The markets saw an almost vertical rally in the last two months of December and this has propelled all major indices into overbought territory. Stock markets usually don’t go up in a straight line and a pullback is possibly around the corner. With this view in mind, I am looking for a bearish trade on any of the major Index ETFs. I have shown a chart of IWM which is an ETF that tracks the small-cap benchmark Russell 2000. The first chart shows a 30k-foot view zoomed out to a 5-year weekly chart. Note that IWM is stuck in a multi-year trading range starting January 2022. The range is approximately between $200 to $170. It took a two-month long rally for IWM to go up and test the top of its trading range, but it is showing some signs of weakness now. To further confirm my bearish bias, I have shown a zoomed in version of this chart below. The chart tracks the 1-year daily timeframe with some technical indicators like RSI and DMI plotted on the chart. Here is a summary of the indicators I have used to provide confirmation Price Action: As highlighted in the 5-year weekly chart, IWM is trading around a strong resistance zone and is likely to pullback on any weakness in the broader markets. RSI (Relative Strength Index): Using the RSI indicator is straightforward. If it moves above 70 that means the stock is overbought. Once overbought, a trader needs to wait for the stock to drop below the 70 area for a bearish setup to form. IWM has flashed two such signals so far. One on 12/20/23 and another one today (2/1/24) DMI (Directional Movement Index): When the DI+ (green line) is above DI- (red line), the stock is in an uptrend. However, when the DI lines start changing direction, that indicates a possible change in the current trend. This is exactly what we are seeing in the chart below. The Trade Set-up: IWM $200-$199 Bear Put Spread With a bearish directional bias in place, all I need to do is find a suitable options structure to take a bearish trade. The trade structure I am using here is called a “bear put spread” also known as a “put debit spread”. To construct my bear put spread, I need to buy a $200 put and sell a $199 put as a single unit. Most trading platforms will offer a bear put spread (or long put spread) as a trade type and automatically construct the trade for you. All one needs to do is make sure that they pick the right strikes and expiration dates. Here is my exact trade set-up: Buy $200 put, Jan. 19 expiry Sell $199 put, Jan. 19 expiry Cost: $50 Scaling up: I am using 1 contract as an example. But scaling up this trade is as easy as adding more contracts. Eg. Adding 50 contracts would risk $2,500 to make $2,500 (i.e 100% ROI) on this trade. Strike selection: Based on how markets trade today, I could have taken a $199-$198 put spread or even a $198-$197 put spread and my technical analysis and thesis would remain the same. As far as expiration is concerned, bear put spreads are best suited for expirations 14-22 days away. I have chosen Jan. 19 for this example, but Jan. 26 expiration would be equally effective. Profit target: If IWM is trading at $199 or below on expiration date, this trade will double my money and return a 100% ROI on money invested. Trade Management As soon as I get filled on this trade, I can place a GTC (good till canceled) closing order for 97 cents on this trade. That way, the trade will close on its own when it reaches its full profit target. I like to close profitable trades around 94% ROI. This helps avoid waiting until the last few days of expiration week, thereby reducing gamma risk. If the trade goes against me, I would want to get out of the trade if I lose 50% of my initial investment (i.e .25c). By simply doing this, every winner will cancel out two losing trades. -Nishant Pant Founder: https://tradingextremes.com Author: Mean Reversion Trading Youtube, Twitter: @TheMeanTrader DISCLOSURES: Nishant currently has a bear put spread on IWM expiring on 1/19/24 (Correction: Update corrects the strike price of the put sold to $199.) THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY ANY SECURITY OR OTHER FINANCIAL ASSET. THE CONTENT IS GENERAL IN NATURE AND DOES NOT REFLECT ANY INDIVIDUAL’S UNIQUE PERSONAL CIRCUMSTANCES. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
