bear market strategies...credits – evolution of the bear workshop 2 bear market strategies s1703b...

Credits: Mark McDowell, Robert Tharp, Van Tharp, Ken Long, Frank Eaves

Bear Market Strategies

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Credits – Evolution of the Bear Workshop

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Bear Market Strategies S1703B © 2020 Van Tharp Institute, Inc. All Rights Reserved.

The reproduction or transfer of this material is prohibited by the Van Tharp Institute student agreement.

▪ Mark McDowell – this is dedicated to him – Creator and instructor for Bear Workshop v2.0. RSI(2) trader. Bear market phases

▪ Robert Tharp – Original Bear Market Strategies creator, RSI(2) & Rocks & Rockets originator/trader

▪ Van Tharp – Author and presenter of v1.0, NCAV system, Tharp Think, market type etc.

Other Contributors: ▪ Ken Long

– Market type methodology, day trading methods, learning journal, Brown’s permanent results, volatility monitoring etc.

▪ Frank Eaves – NCAV research & back testing

My Professional Background

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▪ 1989-1991: Equity & Derivative Research, London Life Insurance Co.

▪ 1991-1993: Equity & Commodity Derivatives, Citibank Canada

▪ 1992-1996: Cooper Panko & Partners, Investment Management

▪ 1993-1996: Head of Equity Derivative Trading, Citibank Canada

▪ 1996-1999: Equity Proprietary Trading, Deutsche Bank Canada

▪ 1999-2007: Equity, Fixed Income, and Alternative Investing, Self-Employed

▪ 2007-2013: Managing Partner, Portfolio Manager, GMPIM LP

▪ 2013-2015: Senior Portfolio Manager, Fiera Quantum LP

▪ Present: Trading, VTI Instructor, ST2 Candidate, Self-Employed



My Education & Certifications

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▪ Commodity Trading Manager (2010)

▪ Investment Counsel & Portfolio Manager (2007)

▪ Masters of Transpersonal Psychology (2005)

▪ Chartered Financial Analyst (1996)

▪ Bachelor of Mathematics (1993)

▪ Canadian Investment Finance (1992)

▪ Canadian Securities Course (1989)



My Psychological Profile

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▪ Myers Briggs: I-N-T-J - The Architect

▪ Enneagram: Type 3 - Achiever

▪ VTI Trader Test: Strategic Trader



My Passions

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Self-Development

Spirituality

Trading

Making money Role model

Who AM I?

Challenge My potential



Dream Life: Experience life to its Full Potential being happy, healthy, wealthy and wise

Life’s Purpose: To Inspire (in-Spirit) by fully embracing Who I Am, creating Abundance in All-Ways

Bear Market Experiences – S&P500

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Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD

2006 6.04 6.16 1.38 14.23 -0.42 29.82

2007 3.15 1.51 -0.46 4.25 4.78 -1.28 -3.06 0.60 3.65 3.33 0.02 n/a 17.41

2008 n/a n/a n/a -1.21 6.41 3.20 1.74 -0.90 0.41 5.45 2.56 1.67 20.76

2009 1.46 -0.76 -0.73 3.67 -0.67 1.79 0.22 4.03 3.59 -2.40 5.45 2.33 19.17

▪ 1987

▪ 1998 – proprietary trading

▪ 2001 – ‘sabbatical’ & research



Objectives

“…the future belongs to those who prepare for it today.” - Malcolm X

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Beliefs Disclaimer

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▪ “…you trade your beliefs about the markets…” – Van Tharp

▪ This workshop reflects my beliefs and/or the beliefs of those that have presented the material prior.

– They MUST fit you – They MUST be useful to you – create your map



Workshop Primary Objective

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▪ Assist with your bear market preparation:

– Provide you with tools to trade a bear market with confidence

– Allow you to begin (or continue) to develop a bear market trading plan that fits you – there will be homework to do to integrate material!!

– Be in a position to profit from bear markets (or at a minimum get more out of bull markets)



Workshop Objectives

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▪ Learn methods to identify and define bear markets ▪ Understand what causes market cycles and what to monitor in terms of

the big picture ▪ The importance of market psychology in bear markets ▪ Provide an introduction to options - consider if using them suits you ▪ Provide an introduction to hedging techniques and strategies ▪ Learn several strategies & systems for bear markets (for the beginning,

middle and ending phases) ▪ Applying Tharp Think to bear markets trading including:

– Learn about the psychology (self) of trading in bear markets – The importance of setting objectives – System development plan/process

▪ Outline your next steps to develop your plan for trading bear markets ▪ Network with other traders during and after the workshop

– Set up personal accountability / inspiration



Outline

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Overview of Workshop – Outline

Self

SystemMarket

Big Picture

▪ Psychology ▪ Objectives ▪ Business / Trading Plan ▪ Networking

▪ Options ▪ Hedging ▪ Strategies ▪ Systems ▪ Development ▪ Position Sizing

▪ Identification ▪ Characteristics ▪ Market Psychology

▪ Monitoring



Workshop Outline

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Part One = Day 1 ▪ Introductions = people here are resources ▪ Overview of bear markets ▪ Big picture view – what to look for? ▪ Identification – bear market type ▪ Market Psychology ▪ Introduction to options ▪ Introduction to hedging

Workshop Outline

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“Pre” Examples Beginning During End

All Weather Cash / stop loss RSI(2) NCAV

Brown’s Permanent Hedging: futures, ETFs, Shorting

Rocks & Rockets Sell puts on quality

Volatility targeting Fake Out Sell options –delta hedge

Hedging: puts Option Spreads Option spreads

Hedging: puts & covered calls

Prepare for bull market…

Defensive portfolios Faber10SMA

Option spreads Buy Dips

Part Two: Strategies and systems

Part Three: Trading Bear Markets



Big Picture Frameworks

“To eliminate emotional risk, neutralize your expectations of what the market will do.” - Mark Douglas

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The A HA! Moment What I think about it/ How it connects

What I will DO about it ResultsTrader’s Learning Journal Date:

Learning Journal reprinted courtesy of Ken LongBear Market Strategies © 2020 Van Tharp Institute, Inc. All Rights Reserved.


