How to Make Money – Safely – in a Bear Market

By Jeff Clark, editor, Advanced Income
Saturday, April 12, 2008

Making money in a bear market takes unconventional thinking.

The best way to profit during a bull market is often to buy the strongest stocks in the strongest sectors and then ride the momentum to riches. But that doesn't work so well when the bear is in charge. Just ask anyone who bought Apple or Google back in December.

The best way to make money buying stocks in a bear market is to buy the weakest stocks in the weakest sectors, and play them for a short-term bounce.

I know it sounds crazy. After all, it goes against all of the best-known Wall Street clichés... Buy the best and ignore the rest... Don't try to catch a falling knife... It's better to buy a good company at a bad price than a bad company at a good price, etc. But in a bear market, everything turns upside down. None of that stuff works.

Look at the best-performing stocks of the past few months. The list is full of homebuilders, banks, and brokers – the industries with the absolute worst headlines. Meanwhile, the sectors with the best press and the stocks that should be firing on all cylinders – like gold stocks – have fallen on tough times.

Like most abnormalities, this "upside down" condition should only last a short while. But while it lasts, we ought to at least make it pay off.

And so far, we've proven we can with a little-known strategy I use in my Advanced Income newsletter. I'm going to show you this strategy today, which you can use to your benefit immediately.

Since I started writing Advanced Income in September, we've sold out four positions for gains of 7% and 8% in two months, 13% in six months, and 17% in three months. We're sitting on three other positions with current gains of 23%, 18%, and 4%. And we did it taking on very little risk.

Let me show you how this strategy works...

Back in December, I told Advanced Income subscribers to buy shares of the S&P Homebuilders ETF (XHB) and sell the March 21 call options against the shares. The stock was trading at $19.73 at the time, and we sold the calls for $1.80.

Put another way... we bought XHB at $19.73 per share. We then entered into an agreement to sell the stock to someone else for $21 per share in March. We were paid $1.80 per share for agreeing to these terms. This strategy is called "covered call writing."

It's not nearly as complicated as it might sound, and it does a terrific job generating income in a very short time...

Doing the Math on
Covered Calls

We bought 100 shares of XHB in December @ $19.73 = $1,973.

We sold 1 call contract, agreeing to sell our 100 XHB shares for $2,100 in March. Selling this contract earned us $180, since a standard option contract is for 100 shares ($1.80 x 100 shares = $180).

That means we only had to pay $1,793 to open the position ($1,973 - $180).

XHB rose to $22 by March. We sold our shares for the agreed-upon price of $21, pocketing a gain of $307 ($2,100 - $1,793).

So... our final return was roughly $307 on our initial investment of $1,793 – a 17% gain in four months.

We closed the XHB position three weeks ago for a 17% gain. The S&P was down 11% for the same period. Not bad for a three-month trade in a bear market. (Check the sidebar for a summary of how a trade of 100 shares worked out.)

The best thing though, is that even if XHB fell below our original purchase price, we could recoup any downside simply by selling additional calls against our shares.

That's the beauty of covered call writing. You can buy a stock, create immediate income, protect your downside, and continue your income stream as long as you own the shares.

It's a great strategy to use for generating income. And it's a fabulous strategy for dealing with bear markets.

In fact, today's market is the ideal environment for getting started with this technique. Options are expensive because of the recent market volatility, and a large number of stocks are trading at ridiculously low valuations. So investors have a unique opportunity to pick up low-risk value stocks and generate high rates of return by selling those expensive calls against them.

My point is, it's possible to make money during bear markets... far more than you'd ever expect, actually. And selling covered calls on low-risk stocks is the single best strategy I know to profit when stocks are falling.

Sure, you can speculate and bet on stocks falling farther – but there's more risk involved here than most people are willing to accept. On the other hand, if you write covered calls on the right stocks, there's very little risk. And you can generate safe income even in the worst bear markets.

Best regards and good trading,

Jeff Clark

Editor's note: Jeff Clark is a regular contributor to DailyWealth, a free investment newsletter focused on the world's best contrarian opportunities. We write with a simple belief in mind: You don't have to take big risks to make big money with your investments.

Further Reading:

Mortgage Your House and Buy as Much of This as Possible

How Wall Street Will Pay You to Buy Stocks

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WHY SELLING CALLS IS WORKING

In today's essay, Jeff Clark mentions the key reason why writing covered calls is working so well right now: increased volatility.

This week's chart is the picture of that volatility: the past five years of the "VIX."

Called the "fear gauge," the VIX tracks the prices traders are willing to pay for portfolio protection... in the form of stock options.

For much of the bull market of 2003-2007, volatility was nonexistent. Everyone was serene, as their stocks, real estate, and commodities worked their way higher.

Now, as the credit and housing market boils like a pot of hobo chili, protective options are being "bid up" to the sky... So Jeff does the prudent thing, he sells them.

– Brian Hunt

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