shares, he purchases a covered call for the same number of shares he plans on selling. The strike price, which is the price he agrees to pay, is out-of-the-money because it's above the stock price.In reality, he has no intention of executing this contract because it has a high strike price. Yet he chooses it because it has a lower premium.Once he's covered, he sells a different out-of-the-money call option that matches the number of shares and expiry date from the call option he purchased. This time, he sets a strike price that would earn him a premium higher than the purchased contract.In the event that the trader who purchased Chen's call option decides to exercise the contract and take possession of the shares, Chen would need to purchase those shares to deliver on the contract. To avoid being in a position where he overpays for the stock, he sets up a third step, which is a buy stop order slightly below the strike price of the call option he sold. Traders who don't take this third step would have to purchase the shares at market value and risk incurring a realized loss.\"My intention is to not let the stock [price] surpass my sold call option contract strike [price],\" Chen said.One example of him setting up a bear call spread was on June 26, when he bought four call options for AMD with a strike price of $150 that expired on July 15. At the time, AMD was trading at around $87. The contracts cost him $82.64. Once he established his proxy, he sold four call options of AMD at a strike price of $125. The premium he earned on that contract was $525.34.He then set up a buy stop order at a share price of $124. This way, if his shares were called away, he'd sell them with a capital gain of $1 on each share for a total of $400. However, in this instance, Chen kept his shares. Therefore, after deducting the cost of the call order he purchased, his total profit from the premium was $442.70, according to records viewed by Insider. In the event his buy order was executed appropriately and his shares were also sold, he could have had a total profit of $842.70.Chen will also reduce his risk by purchasing his call option back when the contract loses 50% to 80% of its value. This allows him to pay less than what he initially sold the call option for and close the contract. In turn, reducing the number of days he's at risk. He sets expiration dates that range from 30 to 45 days out.Chen teaches his students to pick expiration dates two to five weeks out because that's when the theta decay, which is the rate of decline in the value of the contract over time, is fastest, while the premium collected is optimal. The goal is to get both options to expire worthless as fast as possible during a downward trend.RisksOne of the main risks Chen considers when setting up the options trade is the possibility of a buy stop order not executing. This could happen if the stock's price moves up too quickly. To avoid this, he will set up a buy stop market order rather than a buy stop limit order. The former will purchase the shares once it surpasses the set price even if it's slightly above. On the other end, the latter will only execute a buy order at exactly the set price.While his risk is reduced, he may end up paying slightly over the price he intended. So far this incident has only happened to him once when Nike's (NKE) stock price shot up in September of 2020. Chen told Insider that by the time the buy order was executed, it was above his contract's strike price. Therefore, he purchased the shares at a higher price than what he sold them for.The second risk happens when a buy order executes while the stock's price is rising but then the price drops before the trader decides to purchase his shares away. This could leave Chen with an unrealized loss.For example, in 2020, Chen recalls setting up a bear call spread on AMD. The buy stop ordered was triggered but the shares were not purchased away from him. He was left with AMD shares that didn't move up in value. To mitigate his losses, he converted the trade into a covered call and kept collecting premiums on it until the shares were called away, sending him into a net positive.3 criteria for picking the underlying stocksIn the event Chen ends up with an executed buy stop order but the shares aren't sold, he wants to ensure he's still holding stocks that have a higher probability of appreciating in the long term. Therefore, he sticks to what he believes are quality stocks.He picks stocks that are in the S&P 500 or the Dow Jones Industrial Average because there is more institutional involvement and they have a higher probability of increasing in the long term.He picks companies with strong fundamentals, which include consistent revenue growth and selling high-demand products or services.The company's historical stock chart has a strong upward trend, especially over the past five years.","kind":null,"is_publish_news":true,"is_publish_highlight":true,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":9074923822,"gmtCreate":1658284126166,"gmtModify":1676536134873,"author":{"id":"4101955883486630","authorId":"4101955883486630","name":"Thalos","avatar":"https://community-static.tradeup.com/news/55ba87139db7cd8dd783879dbd6ed4c5","vip":1,"crmLevel":9,"crmLevelSwitch":1,"authorIdStr":"4101955883486630","idStr":"4101955883486630"},"htmlText":"Deep read. Not for people hasn't done option before","listText":"Deep read. Not for people hasn't done option before","text":"Deep read. 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