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The A HA! Moment What I think about it/ How it connects

What I will DO about it Results

What got my attention? How does it relate to what I already know?

What actions will I take based on the insight?

What were the results of my actions?

What did I notice that’s new information?

What material is new to me?

What can I do that will help me implement this idea?

Did the results meet my expectations?

What did I just learn / realize / see / hear that seems useful ?

How does this connect with or relate to my beliefs?

Who do I need to talk with to get more information?

Are there additional steps or action items I should consider?

What insight do I have about the material being presented?

What other aspects of my trading might be affected by this insight?

What additional questions do I have?

Did the implementation generate new insights or ideas that were new “A HA!” moments?

Trader’s Learning Journal Date:

Learning Journal reprinted courtesy of Ken LongBear Market Strategies © 2020 Van Tharp Institute, Inc. All Rights Reserved.


The headings above are the 4 columns of the Trader’s Learning Journal

The questions below are intended to help you fill out the Learning Journal. Be creative. Keep notes on anything that may be useful or needs more explanation.

The Learning Journal will help you get the most value out of this workshop. It will help you remember what you found most valuable and what you intended to do

about it.

The Big Picture: Economy

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▪ How will you monitor it?

▪ Example: How the Economic Machine Works – Take notes, get ideas – build your plan – Ray Dalio, Bridgewater

▪ http://www.economicprinciples.org/

http://www.economicprinciples.org/http://www.economicprinciples.org/http://www.economicprinciples.org/

The Big Picture Beliefs – Dalio Discussion

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Government ▪ Central Government – collects taxes and spends money ▪ Central Bank – controls the amount of money and credit by influencing interest rates and printing $ Credit ▪ The most important part of the economy – biggest and most volatile ▪ Spending drives the economy - ones persons spending is another person’s income ▪ Short term debt cycle

– 5-8 years – Credit not available = recession – Credit available = expansion

▪ Long term debt cycle – 75-100 years – Credit bubble caused

▪ Inflation: when amount of spending and incomes grow faster than the production of goods, prices rise – central banks raise interest rates and fewer people can afford to borrow $ and cost of servicing debt rises. Spending slows and incomes drop.

▪ Deflation: when less spending causes prices to fall ▪ Recession: when economic activity decreases. Then central bank will lower interest rates, etc.

The Big Picture – Reducing Debt Burdens

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1. Cut spending – austerity – But causes incomes to fall faster than debts do – Higher unemployment – Deflationary

2. Reduce debt - through defaults and restructuring – Banks squeezed – Deflationary

3. Redistribute wealth – From wealthy to unemployed – Deflationary

4. Print money – Inflationary and stimulates – Buying assets – only helps those who own financial assets – Central bank must work with central government

Beautiful Deleveraging – Balance of spending cuts; reducing debts; transferring wealth and printing money – debts

decline relative to income; real economic growth is positive; inflation not a problem – Economic and social stability maintained – Incomes must rise faster than debt

The Big Picture – Monitoring Plan Example

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▪ {R + I – B} > {S – T} ▪ Note: 1 million seconds = 12 days; 1 billion seconds = 31 years; 1 trillion seconds = 31,000 years


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▪ US GDP$ ~ 18.5 trillion ▪ R = 2.6% GDP ▪ I = 1.5% ▪ B = 2.5% 10 Year Yield ▪ S = 3.9T / 18.5T = 21.1% ▪ T = 3.3T / 18.5T = 17.8%

▪ {R + I – B} = 2.6% + 1.5% - 2.5% = 1.6%

▪ {S – T} = 21.1% - 17.8% = 3.3%

▪ {R + I – B} ⬄ {S – T} ???

1.6% < 3.3%

▪ {Real Output + Inflation – Borrowing Costs} > {Spending – Taxes}

The Big Picture: Governments

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▪ Decisions that impact the trading game ▪ Geo-political issues ▪ Elections / Referendums ▪ Wars / Conflicts ▪ Sanctions / Trade wars ▪ Trade pacts / Treaties ▪ Protectionism – Tariffs ▪ Taxation ▪ UN / NATO etc.

The Big Picture: Elections & the Euro Zone

▪ Netherlands March 15, 2017 ▪ France April 23, 2017 ▪ Germany September 24, 2017? (between August 27 – October 22)

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The Big Picture: Governments

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▪ Ray Dalio & Timothy Geithner ▪ Full Interview At Delivering Alpha (Sept 2016)

▪ What are some things that make you think about your monitoring of the big picture?

(Revised Link) 

https://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.html  Ray & Tim 33min

https://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.htmlhttps://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.html

The Big Picture – Government

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▪ US Economic Policy Uncertainty Index

Big Picture example - Presidential Cycle?

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▪ Does the Presidential cycle matter?

▪ Average = 1.87 years into

presidential term

▪ 2008: Mar’09 ▪ 2012: n/a or ~ Nov’12 ▪ 2017: ?

The Big Picture: Monitoring Trading Firms

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▪ Stock Price (if available) ▪ Quarterly Earnings Releases ▪ CMBX – debt insurance (if available) ▪ Market Share Analysis ▪ Personal Contacts – Brokers etc. ▪ Your experience ▪ Depositor Insurance in your country

The Big Picture: Trends - Example

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▪ Eastman Kodak: – In 1998, Kodak had 170,000 employees and sold 85% of all photo

paper worldwide

– 3 years later you would never take pictures on paper film again

– Market capitalization peaked around $25 Billion

– Digital cameras were invented in 1975 - the first ones only had 10,000 pixels, but they followed Moore's law…

The Big Picture: Markets

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▪ Equities (Indices, ETFs, Stocks) – Developed & Emerging

▪ Debt / Rates – Government (federal, state, muni) – Corporate (investment, high yield) – Developed & Emerging

▪ Commodities (Energy, Currency, Metals, Agriculture, Livestock, etc.) ▪ Spot Currencies ▪ Real Estate (liquidity and transaction cost considerations) ▪ Collectables (liquidity and transaction cost considerations)

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33





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▪ VIX traded close to lows as Donald Trump entered the office. But the cost for hedging tail risk spiked

up to highs! CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk.


