After yesterday – the worst trading day in recent memory – I want to get serious with you about risk.
If you get this right, you could have banked serious profits yesterday.
And I want to make sure you DO get it right.
One of the biggest mistakes investors can make is being too heavily invested in one trend, one sector, or even a single stock. Diversification is a tool that traders use to mitigate risk. The thinking goes, if you spread your investments out, your gains will neutralize your losses and you will yield better returns over time.
Your financial advisor has probably encouraged you to diversify your holdings by buying different stocks in different sectors, some commodities, some gold, and even some downside protection. But it’s difficult for the average investor with a limited budget to diversify in a way that truly cuts risk – experts say you should own somewhere between 25 and 30 stocks for it to really work.
That’s great – if you can afford it. But there’s another way to diversify that your broker or your financial advisor probably won’t tell you about, and it’s a great way to truly slash your risk.
The Easiest Way for Individual Investors to Diversify
I like to have a percentage of BOTH bullish and bearish trades in my portfolio whenever possible. If you are fully invested 100% one way or the other, the ramifications can be severe, as many traders no doubt experienced yesterday.
Don’t get me wrong – when the going is good it can be REALLY good. When you anticipate the market’s direction, your trades are winners and you bank the kind of returns people write songs about.
But if all your trades are bullish and require the markets to keep moving higher, all it takes is a single event – a bad jobs report, a stock market glitch in London, currency shenanigans in China, or heaven forbid some global catastrophe – to sink your entire portfolio.
The markets have a tendency to fall in price faster than they rise, and usually by a much larger percentage. That means, when markets are going down, you can lose a lot of money very quickly. This played out yesterday, when the Dow dropped 1000 points at the open, wiping out trillions in market value in a matter of minutes.
This is why I teach traders to diversify by having a mix of both bullish and bearish positions in their account at any given time, and why I trade that way myself.
I’ve talked about the bullish or bearish sentiment on Money Calendar many times. We are currently in a period of overall bullish sentiment through the rest of August and the first two weeks in September, as you can see below:
That’s not to say we won’t see market volatility, just that Money Calendar sees more bullish opportunities than bearish ones. Remember, volatility doesn’t mean that you have to lose money – it just means there’s more opportunity to make money in BOTH directions.
I try to find a bullish and bearish trade for my subscribers, my students, and my own account even when Money Calendar is showing green across the board.
Many investors are hesitant to put on bearish trades for one reason or another. But it’s a great way to cut your risk and balance your holdings.
How to Find the Best Bearish Options Trades
For those of you on the fence about putting on bearish trades, I have some great news.
I use exactly the same screening techniques to identify my bearish trades that I use to identify my bullish trades. So if you’ve been following along with Power Profit Trades or Money Calendar Alert, then you’re already familiar with what to do.
First, I run a few screens to get a list of the week’s top moving stocks (I’ll have more on how I identify my “Top Movers” in a future issue – so stay tuned for that).
I check those stocks against Darknet (my proprietary tool for looking at undervalued companies that have pulled back and are ready to make a dramatic move upwards) and Money Calendar. If one of these top moving stocks makes one of these lists, that’s my green light to initiate a trade. And when a stock makes both lists, I can really pin my ears back on those trades.
Looking for the best bearish trades doesn’t necessarily mean we’re looking for the stock that will drop the most in price. For example, if a stock shows the possibility of an 8-point move to the downside, but the options are thinly traded, I would rather take an option that has an expected 4-point move with better liquidity.
Let me show you why that’s important.
The difference between the bid price and the ask price is called the spread. The closer the bid and the ask, the tighter the spread. That speaks to an option’s liquidity.
More importantly, it’s a good indicator of how much a stock has to move for your options to be profitable. With spreads below $0.05, which is where I like to target them, the slightest move in a given stock can push your options into profitability.
So when you want to make a bearish options play (or bullish, for that matter), look for tight bid/ask spread. Volume and open interest in an option are indicators of liquidity, but the best indicator is the bid/ask spreads. The tighter the better.
Another factor I look for in selecting the best bearish option opportunity is the one with the lowest “percent to double.”
I’ll have a more thorough explanation of that technique later, but for now, here’s a quick example:
Let’s say I’m looking at two options on two different but similarly priced stocks that I think have the potential to make a bearish move. One option requires a 3% downside move in the stock to double, while the other requires an 8% move to double.
Obviously, we’d pick the option that only needs a 3% move to double – we want to make the most amount of money with the least amount of effort.
Sometimes the Best Trade is No Trade
As much as I would love to always find both a bullish and bearish opportunity, I don’t always get one. Rather than force a trade just for the sake of having one, I have learned to NOT take trades if they’re not there.
I have said it before and I will say it again – sometimes the best trade is no trade.
I may find a bullish trade, but no bearish trade, or vice versa. That’s OK. Sometimes you just have to take what the markets give you.
If you find yourself with only bullish trades in your portfolio, don’t sweat it. Just make sure you don’t have ALL of your money in on those bullish trades. Keep in mind that cash is a position, and keeping some of your capital liquid is essential. This way if something rattles the markets, you don’t have 100% of your money tied up in trades that aren’t working. And you can deploy that cash into bearish trades when they present themselves.
|Here’s Your Trading Lesson Summary: Having a mix of bullish and bearish trades in your portfolio is a great way to diversify your holdings:
- Markets fall faster than they rise, and usually by a larger percentage.
- Trading in both directions helps balance your portfolio and cut risk.
- Just as with bullish trades, look for highly liquid options with a low percent to double.
I’ll be back with you soon.