Can you safely sell puts in a bear market?
This is a common question I get asked here at Dividend On Fire but let us take this question one step further: Can you safely sell puts in a bear market and still generate a high yield income (15-25%) and still keep things relatively low risk?
In this article, we’ll explore whether put selling can still work when stocks are in a downtrend.
Table of Contents
1. Bear Markets Aren’t as Bad for Put Sellers as You Might Think
A bear market is not the end of the world for put sellers. Here’s why:
– Not everything goes down in a bear market
There are always some “defensive” stocks and sectors that hold up well during market declines.
Stocks in sectors such as Walmart, dollar stores, tobacco and alcohol, as well as utilities, tend to perform well
– Even stocks in downtrends don’t go straight down
Selloffs take breaks and stocks become oversold and bounce. They experience short term rallies, only to hit resistance and then continue to experience lower highs and lower lows.
However, there are always opportunities to capitalise on where there are temporary upside moves.
– Higher implied volatility is good for put sellers
In bear markets, option prices tend to rise due to higher implied volatility. This allows us put sellers to collect more premium income.
In other words, we get paid a lot more when Mr Market sends the bears in.
This means we can set up our short put trades more conservatively, choosing strike prices further out of the money than usual.
The higher implied volatility also makes repairing our put trades that have gone against us much easier.
2. Bear Markets Happen All the Time in Individual Stocks
Stocks enter their own bear markets all the time.
Just look at this $CROX example.
>> (A) March’20 the coronavirus hit and CROX dropped 83% in a month.
>> (B-C) Shortly after it then went on to rally over 2000% from trough to peak (C).
>> (C-D) From November17’21 another bear market set in and CROX dropped 75%
>> (D-E) July01’22 CROX advances 221%
>> (E) Since April20’23, CROX has dropped another 44%.
It’s important to note that from point E, the overall market has been grinding higher in a steady bull market but CROX has experienced it’s very own bear market.
CROX is currently on my watch list to sell puts on. It’s traded back down to 7x earnings much lower relative to its peers.
When looking at CROX, I believe that most of the recent damage has been done which is a key part of our put selling strategy.
Some additional takeaways:
When you incorporate value investing with selling options, you look for opportunities where stocks are attractively valued and not near their previous highs.
This means our main strategy is to stay away from high growth momentum stocks that are trading at high valuations.
Yes, we sometimes sell puts on these stocks such as TSLA, CRWD, SNOW, to name just three, but our bread and butter is world class business that are trading at attractive valuations.
As Benjamin Graham stated: The market is a pendulum that forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes stocks too cheap).
As mentioned already, you want the damage to have already have been done before you enter a short put trade on a position.
This, for Graham, increases our ‘margin of safety’—never overpaying for a stock no matter how exciting an investment it might be.
When you adopt a strategy like this, selling puts in a bear market allows you to follow a process that is adaptable, tolerant of missteps, and highly practical. This approach dramatically diminishes the likelihood of a catastrophic mistake that could jeopardise your entire portfolio.
And lastly, every time we enter a put position on a stock it’s never a one time only event. By following a campaign mode approach—rather than a one-off skirmish—we allow ourselves more flexibility, further stacking the odds in our favour for victory against Mr Market!
3. We Don’t Have To Sell Puts All the Time
Adaptability is important for navigating changing market environments.
– Can modify strategy in different market environments
In bear markets, a put selling strategy can be adjusted by selling further out-of-the-money puts and being more selective.
– Can scale things back
Reducing trade frequency and only selling puts on stocks that you really want to own is prudent in bear markets (although this is the mantra we try adopt all of the time).
– Repairing short puts is easier
When we are in a bear market we need to learn to stop drop and roll like a fireman. The good news is, it’s easier to roll down and out a short put to lower strike price whilst still collecting our premium pay cheque during times when volatility is high.
4. Do NOT Use Margin or Leverage
This one is so simple but many people get it wrong.
In a bear market you really want to stay away from margin or using leverage.
Whilst it can help your returns and cash flow when things are going good. When things turn bearish it can really go against you in a big way.
When selling options we want to follow a sleep easy strategy. Margin is the sort of thing that will keep you awake at night.
From my own experience, I only use a cash account. I stay fully away from using any sort of portfolio margin when trading options.
- Selling puts provides flexibility to manage trades—even in bear markets
- Ability to repeatedly adjust our strike price lower is a powerful tool we options sellers can (and should) utilise.
- Can limit damage even if trade goes against you by rolling down, collecting premium and lower our cost basis per share.
- Stay away from using margin.
The bottom line is that put selling can still work in a bear market if done selectively and managed actively. While the system often favours Wall Street and large institutions, as savvy options sellers we can still shape the rules to our advantage.
The flexibility to adjust, revive and and repair a trade that misbehaves makes put selling one of the most forgiving investment strategies that we teach here at Dividend On Fire.
By the way, did you know this entire strategy of selling put options can be learned in a free 29 page ebook I created? It’s true. Check it out.