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The Big Picture: Markets Example

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▪ What is important to monitor for the markets you are trading?

▪ Are there opportunities that can be monitored for trades?

The Big Picture: Markets - Sentiment Indicators

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Definition: ▪ A Sentiment Indicator is a graphical or numerical indicator designed to show how a group

feels about the market, business environment or other factor.

Examples: ▪ Put-Call Ratio: is calculated by dividing the number of traded put options by the number of

traded call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off.

▪ AAII Sentiment Survey ▪ U of Michigan US Consumer Sentiment ▪ The Commitments of Traders (COT) reports provide a breakdown of each Tuesday’s

open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Reports are available in both a short and long format. The short report shows open interest separately by reportable and non-reportable positions.    

http://www.investopedia.com/terms/i/indicator.asphttp://www.investopedia.com/terms/p/putoption.asphttp://www.investopedia.com/terms/c/calloption.asphttp://www.investopedia.com/terms/h/hedge.asphttp://www.investopedia.com/terms/s/sell-off.asp

The Big Picture: Markets - TED Spread ▪ 3 month Eurodollar minus 3 month US T-Bills ▪ Indicator of credit risk

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Correlation – Single Stocks vs. S&P500

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▪ Using SPX options prices, together with the prices of options on the 50 largest stocks in the S&P 500 Index, the CBOE S&P 500 Implied Correlation Indexes offers insight into the relative cost of SPX options compared to the price of options on individual stocks that comprise the S&P 500.   

The Big Picture: Self

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▪ Ongoing Training & Education ▪ Physical Fitness ▪ Personal Psychology ▪ Business Planning ▪ Vacations / Down Time / Recharging ▪ Goals / Objectives ▪ Mistakes Analysis

The Big Picture: Base Currency

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▪ How will your base currency fair during a bear market? ▪ What are your exposures?

– In what currency is your trading account denominated? • Profits / Losses

– In what currency do you make money? – In what currency do you have liabilities/expenses? – What is the impact to the goods and services you consume?

▪ Other considerations?


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▪ Bloomberg Markets [email protected] ▪ 5 things to start your day February 9, 2017

mailto:[email protected]

The Big Picture: Monitoring sources

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▪ https://tradingeconomics.com/

https://tradingeconomics.com/

The Big Picture – Monitoring Sources

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Source Source

www.forexfactory.com www.cnnmoney.com

alerts.google.com www.bigcharts.comfinance.yahoo.com www.cboe.comwww.quicken.com www.nyse.com

www.Bloomberg.com www.nasdaq.comwww.stockcharts.com Bloomberg TV

www.cbsmarketwatch.com CNBC TVhttp://www.tradingeconomics.com [email protected]▪ What are some other good sources to consider?

Van’s monthly SQN report

http://www.tradingeconomics.com/mailto:[email protected]

The Big Picture

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▪ Must be useful to you ▪ Can involve very little effort or a great deal of analysis

Max: Comprehensive overview & Analysis

NOTE: see example from Robert van Paridon in appendix

Select Specific Opportunity &

Research

Min: Self, Broker & System(s)

DANGER

:

BALANC

E

REQUIRE

D

NOTE: See example from Robert Van Paridon in appendix.

Markets and Market Type

“The most intelligent way to trade is to confess you don’t have a clue where the markets are going.” - Hugh Johnson

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What is the Purpose of Market Type?▪ Market type answers the question:

– Has the market has been going up, down or sideways?

– Has it shown the same, more, or less volatility compared to the past?

▪ Market type is NOT predictive. It does not predict what the next period (day, week, month) will be like.

▪ We use market type to tell us which trading systems to use, because trading systems work best in the market type for which they were designed.

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Determining Market Type▪ The simplest way – look back at chart

– Is the market going up, down or sideways for that timeframe? – Is it more or less volatile than it was before?

▪ But - how to make it more objective / useful?

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Up, normal volatility

Sideways, normal volatility

Down, high(er) volatility

Down, normal volatility

Sideways, high(er) volatility



Determining Market Type

Why knowing the market type is important: • Trading systems do not work in all market types • Determine which trading systems will work in each market type • Use trading systems based on when they are most effective • When the trading system isn’t aligned with the market type, stop using it

When to look for bear markets: • When market moves from bull to sideways • When volatility begins trending up • Market begins to make lower highs and lower lows

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Side-ways

Bear

Bull Normal

Volatile

Quiet

Market Classification Volatility



Calculating Market Type

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While observation can

be useful, we can use data to

calculate market type

Use historical price data to calculate the

direction price has been moving

Use historical price data to

calculate volatility

compared to volatility in the

past

Examples of categories: For direction: 1) up - down - sideways 2) strong bull – bull – neutral – bear – strong bear

For volatility: 1) low – normal – high –

very high

Examples: Timeframe: intraday, daily, weekly Stats used: SQN, MA, RL? Price data: close? high? mid-point?

Choose lookback period: 1) 5 to 10 days for intraday system 2) 30 to 100 days for swing system 3) 100 to 200 days - trend following

Examples: Average true range (ATR)

Standard deviation (SD)

Historical volatility (HV)

Implied volatility (IV)



Determining Market Type

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▪ Linear Regression Line – Linear Regression Line finds the “best fit” for a set of data points – Select a look back period consistent with trading system – Slope indicates market type (up – sideways – down) – Add a calculation to measure volatility (e.g., ATR compared to historical ATR) – Use multiple timeframes to show potential turning points



Market Type – Van Tharp▪ Dr. Van Tharp’s methodology

– Updated every month in the VTI newsletter – Calculated using System Quality Number (SQN)

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Measure daily percent changes of SPY for 100 days and then calculate the SQN • SQN > 1.47 is Very BULLISH • SQN between 0.75 and 1.46 is

Bullish • SQN between 0 and 0.74 is

neutral • SQN between 0 and -0.7 is

Bearish • And SQN below -0.7 is very

Bearish

Measure volatility • Calculate daily average true range

(ATR(20)) as percentage of daily close and determine the mean and standard deviation for all 20 day windows

