How to Make Money When the Market Declines

When you take a trade off, you need to put one back on again.

So that’s just what I did.

I was looking at the Dough platform and running through the checklist in my head:

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  1. High Volatility (preferably greater than 50)
  2. Liquidity = 4 stars
  3. No upcoming earnings
  4. Notable movements

QQQ Trade

I decided to place a trade in the Q’s (QQQ) which is an ETF that tracks the Nasdaq 100, aka the tech stocks (AAPL, GOOGL, FB etc).

The 30 Day IV Percentile was at 95, which means that out of the last 30 days, the QQQ’s are at the 95th percentile of IV measurement (pretty high). That met my criteria of greater than 50.

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A 1 YR Chart showing the movement of QQQ

The liquidity was 4 stars, which is good for getting in and out of the trade.

The QQQ’s don’t have any upcoming earnings, so we are good on that front too.

I’m pretty contrarian, meaning that if I see something on an up movement in price, I like to place a bearish trade. This plays into the idea of large numbers – there is always a reversion to the mean, a baseline number that the stock price returns to.

However, I’m mechanical too. I look at the probability of profit and relative breakeven point on each trade I make. I can think that the underlying is going to drop, but if the market is not paying me in premium for that contrarian stance, I won’t make the trade.

I placed a 161/164 bearish call vertical spread on the Q’s. I bought the 164 call, and sold the 161 call with a 50 day expiration date.

I sold the 161 call for $5.09. I bought the 164 call for $3.63. This resulted in a total credit of $1.46.

Visualization of the QQQ (@ $158.83) Trade:

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We make money along the green line (below breakeven), and lose money along the red line (above breakeven).

To calculate my breakeven point, I subtract the credit I received from the call I bought, 164. That’s the price that I need the trade to remain at or below in order to make money. So the price of QQQ has to stay below 162.54. I calculated this by [164 – 1.46]

  • Breakeven Point: Long Call – Credit Received 

To calculate my probability of profit for a vertical spread, I would take 100 – ((Credit Received / Width of Spread) x 100), to get a probability of profit of [100 – (($1.46 / 3)) x 100]. I would I have a 51.3% probability of profit, which isn’t great.

But I am only risking ($3 – $1.46) $1.54 on the trade. I tend to trade along the border line of 50-60% usually, because the risk-reward balance is pretty even. Risking $154 to make $146 is a pretty good deal.

  • Probability of Profit: [100 – ((Credit Received / Width of Spread)) x 100]
  • Capital Risk: (Width of Strikes – Credit Received)

51% is higher than the 50% I’d have with stocks, after all.

GLD Trade

The whole market has been in something of a flat line for the past few weeks, but calls for a correction have gotten louder and louder recently. I’ve talked about this in many blog posts – business cycles call for down swings in the market for a healthy economy.

What’s great about options is that we can play into market directional movements. We can bet that the market is going down – and STILL make money. With stocks, you only want the market to go up – that’s the only choice you have to make money.

With the Q’s trade I just made and the GLD trade I am about to make, I will make money if the market goes down a lot, goes down a little, or remains relatively the same.

When the market goes down, gold tends to go up, as risk aversion method. The broad market and gold have historically been negatively correlated. If large cap stocks are a safe-haven compared to small-cap, gold is a vault with a lock on it for investors (theoretically).

However, with the interest rate hikes and the “improvement” of the economy, the flow of capital to gold isn’t as much as it has been in the past. When interest rates rise, the dollar gains strength, which weakens gold.

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Image via Seeking Alpha (Gold: Red, SP 500: Green)

As you can see in the above graph, when SP 500 (green line) increases, gold (red line) tends to decrease. This showcases the correlation between the two assets.

I decided to match my Q’s trade with a trade in GLD, the SPDR Gold Trust ETF that denotes a share of gold bullion which is held in the Trust (so not exactly a basket of stocks). Other Gold ETF’s track the movement of mining companies, like GDX.

But as you can see in the below graph, GDX doesn’t match the movement of gold as well as GLD does.

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Image via the Motley Fool

I went bullish on GLD. I did that because I went bearish on the Q’s. Ideally, GLD will increase when the QQQ’s decrease. Not quite sure if it will happen exactly like that, but it was a good trade for probability of profit purposes, and to balance out the deltas of my portfolio.

I could have done a trade going bearish on GLD too – that way, either way the market went, I would have made money. If the market had decreased, I would make money on the QQQ’s bearish play. If the market increased, I would have made money on GLD. Hypothetically, of course. Unfortunately, nothing works exactly the same each time.

I sold the 125/120 put spread, buying the 120 put and selling the 125 put for a total credit of $1.46, the same as my Q’s trade. However the implied volatility on GLD was only 58. Liquidity was stars. No upcoming earnings.

Visualization of the GLD (@125.702) trade:

UntitledI had to take on a bit more risk to get the same amount of credit in GLD as I did the Q’s because the IV was lower (58 in GLD vs 100 in QQQ). I have a 5 point wide spread (125 – 120) in my GLD trade, meaning that I am risking $3.54 to make the same $1.46 that only cost me $1.54 in my 3 point wide spread in the Q’s.

So: GLD was 5 points (125 -120) and I got $1.46. QQQ was 3 points (164 – 161) and I got $1.46. More capital risk, same reward, because of lower implied volatility.

I have a [100 – ((1.46/ 5)x100)] 70.8% probability of profit. I need GLD to remain above (125 – 1.48) the breakeven point of $123.52 in order to make money on the trade.

So combined, I made a double trade in QQQ and GLD with a combined probability of profit of 61%, received $2.92, and have $5.08 at risk.

Conclusion

I like to trade ETF’s because risk is diversified. I like to place two trades at once, because then they can balance each other out a bit.

An ETF (read more about them here) is basically a basket of stocks. So the QQQ that I traded earlier was a basket of tech stocks, like AAPL, MSFT, GOOGL, and FB. What’s nice about trading the QQQ’s versus just AAPL, is that I am exposed to the movement of 100 different tech stocks in the Q’s rather than just the rather volatile singular stock movement of AAPL. GLD is an ETF that tracks the movement of gold bullion.

When I place a trade, I tend to look primarily at ETF’s. I also calculate my breakeven point and risk:

  • Breakeven Point: (Long Option + Credit Recieved)
  • Capital Risk: (Width of Strike – Credit Recieved)

And my probability of profit for each trade

  • [100 – (Credit / Width of Spread)*100)].

I placed the trade 50 days out, because the preferred 45 day cycle wasn’t available. I had volatility within my preferred range of 50 on both trades.

I will look to take this trade off in the next 10-15 days, and continue placing on more trades in the meantime.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

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