This is a follow-up to my last article where I provided various economic indicators to see what is likely to happen in 2023 in the stock market and the economy. This article will provide investing strategies to position portfolios based on these conditions.
My previous article shows various signs of a looming recession in 2023. My overall perspective is that the Federal Reserve indicated that they will continue to increase interest rates in 2023 to drive down inflation. The rising rates are already causing a downward trend in the housing market and the yield curve is inverted – both signs of an impending recession. My gut tells me that the economy has not fully felt the negative effects of the interest rate increases. As a result, I think a recession is likely to take place in the second half of 2023.
I am not a registered financial advisor, but I do know what they recommend for retirement accounts to prepare for recessions. For those who have an IRA, 401k, 403b, etc. be sure to review your asset allocations and ensure that you have the proper mix according to your age group or expected years until retirement. This can be done with an asset allocation calculator where you can enter your information and compare the results with your retirement account allocations.
One easy way to make asset allocation automatic is to choose target date funds based on your projected retirement date. The asset allocations will automatically be adjusted as you get closer to retirement. This will reduce the amount invested in equities and increase the amount invested in bonds as time goes by.
Retirement accounts are based on dollar-cost averaging (investing a consistent amount at regular intervals) so that investors don’t try to time the market. If the market drops as it has been doing, investors are buying more shares at lower prices. When the market recovers and increases, the overall value of the account rises.
Dollar cost averaging can also be done outside of retirement accounts for those who don’t want to swing trade or time the market. For example, an investor could put a set amount every month into an index ETF such as the SPDR S&P 500 (SPY) or the Nasdaq (QQQ). I am expecting a down year for the major indexes in 2023. However by dollar cost averaging, investors will be accumulating new shares at lower prices. Then, they will benefit over the long-term as the bear market turns into a new bull market with future price increases.
Certain options strategies can provide income to traders with high probabilities of success. These strategies include covered calls and call credit spreads when the market is overbought and when we expect the market to drop. The current bear market is a good environment for covered calls/call credit spreads in my opinion. Of course, only trade options when you have a comfortable understanding of them.
I would like to point out that the market is not oversold or overbought at the moment. So, I would wait for a clearer signal before trading options. Since we are in a bear market, I would lean towards doing covered calls or credit spreads after a bear market rally. I think having a ‘sell the rallies strategy’ will be wise in the current environment.
For those who own 100 shares or more of an index or of individual stocks, you can consider trading some covered calls when the market becomes overbought and at resistance zones. Overbought conditions can be monitored by pulling up a daily chart of your index or stock and sell calls against your underlying position when the RSI hits 70 or above and reverses. Using other indicators such as the MACD, Chaikin Money Flow and Bollinger Bands can help confirm when to sell calls.
By selling out of the money calls against your position when you think the market will pull back or decline, you will be collecting premium in your account. If the index or stock remains below the strike price at expiration, you keep the full amount of the premium. The risk is if the underlying price of the ETF or stock rises above the strike price that you sold, you could have your position called away. This means you would be forced to sell the underlying position at the strike price that you sold.
For those who have less than 100 shares in an ETF or stock, you can consider doing a call credit spread. This involves selling an out of the money call while simultaneously buying a call that is further out of the money. You don’t need an underlying position in a stock or ETF to trade call credit spreads. However, you need a certain amount of collateral in your account to cover the maximum potential loss.
I will show a daily price chart of SPDR S&P 500 as an example of when to enter a bear call credit spread.
The bright yellow vertical lines show where the ideal conditions were for bear call credit spreads. The RSI (top of the chart) was overbought or nearly overbought and then began to decline. The price of SPY hit the top blue line of the Bollinger Bands and declined to the midpoint, the green MACD line dropped below the red signal line, and the money flow [CMF] began to decline from a peak level.
It might be difficult to choose the perfect moment to enter the bear call spread, but by using multiple indicators, you will be increasing your probabilities of success.
Consider selling an out of the money call with a strike price that has a delta of 30 and buying a call with a strike price that is $5 higher. By choosing a delta of 30, the option has a 70% probability of remaining out of the money, giving you a successful trade. However, that probability increases significantly when using the various chart indicators that I mentioned. So, your chance of success could be 80% or higher. The delta of 30 also provides a decent amount of premium which will be credited to your account minus the cost of the call that you bought.
Here is an example of a successful bear call credit spread that was traded in the summer of 2022:
Price of SPY $427
Choose Options expiring in about 45 days to benefit from time decay without waiting a long time for the trade to payoff.
Sell $434 strike call option with $135 in premium
Buy $439 strike call option for $50
In this scenario, the account was credited $85 ($135 – $50). The broker holds $500 in collateral (difference in strike prices $5 x 100 shares representation). The trade was profitable because the price of SPY remained below the $434 strike call that was sold. The trade made 17% within 45 days ($85 premium/500 collateral). Your max potential loss is $415 ($500 – $85). However, if the trade goes against you, consider exiting the position near the breakeven point, which would have been $434 (to minimize losses).
You might be thinking that $85 is not much, but a 17% return is definitely attractive within 45 days. So, if you have $5000 available in your account, you can trade 10 of these credit spreads instead of just one to make $850 within 45 days.
The market will probably have its bear market rallies in 2023. However, the data from my last article shows that the market is likely to go lower as a possible recession looms. Therefore, I will be looking for opportunities to ‘sell the rallies’ by doing bear call credit spreads on SPY at opportune times based on the indicators that I mentioned in the article. Of course, I will continue to dollar cost average in my retirement account to buy more shares at lower prices.