• ATR% > 3 standard deviation above mean is Very Volatile

• ATR% between 0.5 and 3.0 standard deviation above mean is Volatile

• ATR% between -0.5 and 0.5 standard deviation from mean is Normal

• ATR% < -0.5 standard deviation from mean is Quiet



Dr. Van Tharp Market Type – from IITM newsletter

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Market Type – Ken Long

▪ Market Type – from Ken Long’s market type (chart on next page) • Bull market: SPY price >= 2% above 200 day moving average • Bear market: SPY price +1 SD from

average • Ken’s market type is also available

from his Daily Reports (Tortoise Capital Management)



Example of Market Type - Ken Long

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Comparison of Market Type: Tharp vs. Long  Tharp’s Market Type (same period as previous slide)

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Strong Bull Bull Neutral Bear

Quiet Normal Volatile

Direction based on Market SQN for 100 day period

Volatility based on ATR% for 20 day period



Comparing Market Types – Tharp vs. Long

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• For this time period: • Bull, neutral/sideways and bear types are similar, with

Van’s market type highlighting the bear earlier than Ken’s market type

• Volatility types are sometimes different between the two approaches



How to Determine Market Type

▪ Other methods for market type: – Moving average crossovers

• Example: SPY’s 100 day moving average crosses below 200 day moving average

– Price closes below moving average • Monthly moving average: 4, 6, 8, 10 months

– ADX (Average Directional Index)

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Another Version of Market Type

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▪ Direction: Regression Slope(100) – Is the slope positive, negative or close to flat?

▪ Volatility: Historic Volatility(20) – Is the historic (close to close) volatility over 20 days greater than +1 standard deviation, below -1 or

within -1 to +1?

Another Version of Market Type

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▪ Direction: Regression Slope(100) = slope of line of best fit over 100 days RS(100) = [Value RS(100)n – Value RS(100)n-100] / 100

– Up more than 2% – Sideways within 2% of flat – Down more than 2%

▪ Volatility: Historic Volatility(20) = standard deviation of price returns H.Vol(20) = StdDev [ln(Closen/Closen-1)] x Sqrt(252)

– High when greater than 1 standard deviation (16% of the time) – Normal when within 1 standard deviation (68% of the time) – Low when less than 1 standard deviation (16% of the time)

Psychology of Bear Markets

https://www.youtube.com/watch?v=hashPaU7Dpk eTrade

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https://www.youtube.com/watch?v=hashPaU7Dpkhttps://www.youtube.com/watch?v=hashPaU7Dpk

Psychology in Bear Markets

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Graphic: http://wdongli.wordpress.com/



Cognitive Biases – Drive Market Behavior

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65




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▪ See article in Appendix on Behavioral Finance

Loss Aversion / Prospect Theory

▪ Loss aversion is encapsulated in the expression “losses loom larger than gains” (Kahneman & Tversky, 1979)

▪ Pain of losing is psychologically about twice as powerful as the pleasure of gaining ▪ People are more willing to take risks to avoid a loss ▪ Loss aversion can explain differences in risk-seeking versus aversion ▪ It is associated with prospect theory ▪ Loss aversion has been used to explain the endowment effect and sunk cost fallacy, and it may also

play a role in the status quo bias

▪ Know this exists within market psychology – don’t allow it in your psychology

Sources: ▪ Gächter, S., Orzen, H., Renner, E., & Starmer, C. (2009). Are experimental economists prone to framing effects? A natural field experiment. Journal of Economic

Behavior & Organization, 70, 443-446. ▪ Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.

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http://www.behavioraleconomics.com/endowment-effect/http://www.behavioraleconomics.com/sunk-cost-fallacy/http://www.behavioraleconomics.com/status-quo-bias/http://www.behavioraleconomics.com/status-quo-bias/

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Beliefs about bear markets – any useful? 

Quiet Bear: ▪ Rare to non-existent ▪ Pessimism ▪ Lack of interest ▪ Low volume ▪ Early – inst. quietly selling ▪ End – inst. quietly buying ▪ Little news ▪ At end of bear ▪ After sideways? ▪ Time to buy options?

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Volatile Bear: ▪ Violent ▪ Crashing ▪ Oversold? ▪ Fear ▪ Stops ▪ Gaps ▪ Liquidity ▪ Regulation changes ▪ Policy changes ▪ Margin calls ▪ Bankruptcies ▪ Underwritings down ▪ Safe havens sought ▪ Money tight - scared

Other: ▪ Stops get hit causing more downward

pressure ▪ Lack of stops or rule-based systems

causes panic selling ▪ Fear is the driving market force ▪ The safest place for money is cash ▪ I just want to get out! ▪ Stocks are on sale ▪ Best time to buy stocks ▪ Volatility increases ▪ Odds of prices going down are higher ▪ Irrational behavior ▪ Gaps occur – SL not filled ▪ Liquidity at risk ▪ Illiquid securities more risky ▪ Margin calls ▪ Financial system at risk ▪ Guns and gold ▪ I’m not going through this again

“Everything” goes down

Volatility goes up

“Average” investors take a long time to recover

and re-enter the market

Traders just want to get out

at any price

Fear and panic are common emotions

Most people have a “long”

bias – we prefer to be buyers of

stocks

Psychology in Bear Markets

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Photo: http://livinglifewithchemobrain.blogspot.com/



Options and Hedging

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Option Terminology - Test 

▪ Strike: _____________________________________________________________________________________ ▪ Expiration or Maturity: _________________________________________________________________________ ▪ Call: _______________________________________________________________________________________ ▪ Put: _______________________________________________________________________________________ ▪ Write: ______________________________________________________________________________________ ▪ Open: ______________________________________________________________________________________ ▪ Close: ______________________________________________________________________________________ ▪ Premium: ___________________________________________________________________________________ ▪ Money-ness: ________________________________________________________________________________ ▪ Intrinsic Value: ______________________________________________________________________________ ▪ Time Value: _________________________________________________________________________________ ▪ American: __________________________________________________________________________________ ▪ European: __________________________________________________________________________________ ▪ Historic Volatility: ____________________________________________________________________________ ▪ Implied Volatility:_____________________________________________________________________________ ▪ Contract Size: _______________________________________________________________________________ ▪ Delivery: ___________________________________________________________________________________ ▪ Style: ______________________________________________________________________________________ ▪ LEAP: ______________________________________________________________________________________ ▪ Time decay: _________________________________________________________________________________ ▪ Margin: ____________________________________________________________________________________ ▪ Delta Hedging: _______________________________________________________________________________ ▪ Underlying: _________________________________________________________________________________ ▪ Exercise: ___________________________________________________________________________________ ▪ Delta: ______________________________________________________________________________________ ▪ Gamma: ____________________________________________________________________________________ ▪ Rho: _______________________________________________________________________________________ ▪ Theta: _____________________________________________________________________________________ ▪ Vega: ___________________________________________________________________________________________________________

