The 'Trader's Terror' Is Our Golden Opportunity

"The economy looks bleak," a friend of mine texted me last night.

He's right...

Everywhere you look, the media is warning that a recession is on the way. What's more, the S&P 500 Index entered an official bear market this week. That's the first bear market since the start of the pandemic.

My friends and family are showing an unprecedented interest in finance... because the market's terror has spilled into their living rooms.

There's still hope though. One indicator shows us just how bearish folks have gotten... And history shows this massive negativity can set up immense long-term upside.

Let me explain...

We can look at the options market to see today's extreme bearishness. This market can be complex. But one way to get your head around it is by thinking about crops...

Let's say you're a farmer. You're growing a bumper crop of corn. But you think that corn prices could sink by the time your crop is ready. So you make a deal with your buyer...

You agree to lock in today's corn prices, and deliver the corn at a set date in the future (when your crop is fully grown). The buyer charges you a small upfront fee to lock in your rate.

When the corn is grown, you have two outcomes... If your corn is worth more than the amount you and the buyer agreed on, you can simply sell at the higher price. But if prices have fallen, you can exercise the contract and get the old price you agreed to.

With this kind of trade, you don't have to worry about a corn slump. You bought insurance. In options terms, this is called buying a "put."

The inverse trade is possible too...

Say the buyer believes the price of corn will skyrocket from here. This time, the buyer pays you upfront to lock in today's prices until the corn reaches maturity.

If corn prices fall, you simply sell to him at the market price. But if corn prices soar, the buyer saves some cash, because he locked in a rate back when corn was cheap... And either way, you get to keep your upfront fee.

Options traders refer to this contract as a "call."

These options represent two sides of the emotional coin. Puts are bets that an asset will fall... Calls are bets that it'll surge.

That makes the put-to-call ratio a powerful sentiment indicator.

When traders expect prices to rise, the "put-call ratio" dips. And when traders fear a crash, this ratio goes higher.

As you might expect, today's put-call ratio is at a two-year high. That means traders are bearish today. Take a look...

Options traders are as pessimistic as they have been since the start of the COVID-19 pandemic.

They're betting on a big crash. But history says it's a smart idea to take the opposite bet...

The table below shows the returns you'd have made since 1997 after the put-call ratio reached 0.85 or above, compared with a typical "buy and hold" strategy over the same period...

Buy-and-hold is a decent moneymaking strategy. It typically returns around 7% per year. Let's compare that to buying after a bearish put-call ratio, though...

This strategy slightly underperforms in year one, returning about 5%. But it returns 25% in three years, compared with 22% from buying and holding.

And in five years, it typically returns 53%... significantly outperforming the 38% return you'd expect otherwise.

Simply put, buying on highs in the put-call ratio is a great long-term move.

Today's market is scary. Traders are prepared for the worst. And that probably feels like the right bet to make...

But if you waited on the sidelines during the last bull market – your moment to jump in may be coming.

Good investing,

Sean Michael Cummings

Further Reading

"With a recession not likely for many months, we want to take advantage of all the fear that's out there," Dr. David "Doc" Eifrig says. Investors are exiting the market in droves right now, trying to avoid huge losses amid ongoing uncertainty. And this gives us the perfect chance to earn extra income... Read more here.

"Right now, fear is elevated," Doc writes. And with no clear end in sight for today's market volatility, we can use one of our favorite strategies to profit off investor fears... Learn more here: A Smarter Way to Use This 'Bulletproof' Rally Indicator.