What do options traders fear the most? A crash. But smart traders? They prepare for it.
From recent history, there are perhaps no better examples of a big market crash than those that occurred in 2020 and 2022. The first, of course, occurred in the wake of the COVID-19 pandemic, and the other was the onset of inflation along with Fed tightening that caused lackluster economic conditions to settle in around the world.
In this guide, we will highlight some key lessons from these two market crashes and show you how traders could have employed winning strategies to make the most of the situation at hand. Of course, we will outline some of the common mistakes that a lot of new, inexperienced traders made during those chaotic times that they soon regretted. We hope to teach you what to do and not do amid a major market crash.
Quick Recap—What Happened in 2020 and 2022
In case you’re unaware of how these two instances played out in the economy, we are going to do a quick recap of what happened in the stock market during the COVID-19 pandemic and the inflation fears and Fed decisions that led to the 2022 Bear Market.
2020 COVID Crash
The time leading into the start of the COVID-19 pandemic was characterized by a lot of uncertainty among investors and some significant market volatility. Between February and March 2020, the S&P 500 fell ~34% in a month. This time also saw a historic VIX spike that went above a level of 80. Though it was a time of apprehension among investors, there were ways that some capitalized on the conditions, implementing strategies like selling put options or using long VIX calls.
February and March of 2020 also saw massive Fed intervention through major interest cuts and quantitative easing. Interest rates were brought down either to 0% or close to it (0.25%), and it was done to lower the borrowing costs for businesses and households as a way to stimulate the economy. In terms of quantitative easing, the Fed bought up large quantities of mortgage-backed securities and Treasury securities to inject cash back into the economy and stabilize the markets.
2022 Bear Market
This period of the US economy was notable for being affected by rising interest rates and high inflation levels. The Fed increased interest rates to combat rising inflation, which led to a slowdown in the economy as it became more expensive for families and businesses to borrow money. The S&P 500 was down ~20% YTD by the end of 2022.
Due to the Fed rate hikes and inflation fears, the bear market of 2022 was longer and more drawn-out, lasting for several months. During that time, the S&P 500 experienced its worst year since 2008, and the financial crisis that was notable that year. Another contributing factor that made things worse during this period of 2022 was supply chain issues caused by the war between Russia and Ukraine.
Why Options Trading Can Shine (or Burn You) During a Crash
When there is a market crash, there are ways that options traders can benefit from the volatility that comes down the pike, but there are some ways that traders can get burned if they aren’t careful. In this section, we’ve outlined some of the ways you can thrive or falter during market crashes, showing you what kind of challenges you could be up against.
- High Premiums: Options prices during a crash are marked by a high level of volatility, which leads to higher premiums for options contracts. This is an environment that is great for sellers because their investments go up in value, and they can secure a good profit if there are any interested buyers. Higher premiums, however, aren’t a good thing for buyers, making everything much more risky for them.
- Quick Price Swings—These can create opportunities for both hedging and speculation, but it’s all about gauging them correctly to get directional moves right. Traders can use calls or puts to take advantage of market movements that either push prices up or down for certain stocks, assets, or commodities. Hedging can also be used in these conditions, where it can protect against adverse price movements and uncertainty during periods where there are quick price changes.
- Leverage Cuts Both Ways—Being able to manage a large position with a relatively small amount of capital can allow traders to enjoy fast profits, but another possibility is painful losses.
Key Lessons from 2020 and 2022
If there was anything you could take away from what happened to traders and investors during the 2020 and 2022 crashes, it would be the key lessons we are about to present here in this section. Learn about effective hedging strategies, how to carefully manage IV and use it to your advantage, and a few other useful tidbits of knowledge that can help you navigate a market crash effectively and successfully.
Hedging Works (If You Plan)
Put options protected portfolios during both crashes. This is because put options make investors money when the stock or asset that the put is tied to decreases in value. When a market crash is imminent and certain underlyings are going to take a big hit, it makes complete sense to speculate on their decline using put options. However, these only work if you plan as a trader, checking the market signals for indications that a market crash is imminent or that your investments are going to take a bearish turn.
Long VIX Calls
Long VIX calls were another way that traders could and did make money during the crashes of 2020 and 2022. This strategy is where investors speculate that the implied volatility of the market will increase. It is a move that is often used right before market crashes or downturns set in, and is a good way to profit from the circumstances.