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Options - Introduction  ▪ An option is a contract to buy or sell a specific product (underlying) at a specified price (strike) at (or

over) a predetermined time (expiry or maturity)

▪ A call option gives the buyer the right (but not the obligation) to buy (i.e. call the product away from the seller)

▪ A put option gives the buyer the right (but not the obligation) to sell (i.e. put the product to the seller)

▪ A seller is giving the buyer these rights for a price (premium)

▪ Uses: – Hedging – Generating Income – Speculating

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Call Payoff Diagram  ▪ A call option gives the buyer the right to purchase the underlying at the strike ▪ Long = a bullish view ▪ Short = generally a bearish view, or used to generate income Note: Max loss on short is theoretically unlimited

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Put Payoff Diagram ▪ A put option gives the buyer the right to sell the underlying at the strike ▪ Long = a bearish view ▪ Short = generally a bullish view, or used to generate income Note: Max loss on short = strike price – 0

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Options and the Assumption of Normality  

▪ It is assumed that asset prices (stocks etc.) follow a normal distribution ▪ This makes the math easier in option pricing and in virtually all areas of

quantitative finance

IT IS AN OVER-SIMPLIFICATION AND IS INCORRECT

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Normal Distribution  

▪ A process that is normally distributed says that a 6 sigma event has a 1 in 500 million chance of occurring…

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Normal Distribution  

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Kurtosis: Measure of tails. - Normal = 3. Greater 3 => more outliers than normal.

Skewness: Measure of symmetry. - Zero = balanced. Positive = tail is on the right.

Historic Volatility  

Genesis Trade Navigator Example of 20 day Historic Volatility: ▪ MovingStdDev (Log (Close / Close.1) , 20) * SqrRoot (252)

80



Excel Example:

Hist.Vol = StdDev [ ln( Closen / Closen-1 )] x Sqrt(252)

Options - Volatility

▪ Volatility – A measure of asset price movement - how

much a asset price moves up and down – Larger up-and-down movement of the asset

increases the volatility and affects the price of the options, because it increases the uncertainty as to whether the option will expire “in-the-money”

▪ Volatility of the underlying asset is a key factor in determining the value of an option. – As the volatility of a asset increases, an

option's premium will increase (all else equal) – The difficulty of predicting the behavior of a

volatile asset allows the option seller to command a higher price for the additional risk assumed.

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Graphic: http://www.optionsplaybook.com/

Historical volatility for 2 stocks



Volatility – Implied vs. Historic  

▪ Historical volatility is a measure of price movement based on how the security has behaved in the past - it is a function of historic price movement

▪ Implied volatility is the volatility implied by the option price – i.e. the level sellers are willing to sell and buyers are willing to pay – It also reflects what is expected to occur in the future

▪ Although related - implied does NOT necessarily equal historic ▪ If they vary too drastically arbitragers will intervene

– Buying options and delta hedging when implied vols are too low relative to historic – Selling options and delta hedging when implied vols are too high relative to historic

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The Option Greeks 

▪ Delta = rate of change of option price for a unit change in the underlying

▪ Gamma = rate of change of delta for a unit change in the underlying

▪ Rho = rate of change of price for a unit change in interest rates

▪ Theta = rate of change in price for a unit change in maturity

▪ Vega = rate of change of price for a unit change in implied volatility

Note: the units of change can vary depending on convention.

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Option Pricing Basics - Quiz  

84



Impact Call Value Put Value

Underlying Price Up

Underlying Price Down

Longer Expiry

Shorter Expiry

Volatility Increases

Volatility Decreases

Interest Rates Increase

Interest Rates Decrease

Other (dividends, storage etc.)

Option Strategies 

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Strategy Objective View Risk Return

Call BuyingProfit from

appreciation Lock in good

purchase price

Neutral to Bullish

Limited to premium Unlimited

Call WritingIncome

Lower cost of purchasing

Neutral to Bearish (covered call

writing may be bullish)

Unlimited if naked

Limited if covered

Only premium received

Put BuyingProfit from down

moves Protect against

losses

Neutral to Bearish

Limited to premium Substantial (i.e. to 0 price)

Put WritingIncome

Lower purchase price

Neutral to Bullish (cash secured

puts may be bearish)

Substantial (i.e. to 0 price)

Only premium received

SpreadsProfit from

differences in value of options

Any Limited Limited

Collars Protect unrealized profits Any Limited Limited

Option Diagrams 

86



Option Spreads 

87



▪ Bull Put: Credit trade. LP + SP. ▪ Bull Call: Debit trade. LC + SC. ▪ Bear Put: Debit trade. SP + LP. ▪ Bear Call: Credit trade. SC + LC.

▪ Calendar: X = X. Different Expiries. ▪ Diagonal: X ≠ X. Different Expiries. ▪ Butterfly: 3 X’s. ▪ Condor: 4 X’s. ▪ Iron Condor: Both Puts & Calls. ▪ Double Diagonal: Short and Long Straddles. Different Expiries. ▪ Ratio Back Spread: Slight credit. Add OTM LP / LC.

