Lessons from the Pros


Happy Days Are Here Again

As I’m writing this on May 15, 2013, the U.S. equity indexes are making all-time highs, for the ninth time in the last ten sessions. Most everyone who owns stocks today has a profit, and everyone who doesn’t own them wishes they did. It seems that the market can’t do anything but go up, up, up.

Even bad news is good news, because it means the Federal Reserve won’t have to turn off the stimulus. Manufacturing down? Unemployment claims up? Retail sales flat? Hurray! The Fed will make sure that the good times keep rolling.

And so they will, for some time, anyway. How much time? There’s no way to know. Once a bull market gets real momentum going, it can carry on far longer and far higher than logic and good sense would indicate. This bull market is entering its fifth year. In the past, bull markets have lasted anywhere from 4 to 29 years; while major bear markets have taken anywhere from 3 to 15 years, as shown in this chart from dShort.com:


Note that in the table above, the figures for Percent change and for Returns are inflation-adjusted. That’s why the percent change from the 2009 low to “now” (April 1, 2013) in the last row shows only a percent change of 89%, vs the nominal gain of over 100%.

My point here is that bull markets can last for a very long time. While they’re in progress, there are always excellent reasons why they shouldn’t go any further, and yet they do. When they eventually do terminate, it’s always with a bang, not a whimper.

So what’s to be done when we’re trading in nosebleed territory?

There are several good ways to go about it, and that will be the subject of my next few articles.

For short-term traders, the fact of the all-time highs poses no particular problem. When we wear our traders’ hats we can simply do what we always do in uptrends: initiate bullish trades when prices make short-term pullbacks into strong demand (support) areas; liquidate these trades partially when prices regain the recent highs; and allow part of the profits to run as long as the immediate phase of the uptrend continues. It’s just another week at the office.

Longer-term traders, and investors, have a slightly different set of decisions to make. Say that you have a long-term position with a substantial unrealized profit. The market has gone parabolic and continues to chug higher, with only clear air above.  How do you decide between protecting your existing profit, vs participating in the ongoing uptrend in case it continues? Here are some different ways a stock owner might consider proceeding:

  1. Sell everything now and keep a nice profit. What goes up must come down. Plan to buy back in when it does.
  2. Sell everything, but not now. Hang on for as much of the ride as possible, using something like a trailing stop. Exit when the trend reverses.
  3. Sell a portion now and the rest later. Sell part of the holdings now to bank some profit. Use a trailing stop to participate further on the upside, if there is any.
  4. Sell nothing, ever. Stay the course. The fact that we’ve just made new all-time highs proves that what goes down must come back up, too. The buy-and-holders were right after all.

This decision would be so much easier if we could expect something like this:

“We interrupt our regularly-scheduled programming to bring you this special announcement. At 11:30 AM Eastern Daylight Time tomorrow, the bull market will terminate. A bear market will begin, which will continue until August 14, 2017. All stock owners are advised to sell all of their holdings and keep the proceeds in cash until that time. We now rejoin Family Guy.”

Of course, in real life we don’t get a special bulletin when a bull market is over. We don’t know ahead of time which of the above approaches will turn out to be the most profitable this time around. We never do. But with options in our toolkit, we have several ways to achieve a combination of collecting profits now and continuing to participate on the upside. We could do one of the following:

A. Keep the stock position; sell call options to collect premium that will cushion some downside movement.

B. Keep the stock; buy put options as insurance.

C. Combine the above two alternatives. Keep the stock; sell call options; use the call proceeds to buy put options as insurance. This then becomes a collar, also known as a fence or split-strike conversion.

D. Sell the stock position. Determine at what price we would be willing to buy back in, and sell put options at that strike price. This enables us to bank our profit now, and be paid to wait for the stock to reach our buy price.

E. Sell the stock position and bank the profits. Use some of the cash to buy call options to participate in further upside movement. We still have unlimited upside profit, and most of our money in our pocket.

F. Consider other variations of choice number 5, substituting for the long call options cheaper bullish option strategies, such as vertical spreads, horizontal spreads, diagonals, call backspreads or butterflies.

Next week, we’ll continue this discussion by comparing these alternatives, and discuss what combinations of price and volatility outlook would favor each one.

Before I close, I need to make a correction of a remark that I made last week in response to a reader’s question. Lynn asked whether there was any advantage to using a debit vertical spread vs a credit vertical spread at the same strikes; for example using a 150/155 debit call spread vs a 150/155 credit put spread. Part of my answer was:

Capital requirements on the credit spread are often larger. While the debit spread can only lose the net debit, which may be very small, the Credit spread can lose the whole difference between the strikes, minus the original credit, and this much margin must be put up.

This part of my answer was incorrect. The net capital requirements for the debit and credit spread versions at the same strikes will not be very different – they will always be about the same.  This is because for the credit spread, the credit received can be applied to the margin requirement. Thanks to Peter P. for pointing this out.

Thanks for the comments and questions. To send them, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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