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Can We Measure Bear Market Risk
By Lawrence G. McMillan

This article was originally published in The Option Strategist Newsletter Volume 15, No. 13 on July 13, 2006. 

Whether or not the current market decline develops into something more severe – perhaps the elusive 9% (or 10%) correction or even a bear market – one is well-advised to gauge the risk of his strategies before trouble springs up. Most traders handle things on a “case by case” basis, or just figure they’ll play defense if they have to with a particular option or stock position. But perhaps a better approach would be to try to judge the risk of one’s general strategy in light of what could go wrong. Often, it is the increase in implied volatility that is the bane of an option trader, as much as a decline in prices. In this article, we’ll try to formulate the basis for such a general approach.

The “Traditional” Approach

The standard definition of a market correction is a 10% decline, and that of a bear market is a 20% decline. As we know, though, not all indices and/or sectors decline at the same rate. For example, in the most recent decline from the May highs to the June lows, $SPX dropped 7.9%, while the Dow dropped a very similar 7.7%, but QQQQ fell by 12.2%, and small cap indices such as the Russell 2000 ($RUT) fell 14.7%. So by the standard definition, the big-cap indices didn’t even have a “correction,” while small caps are nearing the definition of a bear market. So which is it? The answer is, “It depends.” Depends on what you own, that is.

In the bear market of 2000-2002, things were a little different: $RUT fell 37.5%, the Dow fell 36.3%, $SPX fell 48.7%, and QQQQ fell 83.5%.

The one thing that the two time periods have in common is that the index which had been going up the fastest, fell the most ($RUT was the only one of the group making new all-times earlier this year).

Hence, if you are stock holder, you would first assess which index your portfolio most closely resembled, and then you could have a better chance of assessing the risk of a typical market decline.

In addition, your strategy of stock ownership would play a major role as well. If you are “buy and hold,” then you wouldn’t make any adjustments at all; you’d just figure that your stocks would come back someday (try telling that to the QQQQ’s buyers who paid 120 in early 2000!). But if you are a market timer, then you’d try to assess the lost opportunity of incorrectly being out of the market (i.e., you thought the market was going to decline, but it didn’t) versus the risk of staying too late into a major correction.

These are but simple approaches to a simple strategy – stock ownership (not that making money from simply owning stocks isn’t difficult, but the strategy is simple: either you own them or you don’t).

Covered Call Writing

When one begins to delve into option strategies, the analysis can become more difficult. For example, take covered call writing. On the surface it is a simple strategy, although I’m sure that most who have seriously tried to implement it have found that it takes a lot more work than you thought it would (that’s why we offer money management for covered call writing accounts).

Those who are covered call writers, and who approach the strategy from a total return basis, are likely to want to continue using the strategy in all markets. In fact, bear markets produce huge option premiums, so the expected returns of newly-invested money in covered writes can actually be much higher than they might be in a bull market.

But every covered writer – who is, in effect, a naked put seller (the two strategies are equivalent) – knows that a bear market is going to hurt his existing positions. And an ongoing bear market isn’t going to be particularly kind to new positions, either. However, as premiums expand, one can make adjustments. For example, nearly all of our covered writes are in-the-money writes (some deeply so) and have an expected return of at least 12% cash or 18% on margin. If premiums expand during a bear market, those same levels of expected return can be garnered with even deeper in-the-money options. So one logical adjustment would be to keep the expected return levels constant, but find the lowest possible strikes that yield that return.

The alternative approach during the bear market would be to keep writing calls about the same distance in the money as always, and shoot for the higher returns that those calls’ inflated premium would offer. The potential error in this latter approach, though, is that the computer does not know that there is an ongoing bear market, and so it computes its expected returns with a neutral outlook on the market (although, it should be noted that our Probability Calculator 2006 does allow one to put a “drift” on the distribution, so you could try to adjust for a bear market in that regard).

In either case, one would probably want to keep his time horizons quite short in covered writes during a bear market because that reduces the risk of something going terribly awry.

Eventually, the best covered writing opportunities will arrive at the bear market bottom. You want to ensure that you arrive at that point with your capital relatively intact, so you can benefit from it. In fact, the current “mania” regarding covered call writing began with publicity surrounding the amount of money that covered call writers made from putting on positions in the July through October period of 2002, when premiums were fantastically high and stocks were bottoming.

An increase in implied volatility affects expected returns in what one might consider to be a logical manner:

Example: One has this covered call write in place:
         Long 500 XYZ at 43
         Short 5 XYZ Aug 40 calls at 4.50
         XYZ volatility: 40%

The expected return for this write is 16% cash or 25% margin, assuming that there are 38 calendar days until August option expiration.

What happens if our volatility estimate is too low? Suppose that during the life of the covered write, the stock’s volatility averages 50% (ignoring for a moment whether the stock is going down or not). Using that inflated volatility, the expected returns would be 8% on cash and 7% on margin.

If volatility were to average 60%, then the expected returns would be even worse: –1% on cash and –11% on margin.