Trading Options – One Methodology

88



▪ Source: Options Animal

LEAPS – Long Dated Options

89



▪ LEAPS = Long-term Equity Antici-Pation Security

▪ Options with a longer time to maturity

▪ Options were originally created with expiry cycles of 3, 6, and 9 months, with no option term lasting more than a year. Options of this form, for such terms, still constitute the vast majority of options activity

▪ Equity LEAPS always expire in January

and…

▪ There are now options that expire weekly

Ex: Put Option Chain for SPY as of 09/24/2014

90

Graphic: optionsXpress.comBear Market Strategies S1703B

© 2020 Van Tharp Institute, Inc. All Rights Reserved. The reproduction or transfer of this material is prohibited by the Van Tharp Institute student agreement.


91

Graphic: optionsXpress.com

Underlying stock

Option chain

Strike prices

Expiration months




92


Calls expiring Dec 2016

Puts expiring Dec 2016

In the money

Out of the money

At the money




93


In the money

Out of the money

At the money




94


Implied volatility Delta



Option Chain Example – with Greeks

95



Option Chain Example

96



▪ CQG Trader ▪ DOM (depth of market) view ▪ Notice bid / offer spread

OptDriver – Option Pricing  http://www.fis-group.com

97



OptDriver – Option Pricing  http://www.fis-group.com

98



OptDriver – Option Pricing - example  http://www.fis-group.com

99



Option Terminology - Test ▪ Strike: Price at which an option can be exercised – price to purchase if a call, price to sell if a put ▪ Expiration or Maturity: when an option contract ceases to exist - expires ▪ Call: provides the buyer the right to buy the asset at the strike price ▪ Put: provides the buyer the right (but not obligation) to sell or “put” the asset at the strike price at/before expiration date ▪ Write: to sell an option ▪ Open: when a new contact is formed ▪ Close: when an existing option contract is reversed ▪ Premium: intrinsic value + time value, price of the option ▪ Money-ness: the intrinsic value. Relating the strike price to the price of the underlying asset ▪ Intrinsic Value: the amount the option is in-the-money (ITM) ▪ Time Value: price of an option less the intrinsic value - the part of the option price that is based on its time to expiration ▪ American: option can be exercised anytime during the options life ▪ European: option can only be exercised at maturity (expiry) ▪ Historic Volatility: the realized volatility of an asset’s price over a given period of time ▪ Implied Volatility: the market’s “forecast” of volatility for the underlying stock – the volatility “implied” by the price of an option ▪ Contract Size: the deliverable quantity underlying an option contract ▪ Delivery: the method of payout of an option generally physical or cash settled ▪ Style: the exercise convention i.e. American, European ▪ LEAP: long term equity appreciation securities – long dated call option ▪ Time decay: the amount of price depreciation that occurs due to the passage of time ▪ Margin: Equity that must contributed by a customer to enter into an option transaction ▪ Delta Hedging: an options strategy that aims to reduce (hedge) the risk associated with price movements in the underlying by

offsetting long and short positions ▪ Underlying: the asset for which the option contract is written ▪ Exercise: buyer invokes the right to sell the stock to writer (seller) ▪ Delta: the amount an option will change in price, based on a dollar change in the underlying stock ▪ Gamma: rate of change of delta for a unit change in the underlying ▪ Rho: rate of change of price for a unit change in interest rates ▪ Theta: rate of change in price for a unit change in maturity ▪ Vega: rate of change of price for a unit change in implied volatility

100



Hedge Funds

101



Hedging – “Hedge” Fund Strategies

▪ Equity Hedge – Market Neutral – Fundamental (growth, value) – Quantitative – Sector (technology, healthcare etc.) – Short Bias

▪ Macro – Active Trading (systematic,

discretionary) – Commodity (CTA – commodity trading

advisor) – Currency

102



▪ Event Driven – Activist – Credit Arbitrage – Distressed – Merger Arbitrage (aka Risk Arb) – Private Issue – Special Situations

▪ Relative Value – Asset Backed – Convertible Arbitrage – Corporate or Sovereign Debt – Volatility Arbitrage – Yield

▪ Multi-Strategy – These funds provide a combination of the above

A hedge fund is an investment fund that pools capital from a limited number of accredited individual or institutional investors and invests in a variety of assets, often with complex portfolio construction and risk management techniques. It is administered by a professional management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds as their use of leverage is not capped by regulators and distinct from private equity funds as the majority of hedge funds invest in relatively liquid assets.

Hedge Fund Gains

103



Hedging – 3 Infamous Failures

Long-Term Capital Management ▪ Had an arbitrage strategy that could take advantage of temporary changes in

market behavior and, “theoretically”, reduce the risk level to zero ▪ A $3.65-billion emergency loan fund was created – enabling LTCM to survive the

market volatility and liquidate in an orderly manner in early 2000.

Amaranth Advisors ▪ The hedge fund's energy trading strategy suffered a loss over $6 billion on

natural gas futures in 2006 in part due to faulty risk models ▪ Amaranth was charged with the attempted manipulation of natural gas futures

prices

Tiger Funds ▪ The value investing strategy (buying stocks with earnings vs. those with none)

hit a brick wall during the 2000 bull market in technology ▪ The greater fool theory prevailed and tech stocks continued to soar and as a

result, Tiger Management suffered massive losses

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PART I What are Bear Markets?

"Study the past, if you would like to divine the future.“ - Confucius

https://youtu.be/4GX4W5PBESg eTrade

105



https://youtu.be/4GX4W5PBESghttps://youtu.be/4GX4W5PBESghttps://youtu.be/4GX4W5PBESg

U.S. Boom and Bust Cycles 1775 – 1943   

107Source: Tension Envelope Corporation

▪ Red = Federal Debt ▪ Green = National Income ▪ Shaded = Business Activity ▪ ▪ - ▪ - ▪ = Stocks ▪ - - - - = Bonds ▪ - - - - = Commodities

U.S. Boom and Bust Cycles   

108

Source: https://www.thebalance.com/boom-and-bust-cycle-causes-and-history-3305803

▪ The National Bureau of Economic Research (NBER) provides the history of boom and bust cycles.

▪ Since 1854, there have been 33 cycles.

