Note: The following is not investment advice or a specific recommendation for anyone.
In the last post on this blog we considered some technical and fundamental reasons to dismiss the current stock rally as a bear market rally that will end soon. In short, stocks are highly reactive to credit bubbles and draw downs created by central banks. Federal Reserve action on interest rates, quantitative tightening, and their forward guidance, as well as some other data, have been consistently pointed towards a credit draw down for much of the year now. Technically, this market is overbought. Regardless of what happens in the short term, it’s becoming clearer each day that we will see a strong pullback if not new lows.
I’m putting my money where my mouth is, but I didn’t go all in yet. As they say, markets can remain irrational longer than we can remain solvent. I took a starter position that was perhaps less than 10% of what I would be willing to go up to. Since then, of course, the market has popped higher following the latest CPI and PPI reports, quickly showing why caution is warranted.
Here’s a summary of the strategy:
Buy put options as opposed to shorting with shares, to put less capital at risk.
Give plenty of time for this thesis to play out, so the puts will have an expiration date of next year.
Focus on buying puts on leveraged bull ETF’s to take advantage of their natural price decay *
Slowly enter position and tend to add at further out expiration dates, with strike prices close to “at the money”.
Exit positions at least 2-3 months before they expire, and much sooner if there is a steep crash such as we saw June 9-13.
This is still risky so I’ll always primarily remain in cash or other investments.
I began on August 3rd with TQQQ $35 puts expiring 1/20/2023. It’s down about 19% from my initial entry price now. We have since then broken a couple of technical resistance points on the QQQ, including a trend line that was beautifully validated 8 times since December and and the trend line from all time highs through March highs till now. The important 200-day simple moving average remains as the next resistance. I made my second addition to the position today. At this point I’ll probably move on to puts with higher strikes and longer expirations; other leveraged ETF’s will also be considered.
Slowly entering these positions is key to reducing risk. I’m ok with missing out on a big winner because I didn’t size up all the way. If my thesis about the markets is right but my timing is off by even a few weeks it can significantly reduce profitability due to theta decay and swings in implied volatility. By waiting to enter around key resistance levels, I’m more likely to avoid prolonged rallies past my entries. And by staggering enteries, I’ll end up buying longer average expirations and higher average strike prices, which would result better returns when stocks come down.
With leverage comes increased risk, regardless of how careful I try to be. I’ll remain extra alert to identify trends and data changing. For an example of how dramatically things can change, consider that the federal funds rate went up from 0% to 2.5% in the last 4 months; but remarkably, less than a year ago, the odds were under twenty percent of even a single quarter-point hike by July ‘22!
Will the Fed really follow through with quantitative tightening? (History suggests otherwise - it’s actually off to a slow start already). I’ll be watching for news like we saw out of Europe, where they invent new names for the same old inflationism. And I’ll be watching for cracks in the Fed member’s unified hawkishness, a change in the data, or anything else that signals a return to the inflationary booms. Until then, I’m riding with the bears.
*Credit to the Live Better Now Substack for getting my gears turning on this.