Markets in Turmoil — Focus on the 3 Ps
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The S&P 500 traded in a 245-point range last week, only to finish 7.27 points lower.
Every time I thought I had a handle on the market’s direction, it threw me for a loop.
It was exceptionally frustrating.
Then I remembered that sometimes, the best investment is no investment. No, I don’t mean taking all your money out of the market. Nor do I mean you should sit on your hands and hope for the best.
Rather, we want to focus on the what I like to call the three Ps:
- Planning
- Prevention
- Premium
It’s a way to identify opportunities for later, keep yourself out of trouble, and focus on where you have an edge.
Here’s how it works.
1. Planning
We are investment tigers, stalking our prey, striking when the moment is right.But to know the moment to pounce, only one tool is fit for this job: a TradeSmith watchlist.
Watchlists keep track of stocks you want to follow and their key measures.
Here’s a sample from our system.
This model watchlist includes stocks, the Health Indicator, the Volatility Quotient, the latest closing price, and several fundamental metrics.
You don’t need to limit yourself to just one watchlist, either. I have several.
These serve as your shopping list, identifying stocks you want to purchase when the time is right.
But there’s a catch…
You need to update these watchlists regularly, and I don’t mean every single day. More like once a week.
Take McDonald’s Corp. (MCD), for example.
This is a well-run company with a history of profitable performance.
Then, Russia invaded Ukraine. Now McDonald’s, along with several other companies, has shut down and plans to write off operations in Russia.
As we get new material information, we need to reevaluate stocks on our watchlist.
What do I mean by “material information”?
- Earnings releases or warnings
- Major economic data releases like jobs reports
- Interest rate announcements
- Black swan events (things that come as a surprise and have a major impact, e.g., wars)
For example, Apple Inc. (AAPL) recently warned of an $8 billion supply chain impact in the coming quarters.
That’s significant. But I still like Apple as a company and a stock.
You only want to remove a stock from your watchlist if the information alters your investment thesis.
On the flip side, we always want to be on the hunt for new stocks.
This is where scanners and screeners come in.
I’m always on the lookout for stocks with bullish momentum, especially in this market.
For example, here’s a screener using TradeSmith Finance’s various strategies.
With so many stocks falling in price along with the broader market, our system picked out multiple companies that exhibit relative strength and high conviction.
Thanks to the way our system is designed, I can quickly incorporate these stocks into one of my current watchlists or an entirely new one.
Screeners are also great tools for looking at broader market momentum.
If I see many large-cap technology companies move to the Green Zone, chances are the indexes will as well.
2. Prevention
When you try to buy stocks that are in free fall, it’s known as “catching a falling knife” because you get cut.Trying to pick a bottom is difficult, if not impossible, for most of us.
It’s far easier to wait for a bottom to form and then use that as our foundation for making an investment or trade.
In that same vein, I don’t want to rebalance my portfolio during a time like this.
We can’t always know which stocks will bottom first, nor which will necessarily outperform.
Back in the summer of 2020, large-cap technology companies were the first to bounce back, along with stocks that benefited from the stay-at-home trend.
Yet if I tried to rebalance my portfolio based on value before these types of stocks made their comeback, I would have missed the boat entirely.
Portfolio rebalancing should be saved until after markets make a clear bottom.
3. Premium
If you don’t know options, I recommend you start learning.It’s one of the few areas where you gain an edge when markets fall.
You see, the price of an option increases with demand.
And since investors and funds use options to hedge risk, they clamor for them when market volatility increases.
That makes it the perfect time to become an option seller through cash-secured puts or option credit spreads.
As we have discussed in the past, the demand for options is expressed by implied volatility.
Implied volatility is mean-reverting; the further away it moves from its historical average, the more likely it is to snap back toward that average.
When markets are volatile, implied volatility skyrockets.
Now, because market downturns can take time to clear, we can’t rely on implied volatility quickly moving back to the average.
So, instead of working with options that expire in a couple of weeks, we can go out further in time, say 60 to 90 days.
This allows us to lock in a higher premium for longer and increase our potential profit for the trade.
For example, this is the option chain for put options on the SPDR S&P 500 ETF Trust (SPY) for the May 20, 2022, and Sept. 16, 2022, expirations.
If I sold a cash-secured put on SPY for the May expiration at the $402 strike, I would receive a credit of $11.42 per underlying stock share, or $1,142 in total (100 shares x $11.42).
The September option would pay me $26.68 per underlying stock share, or $2,668 in total (100 shares x $26.68), for the same strike.
If implied volatility were lower, I might only get half as much from those premiums.
But at the moment, I get more bang for my buck.
There is always a way to make money in any type of market, and this is a prime example. Cash-secured puts are a great way to collect a premium on a stock you want to own.
With all this in mind, what preparations are you making to your portfolio to address the state of the stock market?
Email me and let me know.