▪ On average; – the booms last 38.7 months – The busts last 17.5



http://www.nber.org/cycles/recessions_faq.html

U.S. Boom and Bust Cycles Since 1929   

109Source: https://www.thebalance.com/boom-and-bust-cycle-causes-and-history-3305803

Cycle Time Comments Cycle Time Comments

Bust Aug 1929 - Mar 1933Stock market crash, higher taxes, Dust Bowl. Bust

Dec 1969 - Nov 1970

Fedraisedrateto9.19%.

Boom Apr 1933 - Apr 1937 FDRpassedNewDeal. BoomDec 1970 - Oct 1973 Fedloweredrateto3.5%.

Bust May 1937 - Jun 1938 FDRtriedtobalancebudget. BustNov 1973 - Mar 1975

Nixonaddedwage-pricecontrols.Endedgoldstandard.OPECoilembargo.Stagflation.

Boom Jul 1938 - Jan 1945 WorldWarIImobilization. BoomApr 1975 - Dec 1979

Fedloweredrateto4.75%

Bust Feb 1945 - Oct 1945 Peacetimedemobilization. BustJan 1980 - Jul 1980

Fedraisedrateto20%toendinflation.

Boom Nov 1945 - Oct 1948 EmploymentAct.MarshallPlan. BoomAug 1980 - Jun 1981

Fedloweredrates.Formore,seeHistoricalFedFundsRates.

Bust Nov 1948 - Oct 1949 Postwaradjustment BustJul 1981 - Nov 1982 Resumptionof1980recession.

Boom Nov 1949 - Jun 1953 KoreanWarmobilization. BoomDec 1982 - Jun 1990

Reaganloweredtaxrateandboosteddefensebudget.

Bust Jul 1953 - May 1954 Peacetimedemobilization. BustJul 1990 - Mar 1991

Causedby1989SavingsandLoanCrisis.

Boom Jun 1954 - Jul 1957 Fedreducedrateto1.0%. BoomApr 1991 - Feb 2001

Endedwithbubbleininternetinvestments

Bust Aug 1957 - Apr 1958 Fedraisedrateto3.0%. BustMar 2001 - Nov 2001

2001Recessioncausedbystockmarketcrash,high-interestrates

Boom May 1958 - Mar 1960 Fedloweredrateto0.63%. BoomDec 2001 - Nov 2007 Derivativescreatedhousingbubblein2006

Bust Apr 1960 - Feb 1961 Fedraisedrateto4.0%. BustDec 2007 - Jun 2009

SubprimeMortgageCrisis,2008FinancialCrisis,theGreatRecession

Boom Mar 1961 - Nov 1969JFKstimulusspending.Fedloweredrateto1.17%. Boom

Jul 2009 - Now

AmericanRecoveryandReinvestmentActandQuantitativeEasing

https://www.thebalance.com/stock-market-crash-of-1929-causes-effects-and-facts-3305891https://www.thebalance.com/what-was-the-dust-bowl-causes-and-effects-3305689https://www.thebalance.com/fdr-economic-policies-and-accomplishments-3305557https://www.thebalance.com/fdr-and-the-new-deal-programs-timeline-did-it-work-3305598https://www.thebalance.com/president-richard-m-nixon-s-economic-policies-3305562https://www.thebalance.com/what-is-the-gold-standard-3306137https://www.thebalance.com/opec-oil-embargo-causes-and-effects-of-the-crisis-3305806https://www.thebalance.com/what-is-stagflation-3305964https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135https://www.thebalance.com/president-ronald-reagan-s-economic-policies-3305568https://www.thebalance.com/savings-and-loans-crisis-causes-cost-3306035https://www.thebalance.com/role-of-derivatives-in-creating-mortgage-crisis-3970477https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-3305745https://www.thebalance.com/2008-financial-crisis-3305679https://www.thebalance.com/arra-details-3306299https://www.thebalance.com/what-is-quantitative-easing-definition-and-explanation-3305881

Bear Markets – Depression to GFC  

110Source: http://www.nbcnews.com/id/37740147/#.UvwLCvldWSp

▪ Losses of more than 20% from peak

Robert FREY - 180 years of Market Drawdowns

111



▪ How often are we in a state of regret? ▪ Creates trading / investing stress

▪ https://youtu.be/27x632vOjXk?t=181

▪ https://www.youtube.com/watch?v=27x632vOjXk 3 MIN FOR 20

https://youtu.be/27x632vOjXk?t=181https://www.youtube.com/watch?v=27x632vOjXkhttps://www.youtube.com/watch?v=27x632vOjXk

Robert FREY - 180 years of Market Drawdowns

112



▪ You are usually in a drawdown state about 75% for S&P500

▪ 60% of the time it is ‘extreme’ (>20%)

▪ Value of long term perspective => danger of bears preventing long term focus

Thoughts?

Many Predicting Doom and Gloom? (or have) …

113



Many Predicting Doom and Gloom? (or have) …

114



Bear Market Overview

115



▪ Outline of a bear market

Bull

Bull

1 - Side

3 - Side

2 - BEAR

When does the bear start for your system?

Bull “corrected”

Note: Sideways can be short / non-existent

Bull

?


116



▪ SPX weekly bars

Bear Market Overview - Volatility

117



▪ SPX weekly bars

Bear Market Overview - Volatility

118



▪ Volatility future (VX) daily bars


119



▪ Nikkei 225 weekly bars


120

▪ Characteristics of bear markets – Extended downtrend (as compared to correction or dip)

• It is important to know the difference – Lower highs and lower lows

• Rather obvious definition of a trend – High volatility - large moves, both down and up

▪ Volatility increases as bear market deepens ▪ Both down days and up days will be wide range days ▪ Gaps at open can be large for assets that are not traded overnight ▪ Consider the impact on a trader’s psychology of large intraday moves ▪ Swing systems are not a good fit for a bear market (MM,KL)



Bear Market Overview – Sector example

121



▪ Oil ETF vs. SPX daily bars

Bear Market Overview Inter-market RelationshipsWatch the money flows during bear markets. Money flows from stocks into other “safe haven” markets to weather the storm

122

Government debt is seen as being “nearly risk-free”, i.e., capital will be repaid Money flows to the US Dollar - the world’s reserve currency. Commodities are priced around the world in USD, so they go up in price.

