Downtrends are not always doom

doom

There is no such thing as a ‘born trader’. Every principle of trading is learned. It is easy to feel daunted by the jargon involved in the sharemarket, but with effort you can learn how to trade like a professional. Professionals make money regardless of the market direction. Most people know how to make money in a bull market, but few know how to profit from a bear market. Let’s have a look at some of the methods that you can use.

Act on Your Stops
Aldous Huxley stated that “facts do not cease to exist because they are ignored”. If you recognise that a bear market is in place, the first step is to review your existing portfolio. Take a close look at where you have set your stop losses, and make sure that these levels are consistent with your trading plan. If your stop is hit, exit immediately. Do not ‘hope’ that your shares will recover. Traders tend to hold onto shares that are trending down, yet sell shares that are trending up prematurely. This trait will ensure that you will stay amongst the mediocre masses, and never fight your way to the top of the class.

Writing Call Options
There are two types of call options – a covered call and a naked call. A covered call is where you own the underlying stock. If you are exercised (ie you are told to sell your shares) and you have written a call with an option strike price greater than your share purchase price, you will realise a capital gain on the share. This is in addition to the premium (eg 40 cents a share) that you received for writing the call. This is the safest way to begin in the options market. Be aware that you must only write options against shares that you are willing to sell, or you will need to take defensive actions to remove yourself from risk before being exercised. By consistently writing calls over shares that you own, you will receive a cashflow similar to receiving a dividend cheque in the mail every month.

If you do not own shares, you can write a naked call. Writing a call assumes that you have a sideways or downtrending view on the future share price action prior to the expiry date of the option. As long as the share price stays below the strike price of the option, then you will get to keep the full premium that the option taker paid you. If the share price goes above the option strike price, you are likely to be exercised, and told to deliver shares to sell to the option taker. Unless you own these shares, you will be required to buy them at market value, and then deliver them to the option taker. This strategy is best reserved for professional traders, or traders that fully understand the risks involved.

Bought options depreciate in value, right up until a defined expiry date. This is called time decay. Once you have sold another trader an option, if all other things remain equal, the option will expire worthless. You will have the money in your bank account and the buyer of the option will be holding a worthless asset. In fact, up to 80% of people lose money when buying options.

Buying Put Options
Writing options involves collecting a small fixed premium, yet incurring a theoretically unlimited loss. Buying options has a lower probability of success, yet due to the leveraged nature of this strategy, the rewards from the 20% of trades that do work, may outweigh the losses from the 80% of losing trades.

In the options market, as the share price drops, the price of put options increase, often very dramatically. If you buy a short dated option, then time decay will erode your profit. For this reason, it is preferable to buy an option that expires in at least four months or more, and exit before the final month.

Short Selling
Usually when we buy a share, we are hoping to buy it at $5.00 for example, and sell it at $10.00 at a later date. Short-selling performs this same process, but in reverse. In effect, you borrow shares that you do not own, sell them with the expectation that the share price will drop, then buy them back at a later date. Your profit or loss is the difference between your sell price, and your buy price – so if the share price drops, you make a profit. If the price increases, you will incur a loss. It is actually quite a simple concept, yet less than 1% of transactions in Australia are executed utilising this method. There are approximately 300 shares that can be short-sold on the Australian market.

In the majority of cases, a leverage of 5:1 applies as brokerage firms usually require you to lodge 20% of the value of the initial share price in a cash management account. Be aware that you will be margin called, and required to place more money into this account if the share price trends upwards (against your initial view). Remember that these strategies must be used with shares that have sufficient liquidity, or you will have trouble extracting yourself from the position if the market suddenly turns bullish. This is absolutely essential, as there is nothing worse than being trapped in a trade due to of lack of volume.

The sharemarket will continue to redistribute wealth to the people that are determined to educate themselves. Much of our success is ultimately determined by the strategies that we implement, as well as our discipline and mindset. Your financial future is in your hands.

louise_bedford Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of four best-selling books – The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. Register on her website to receive a free trading plan template and a 5-part e-course to get you trading like a machine.

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