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The Covered Strangle in Bear Markets

Updated: Jun 8, 2022

The Covered Strangle (for more detail on the strategy, check out this video) is a staple of mine. Although it's by definition, a bullish strategy, I deploy it in ALL markets including bear markets (defined as a 20% drop from recent highs). I'm not suggesting it's the best approach in bear markets, I am however suggesting that based on how we structure our approach, we can consistently deploy the strategy - worrying less about guessing where things are going.


I maintain two distinct allocations to my portfolio, Core and Speculative (learn more about that here). This has served me extremely well and allows me to maintain tighter control over my returns and reduce variance. The Covered Strangle is hands down the most deployed strategy in my core allocation.


Bear markets (as of late) are pretty rare. Using a sample of 75 years, the average duration of a bear market is ~290 days (you can checkout a video on bear market statistics here). They come in many forms, sometimes very steep like what we saw during COVID in 2020. Below is a chart of the drop in IWM (3Y Daily) and notice how steep the decline was but how rapid the recovery was as well.

I have a video that goes into detail on how I traded this drop and made over $36,000 with the Covered Strangle (you can find it here). I'm not going to go super far into detail here, but rather I want to highlight a few important aspects.

  1. Traded a Defined Plan. I've built my covered strangle strategy over years of experimenting and refinement. There are several ESSENTIAL concepts that enable my approach to work in varying market conditions, including a 40% drop like during COVID.

    1. Maintain Cash Reserves. This strategy is not built for small accounts nor is it optimized for efficiency. Having cash on the side is pivotal in the ability for the trade to make money even when the market moves against us. By allowing for additional short puts that are scaled in as the market drops, it allows us to manage our basis more effectively and maintain sensitivity to current market pricing.

    2. Prepare for the Long Haul. The COVID drop was an anomaly - one of the shortest bear markets in recent history. We don't want to scale in too rapidly and run out of money. In doing so, we lose sensitivity to current prices and the ability to continue generating profits on assigned shares.

    3. Trading Specific Products. This is a primary reason I trade things like index ETFs (IWM, SPY, QQQ) for this strategy. If I'm stuck below my basis for extended periods of time, I generally accept it and simply wait. I'm not as concerned due to the inherent diversification. I'm not worried about an individual company going bankrupt (yes, even blue chip stocks can fail) nor am I concerned with the market dropping to never return. Individual stocks can remain suppressed, never returning to pre-fall levels. The broader markets haven't experienced this yet. They don't move as fast as strong individual stocks during the recovery (speculative allocation is a great way to take advantage of this), but index ETFs enjoy the collective rebound.

    4. Rolling to manage basis prior to assignment. By rolling options as the market falls, typically as little out in time as possible while gaining a credit and ideally being able to reduce my strike allows me to onboard shares at a cheaper price (reducing long stock basis) while collecting a healthy credit (max profit upon assignment). This is where I primarily deploy my cash reserves in addition to selling standalone (non-rolled) short puts in conjunction with the strategy.

  2. Getting Comfortable with Red. Depending on how aggressive we want to be, we can always sell calls below our assigned share basis. This obviously runs the risk of locking in a loss if we see a rally above our short call. Nonetheless, this can be a viable approach to continue managing our basis. I'm cautious when deploying this approach but it can work very well. I tend to focus on keeping the short calls further OTM than for other strategies, no higher than 0.35 delta and most often around a 0.20.

  3. Leverage Allocation Split. As I mentioned, I maintain two allocations in my portfolio. While my covered strangle was working and accepting the fact there are often periods of time where I'm simply holding an unrealized loss, I leverage the other allocation in my portfolio to remain active and take advantage of current market opportunities. Ratio put diagonals are a favorite of mine during bear markets.

This is my general approach to deploying the Covered Strangle in bear markets. It's not built for bear markets but it can withstand them ultimately offering tidy profits on the rebound without needing the market to actually fully recover.


Be an Outlier!

Erik


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Reach out with any Questions or Topic. erik@esinvests.com

Join the esInvests Outlier Community on Discord. https://discord.gg/hYGZUEJpve

Website. https://www.esinvests.com#Trading#Stocks#BeAnOutlier

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The stock market is a great tool in our approach to developing wealth. I started investing at 16 and have been actively trading for 15+ years. I don't come from money and am nothing special - yet I still made my first million before I was 30. I share my approach to trading and wealth development without the BS. I cover things like investing basics, options trading, portfolio management, trading psychology, real estate and angel investing, and my first hand experience in creating wealth. I regularly provide updates on the markets and my trades as well as host guests that share their respective perspectives and expertise. Welcome to the Outliers!


I am not a financial advisor. All content is shared for educational and entertainment purposes only.

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