When will we bottom out?
That’s the number-one question on investors’ minds today. Fortunately, our two technical experts, John Jagerson and Wade Hansen, addressed it in their recent Strategic Trader update.
In Strategic Trader, John and Wade combine options, insightful technical analysis, and market history to trade the markets, whether they’re up, down, or sideways.
In their update from last week, John and Wade discuss how long declines like this usually last, what the ensuing consolidation period is like, and when we might expect to see a rebound. It’s great information to help you contextualize today’s volatile market … and use it to your advantage.
So, in this Sunday Digest, let’s turn to our quantitative experts.
Have a good weekend,
Looking Forward to the End of the Crash
By John Jagerson and Wade Hansen
On Sept. 15, 2008, Lehman Brothers declared bankruptcy. For those of you who weren’t in the market at the time, you now have an idea of what that day was like. It felt like the market had no bottom, and we could tell there would be a major shift in the way investors thought about risk.
The market dropped another 40% following the Lehman crash, and it was a challenging time. However, smart investors were realistic about the risks and didn’t lose sight of the opportunities that would arise when the major indexes started to base and bounce.
We feel like this is another Lehman moment. There are serious challenges but also extraordinary opportunities. This week’s update will be a brief overview of what we think about the timing for a bounce and what we can do to take advantage of opportunities when they appear.
The market moves down much faster than it moves up, so bear markets tend to be brief in relative terms. Even the panic selling of the 2008 financial crisis only lasted 23 weeks — from Sept. 22, 2008 to March 2, 2009.
The two declines in 2015 and the bear market of 2011 were over in less than five weeks. If we had to make an estimate based on historical averages, we believe there is a high probability the market will have reached a bottom within the next six weeks.
How long it takes for the market to start to rally again after reaching a bottom varies a lot more when we look at past examples. In 2011 and 2015, the market consolidated for a few months before starting to rally again, and something similar will likely happen this time as well.
The market turning on a dime — like the “v-reversal” we saw after the decline in 2018 — is quite rare.
A Slower Basing Pattern Would Be Good News
If the market consolidates after reaching a bottom, it will actually be good news for option sellers.
Implied volatility should remain very high, which will increase option premiums. With higher premiums we can recoup many of our losses by selling calls against our long-stock positions.
As you can see in the following chart, the VIX is at crisis levels — near 70 — which makes it possible to earn 10%-12% from call selling even without accounting for the use of leverage.
If we sell further out-of-the-money calls, we can collect large returns without the risk of being called out of our stock positions for a loss. This is the strategy we recommended using with Microsoft (MSFT) today.
Two-Week Chart of the CBOE S&P 500 Volatility Index (VIX) — Chart Source: TradingView
Our plan is to time any new covered calls with short-term rallies in the market. As mentioned previously, prices tend to base for a while after reaching a bottom, and we can trade that channel by selling calls on the highs and then buying them back on the lows to grow our income.
Even though stocks were higher on Tuesday, we are still planning to make changes very slowly while the market settles.
Look for Slower Days
Although it may feel like big days to the upside are a good sign, they usually aren’t. Big moves up and down mean that traders realize they are “wrong” and that increases risk. We want to see the average trading range to come back down toward normal levels, even if the overall trend hasn’t turned positive yet.
The following chart is a good example of what we are looking for. As you can see, the average true range (ATR) of the S&P 500 was around 25 following the “flash crash” in May of 2010. As the S&P 500 consolidated, the ATR began reverting back towards its average.
Daily Chart of the S&P 500 During the Flash Crash of 2010 — Chart Source: TradingView
By the time the market broke short-term resistance on Sept. 20, 2010, the ATR had confirmed that investors were feeling more confident about their estimates, and the bullish trend was more likely to continue.
Currently, the ATR is around 140 and we will want to see it fall down to between 50 and 70 before getting more aggressive by writing a lot of new short puts. Until that happens, we should sell calls on our long stock positions.
Catalysts for a Consolidation
We have received a lot of questions over the last two weeks about the timing of the correction: will the market continue to fall until the nation curbs the pandemic? Will it fall until this summer?
That likely is not the case.
Between now and the return to business as usual, traders should be looking for signs of progress.
Investors are trading based on what they think about the future, not what is happening right now. So, if we see progress and better information flowing in April or May, investors will start bidding prices higher in anticipation of normal economic conditions, even if infection levels are rising and day-to-day conditions haven’t normalized yet.
The Great Recession of 2008-2009 is a good example of what we mean. Prices started to rise — and the ATR was much lower — in March of 2009 when it looked like the stimulus plans, quantitative easing and the natural flow of the business cycle were starting to take effect.
The recession didn’t actually end until June, but the S&P 500 had already bottomed in early March. The market was up nearly 40% from its bottom before the recession officially ended. You can see what we’re talking about in the chart below.
Daily Chart of the S&P 500 During the Great Recession — Chart Source: TradingView
The Bottom Line
Here are the key takeaways from this week’s update:
1. As long as volatility is high, we plan to focus on selling calls against our long stock positions to maximize our income and reduce risk.
2. Most declines end within six weeks — they rarely last more than 20 — so we could be closer to the midpoint of the current disruption than it appears.
3. A basing or consolidation range is likely to appear after most of the declines are priced into the market. Historically, those consolidations have lasted two to four months. An immediate reversal can happen but is unlikely. As the ATR starts to fall during a consolidation, option premiums should still be relatively high. Our focus should be on earning income from covered call selling and evaluating adding new risk to the portfolio slowly.
4. Even if the current measures being taken to slow the spread of the virus mean consumers and businesses can’t return to normal until late summer, investors are likely to start pushing prices in the market higher this spring. We will be prepared to take advantage of that rally.
John Jagerson and Wade Hansen