- US Bonds - Gold/Silver - Swiss Franc

Stocks

One trader’s bear market (stocks) may be another trader’s bull market (bonds)



Bear Market Overview – Inter-market Relationship

123



▪ SPX weekly bars vs. TLT (iShares 20+ Treasury Bond) ETF

124



Sovereign Bonds / US Treasuries 

30+ Year Bull Market in Bonds and the Deflationary Dilemma

▪ At zero (negative?) or very low interest rates – will bonds provide the same immunization for “risk” portfolios?

▪ Are US treasuries risk free?

Bear Market Stocks vs. Bonds

125

SPY: ETF for S&P500

TLT: ETF for 20+ Year US Treasury Bonds

• Stocks, represented by SPY, drop > 50+% • Bonds, represented by TLT, rise > 33%



Bear Market Impact – Ratings & Capital Structure

126



Countries: ▪ Ratings

– Developed vs. Emerging ▪ Sovereign Debt (Currency) ▪ Government Agencies Companies: ▪ Ratings

– Investment Grade vs. non ▪ Large/Small Capitalization

“Risk on” / “Risk off”

Restrict/ ban short

selling Restore uptick rule for shorting

Change/ raise margin

requirements

Manipulate interest rates

Impose taxes/fees

on speculators

Change holding periods for long

term capital gains

Impose currency controls

Peg one currency to

another

Confiscate assets

(e.g., gold)

Bear Market Overview Other Considerations

“They” (government, exchanges, “big money”, your broker…) will change the rules

during bear markets

127

Be prepared with contingency plans:

Blueprint for Trading Success Workshop



Margin - The Brexit example

128



129

The Brexit example



The Brexit example

130



▪ Post referendum outcome – June 24, 2016 late AM eastern time…

The 2016 US Election example

131



Defensive Stategies

“Holy grail trading is finding a strategy [system] where you manage the inevitable losses while maximizing profits.” - Mark Shipman

132



Part Two: Strategies and systems

133



“Pre” Examples Beginning During End

All Weather Cash / stop loss RSI(2) NCAV

Brown’s Permanent Hedging: futures, ETFs, Shorting

Rocks & Rockets Sell puts on quality

Trend Following Volatility targeting Fake Out Sell options –delta hedge

Hedging: puts Oops Sell Option spreads

Hedging: puts & covered calls

Option Spreads Prepare for bull market…

Defensive portfolios Faber10SMA

Option spreads Buy Dips

Day 2:

134

Development Overview – Building Blocks

Systems

Strategies

Rules & Indicators

▪ More mechanical methods with rule set

▪ Collection of rules grouped together (aka techniques)

▪ Useful based on history



135

Some Back Testing Beliefs“Study the past, if you would divine the future.” - Confucius

▪ Good to help determine what does ‘not’ work – Shapes direction of research

▪ Useful to frame what is (may be) “possible” ▪ Mechanical => how to improve with TQN

– Provides a foundation ▪ Helps with refinements

▪ Exists are a good example ▪ Still require market intelligence and learning ▪ Fully mechanical systems typically have had a lengthy

development process – Some argue continual…




136



▪ Outline of a bear market

Bull

Bull

1 - Side

3 - Side

2 - BEAR

When does the bear start for your system?

Bull “corrected”

Note: Sideways can be short / non-existent

Bull

?

137



Bridgewater’s All Weather Fund  

▪ “The principles behind All Weather relate to answering a deceptively straight-forward question explored by Ray Dalio with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater:”

‘What kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?’

▪ http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx

▪ In the appendix:

http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx

138



▪ http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx

Bridgewater’s All Weather Fund  

▪ Note: 25% of RISK

http://www.bwater.com/home/research--press/the-all-weather-strategy.aspxhttp://www.bwater.com/home/research--press/the-all-weather-strategy.aspx

139



Harry Brown’s Permanent Portfolio 

▪ 25% in U.S. stocks, to provide a strong return during times of prosperity. For this portion of the portfolio, Browne recommends a basic S&P 500 index fund such as VFINX (Vanguard 500 Index) or FSMKX (Fidelity Spartan 500 Index).

▪ 25% in long-term U.S. Treasury bonds, which do well during prosperity and during deflation (but which do poorly during other economic cycles).

▪ 25% in cash (money market funds) in order to hedge against periods of “tight money” or recession.

▪ 25% in precious metals (gold) in order to provide protection during periods of inflation. Browne recommends gold bullion coins.

140



Harry Brown’s Permanent Portfolio - Performance 

141



Harry Brown’s Permanent Portfolio - Performance 

▪ Assumption: rebalance each year to get back 25% allocation split among all four asset classes

▪ TSM = total stock market ▪ ST = short term i.e. cash proxy ▪ Green; the asset that did the best. ▪ Red: the asset that did the worst in a

particular year Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year.

▪ Orange any year with a loss for the portfolio

▪ Results graciously provided by Ken Long

142



Sovereign Bonds / US Treasuries 

30+ Year Bull Market in Bonds and the Deflationary Dilemma

▪ At zero or negative interest rates – will bonds provide the same immunization for “risk” portfolios?

Systems & Strategies: Divergent Strategy Example

Trend Following

143



144



Trend Following – Divergent Strategy 

145



Trend Following  

▪ Performance of Trend Following versus 60% Equity & 40% Bond during large drawdown periods.

146



Trend Following  

▪ Monthly results from 9 active Trend Following firms.

System: 5 day Highest High & Lowest Low  

147

Beliefs: ▪ Trend following works – lots of research

Edges: ▪ Let winners run, cut losers ▪ Divergent strategy = like being long volatility ▪ Simple and systematic

Data: Daily bars on liquid futures (see Appendix)

Filters/Conditions: ▪ None OR; ▪ Use Regression Slope for Bull and Bear = market type

Entry: buy if trades above 5 day highest high or sell if trades below 5 day lowest low ▪ iStop: none

Target: none

Stop & Reverse: at 5 day highest high or 5 day lowest low



148



Trend Following – 5 Day Results; no Market Type  SeeAppendixforFuturesList 

149



Trend Following – 5 Day Results with R.Slope=75  SeeAppendixforFuturesList 

150



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