Hence, an increase in volatility will produce lower expected returns for a covered call write. That is certainly logical and should not come as a surprise to anyone. Furthermore, this stresses the importance of making a reasonable volatility estimate to begin with (too low and you’re likely to get a worse return than expected, but if you estimate too high, you might be passing up valid money-making opportunities).

By the way, the previous example also shows that margin accounts fare much worse than cash accounts as the volatility increases. Hence, another tactic that a margin covered writer (or put seller) should consider is to reduce the leverage in the account. That can easily be done by just allotting more theoretical capital to each position, rather than using the maximum leverage that the broker allows.

Some critics of naked put selling – and option writing in general – have been warning of a massive wipeout of practitioners of such strategies when the bear market comes. They may be correct with respect to some covered writers (most likely those who are operating on the maximum leverage), but the situation is not nearly that bleak for the average covered call writer or put seller.

For example, in the above XYZ example, suppose that as the volatility begins to increase, XYZ falls through your breakeven point (38.50) and you stop yourself out of the trade. At that point, one can employ new cash with better estimates of volatility – taking into account the fact that implied volatility has increased overall. This is another reason why one should want to keep the writes fairly short-term in nature, because even if one is fortunate enough to be called away (realizing the maximum return), he can then put that cash back to work with a better (higher) volatility estimate.

So, can we measure bear market risk? Perhaps not explicitly, but we can estimate it. Consider what we learned in the above example:

Vol Estimate  Expected Return
              Cash     Margin
    40%       16%        25%
    50%       8%          7%
    60%      –1%        –11%

If this were to be true over the entire marketplace, then we might generalize it so say that 50% increase in volatility (from 40% to 60%) will essentially wipe out our expected profits for the current positions that are in place.

That is not pleasant, of course, but it is not catastrophic, either. By employing the tactics described above – staying short-term, reducing leverage, and using deeper in-the-money calls – with the benefit of more expensive options, new positions can be adjusted to be far less susceptible to the ravages of a bear market. The main point is not to be so leveraged going into the bear market that one is wiped out by the initial surge in volatility.

This is what we would suggest a covered call writer should do. For it is unlikely that one is going to abandon a strategy that has been making money – and perhaps is the only option strategy that one knows or is willing to use – for the unknown possibility that a bear market might emerge. But, once the bear does appear and volatility begins to increase, the covered writer can and should make adjustments to compensate for it. By doing so, he should be able to survive the bear, and he will clearly be outperforming mere stock owners in the process. There is no reason to expect that a bear market is going to wipe out ones account. In fact, in the biggest bear markets that have occurred since the inception of listed options (1973-1974 and 2000-2002), strategic (total return approach) covered writers did rather well, clearly outperforming stock holders and hedging much of their stock losses by selling inflated calls.

Other Strategies

Straddle Buying: Some strategies, of course, will do better during a bear market: straddle buying, for example. We do not need to delve into that in any great detail to prove the point. Clearly an increase in volatility is going to 1) create larger stock movements, and 2) inflate option premiums. Since both of those events are favorable to straddle buyers, it is easy to see that expected returns would surge. In fact, this is one of the reasons that we have begun to favor straddle buys in which volatility is showing a pattern of increasing before we enter the position – because we realize just how important that can be to a straddle buyer.

In fact, any strategy that is predominantly long options (such as a backspread) should fare well during a period of increasing implied volatility.

Credit Spreads: this strategy is perhaps overly popular right now, especially if one considers that Condor Spreads are credit spreads as well. Today, I received a spam email ad extolling the virtues of condors. This deomonstrates the mass appeal that credit spreads have achieved among average option traders. If a credit spreader is too leveraged (which is easy to do since “risk is limited” – limited to 100% of the money in the trade!), he may not be able to withstand the first onslaught of a volatility increase in a bear market.

But, if he is not overly leveraged, then he can establish new positions with farther out-of-the-money credit spreads. In the article we wrote about Condors last year (Volume 14, No. 7), we suggested using the volatility of the underlying to determine the option strike to sell (1 or more standard deviations out of the money). As volatility increased, then, that approach would lead one to writing farther and farther out-of-the-money options, which should help the strategy hold its own against the ever more volatile bear market.

Complex Spreads: more advanced traders may have positions in place, whose reactions to an increase in implied volatility may not be obvious. That is where one would then rely on either an expected return calculator (we are about to release ours – watch for a product announcement next month) or on the vega of the position. The Vega is less inclusive than expected return, but it shows how the position would instantaneously react to an increase in implied volatility.

Of course, traders who are taking more advanced positions might be less “married” to the strategy than a covered writer, credit spreader, or straddle buyer might be. Hence, the advanced trader’s best approach might be to switch strategies as the bear market unfolds – forsaking calendar spreads, for example, in favor of straddle buys or backspreads (or maybe even option sales if premiums get high enough).


So, can we estimate the risk of a bear market? Not exactly, of course, but the use of expected return can give one a much better idea of how an increase in implied volatility will affect one’s positions. After that, it is up to the strategist to modify his strategy so that he can survive the initial surge in implied volatility, thereby allowing him to take advantage of inflated premiums later on.


This article was originally published in The Option Strategist Newsletter Volume 15, No. 13 on July 13, 2006.  

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