Bubble markets trading strategy

Bubble markets trading strategy

At TwoTwoFive we always encourage our delegates to stay in touch after our courses, and we are always willing to answer questions and provide additional information. Last week a delegate who attended our 2 day Derivatives and Options course in November 2018 got in touch to ask about a strategy we discussed during the course. The strategy relates to how to use options to trade a “bubble” market. We thought we’d share the strategy here.

There are many examples of balloon or bubble markets; the Wall Street crash of 1929, the dot-com bubble of 2000 and Bitcoin in 2018 to name but three. Bubble markets are a well-recognised phenomenon that typically occur when a market rises rapidly leading to hysteria and greed; everyone wants to buy! The first thing to recognise is that without exception a market that goes up in this fashion will correct and come down at some point. The correction is usually just as violent as the original move up.  So most advice is to avoid trading these markets as the big problem is spotting when the market will turn and this is almost impossible! However buying options, instead of say futures, can minimise your trading risk. Most people make the mistake of saying “I know one day the market will come down so I will start buying Puts”. But if the market keeps going up you lose the premium you have paid out with no gain. You may be tempted to buy more Puts, but as you don’t know when the market will turn, you are effectively standing in front of a freight train; namely the rising market. Yes your loss is limited to the premium, but it is still a loss!

An alternative strategy is this; If the market is going up but at some point we are confident it will correct, we start by buying out of the money Calls, with relatively short expiry. Say 10 points above the market with one month to go, as an example. Essentially we want to spend a relatively small amount on the premium that we are comfortable to lose.  If we are really unlucky and the market turns just after we bought the Calls then we just lose the premium. (But now confident that the market will fall we can reverse the following strategy….start buying OTM Puts below the market).  More likely the market will continue to rise sharply and the OTM Calls will quickly rise in value. OTM options with short expiry rise in value (and Delta) very quickly as they come into the money. We can then sell them at a healthy profit and immediately buy new OTM Calls, again at a low price at a higher strike as the market has moved up so quickly. If the market keeps rising we keep doing this. Buy cheap OTM Calls, sell for a profit and reset by buying cheap higher strike OTM Calls again.  If the bubble continues for some time you can make a lot of money doing this for very limited risk, as you have already covered the cost of your original options purchase.

At some point the market will turn and drop rapidly, as the bubble bursts. At this point we will probably lose the premium on the last set of Calls we bought as they will be worthless but this is small compared to the profit we have already gained. However now confident that the market will correct and fall a long way we can reverse the strategy and start buying OTM Puts below the market and resetting at lower strikes as the market drops. We should add the caveat that every market and every bubble is a little different so there are no guarantees this will work every time. Your own trading objectives and attitude to risk must be considered too. But in our view this is the best way of trading bubble markets and would have worked in the examples given above. Now we just need another bubble market to trade..!