My Ongoing Approach to Outperforming a Market Downturn

The first few days and weeks of the year might seem like an arbitrary block of time, but as far as history goes, they’re incredibly predictive for the rest of the year.
If you follow the Stock Trader’s Almanac’s “First Five Days” indicator and “January Barometer,” you will want to pay close attention to how the market fares during the first month of the year.
Why?
According to the Almanac, “The last 40 First Five Days that were higher were followed by full-year gains 34 times for an 85.0% accuracy ratio.” I know, it seems too simple to believe, but the historical facts and figures are what they are. Statistics don’t lie.
To investors’ dismay, the “First Five Days” closed lower this year. It’s the second time since 2008 that the first five trading days of the year closed lower. The return in 2008: a pathetic negative 38.5%. And if we go back to 2000, there have been five lower first five days, with all but one leading to negative returns. The average decline was negative 21.3%.
But the “First Five Days” is an addendum to the well-known and closely followed “January Barometer.”
The January Barometer is even more accurate. The January Barometer basically states that as the S&P 500 index goes in January, so goes the year. With roughly one week left until January passes us by, the market benchmark is down roughly 8%.
Over the past 66 years (1950-2015), a positive return in January led to a positive annual return 92.5% of the time. A negative return in January predicted a lower annual return 54.2%. Basically, a coin flip.
But I dug a little deeper into the numbers and discovered some very interesting and potentially useful results.
Over the past 64 years, when the first five trading days of the year showed negative returns and the month of January closed lower, the probability of a negative return for the year increased from 54.2% to 73.3%, with an average return of negative 13.9%. Those are odds and returns to which we need to pay close attention – especially given the length of this ongoing bull run which is seemingly on its last breath.

The Antidote

So what am I doing during the current market downturn and heightened fear in the market?
The same thing I’ve been doing for the last 18 years. Selling options using credit spreads with a high probability of success.
The market remained relatively flat in 2015, vacillating between slightly positive and negative. But now there is no doubt that uncertainty has entered the market.
So, as an investor, are we supposed to sit on our laurels and allow Mr. Market to dictate our returns?
We all look like financial geniuses when the market is going higher. Investors take all the credit for their success when the market is soaring, but blame other factors – such as geopolitical concerns or central bankers – when investments sour. The talking heads make sure the culprits are front and center to make the blame game that much easier.
But, I don’t really care.
I don’t care because the ongoing news cycle never ends. I don’t care because it has been proven that professional analysts can’t outperform the market. But, more importantly, I don’t care because stock picking is a coin flip, and the probability of success is only slightly higher than 50% due to the risk-free rate.
I care about volatility. I care about probabilities. I want every single trade I make to have a high-probability strategy wrapped around it, and an increase in volatility allows me to increase my pot odds even further.
But before I go down that road, let us get back to market uncertainty for a moment.
The S&P 500’s lackluster performance over the past eight months has had a direct correlation with the return of volatility. There is no doubt that we are in the early stages of a bull run in volatility, and in the past, bull markets in volatility have lasted five to seven years.

The Strategy Explained

So far this year, while the market has struggled, I’ve managed to outperform the market substantially using high-probability options strategies.
The strategy is known as a vertical call spread or bear call spread.
It’s a type of options strategy used when a decline, or at least limited upside, in the price of a stock or ETF is expected.
For example, let’s assume that the SPDR S&P 500 ETF (NYSEArca: SPY) is trading at roughly $192 and you expect there is limited upside over the next seven to 50 days. As a result, you decide to use a bear call strategy. I say seven to 50 days because with options we have the ability to customize the duration of our trades.

By definition, a bear call spread is achieved by selling call options at a specified price while also buying the same number of calls, but at a higher strike price.

For instance, with SPY trading at $192, an options investor could sell the 202 strike for at least $0.82 and buy the 204 strike for $0.48. If you subtract the two you end up with a total of $0.34, which equates to a 20.5% return over 36 days.

Now, if you look at the strike sold at 202, the probability of success (Prob. OTM) is 85.21%. That means that there is an 85.21% chance that SPY remains below $202 at the time of February expiration in 36 days. So basically, as long as SPY stays below $202 over the next 36 days, you will make 20.5%, and the chance of that happening is 85.21%.
If we wanted a more conservative trade we could sell a higher strike, let’s say the 205 strike. This would increase our probability of success to 87.93%, but it would also decrease our return on the trade, which is perfectly fine. We could sell the 203 strike for $0.62 and buy the 205 strike for $0.36. If you subtract the two you end up with a total of $0.26, which equates to a 14.9% return over 36 days.
It’s a more conservative trade, but we have increased our probability of success by roughly 2.5% while maintaining a decent 15% return over the next 36 days.
Are you starting to see why so many professional options investors use bear call spreads as their bread-and-butter strategy?
If you would like to learn how I use this strategy, among several others, check out my latest webinar where I discuss vertical spreads and my game plan for 2016. I go over in great detail how I use options selling strategies with a high probability of success.
I realize that for some of you these concepts are completely foreign, but I can promise you that once you begin learning about how options can work to your advantage, you will never go back to just using a buy-and-hold strategy.
There’s just too much opportunity to put your hard-earned money to work in more effective ways. Whether you want to provide another source of monthly income or just protect the hard-earned profits in your buy-and-hold portfolio, options are the ticket.
I hope you can join me in what is becoming the fastest-growing sector in the investment world.