Tail Risk Hedging ETFs
A form of protecting funds during a market crash, tail risk hedging ETFs also helped out many investors during 2020 and 2022. They protect the investor’s portfolio, but they also aim to create positive returns when the market experiences a big decline. The profits that come from using these ETFs can offset the losses that a diversified portfolio would incur from the situation.
Lesson: You can’t wait until the crash starts to hedge.
Implied Volatility Spikes Are a Double-Edged Sword
While implied volatility can pose a lot of problems for traders in the options market, there are some opportunities to be had when these conditions begin showing up in the market. However, to fully take advantage of IV, a delicate balance must be struck because IV can harm you just as easily as it can help you.
2020
A common mistake that investors made during the 2020 crash was buying their puts too late; some only implemented them into their plan during March. A lot of these mistakes resulted from traders acting only when IV was getting super high and not holding on when it was steadily increasing throughout February. The stock market hit rock bottom on March 23, 2020, and then recovered almost immediately, mainly due to government stimulus.
Where investors got into trouble was that they bought their puts far too late into the game, and the market quickly began recovering, rendering the put options worthless. Had they bought the puts in February when news of the emerging pandemic was first setting in, they could have gotten them for a better price, enjoyed a better reward-to-risk ratio, and they could have ridden the decline for a month and a half, profiting the entire way.
2022
During this time, the stock market saw a significant drawdown and uptick in volatility, with the S&P 500 experiencing a severe 25% decline. Amid inflation and market volatility ramping up all throughout the year, many traders made the mistake of panic-selling a lot of their assets and positions due to the downturn without giving them enough time to recover. What investors should have done during this time was take advantage of the elevated IV and use strategies that would let them sell premiums during this time.
The higher levels of IV stayed elevated during 2022, and this results in higher premiums for options contracts. It might not have been a good time to enter new positions due to the increased price of trading, but it was a great time for selling premiums using strategies like simple spreads or the iron condor. Many traders missed out on this opportunity because their knee-jerk reaction to the uncertainty was to panic-sell their assets to avoid incurring losses.
Lesson: Timing is everything when trading volatility.
Short-Term Options Became Dangerous
During the 2020 crash, short-term options that had expiration dates that were only days or weeks away began to experience accelerated time decay. This meant that the options began losing value at a much faster rate when they got closer to their expiration date. Also during this time, there were exaggerated price movements that made for unpredictable intraday swings. This meant that even small price fluctuations in the underlying asset had a larger-than-expected impact on short-term options and their value. As a result, many traders were wiped out on weekly options in the 2020 crash.
Lesson: Don’t overuse short-dated contracts during turmoil.
Liquidity Dried Up Fast
With the 2020 and 2022 crashes, traders and investors saw firsthand the reality that liquidity dries up rapidly during a severe market downturn or crash. This means that stocks and other assets are much harder to buy or sell quickly, leading to much less efficient trader execution. Wider bid-ask spreads occur as a result of market downturns and crashes, which can make some investments much harder to trade.
A key example of this would have been during the 2020 crash, when hospitality businesses were put on pause, including restaurants and vacation destinations. There were not many traders looking to buy these stocks, and anyone holding them who was smart bought put options on them to profit from their price decline.
During these periods of major market downturn, the availability of buyers and sellers goes way down, and this can result in an increase in slippage. This makes it more difficult to make fast adjustments and for traders to execute their orders at the price they are interested in getting. What is going on behind the scenes is that the larger market orders (institutional investors and smart money) can eat up most of the liquidity at certain price levels, resulting in the remaining orders being executed at less favorable prices.
Lesson: Stick to liquid tickers and have realistic fill expectations.
4 Strategies That Worked Well
We would like to draw your attention to the strategies that veteran traders were using during these times that helped them to weather the storms during 2020 and 2022, respectively. These moves worked well then, and they are some solid choices of strategies for future times when a market crash takes the stock market by storm.
Protective Puts
This is a well-regarded trading strategy that was used by long-term investors and traders to guard portfolios. The key to understanding how protective puts work is the knowledge that they work way more effectively when they’re purchased before a market crash as opposed to following the crash.
Credit Spreads (Bear Call or Bull Put)
Credit spreads were a popular choice among investors and traders in 2022 when the bear market began to settle in with the inflation levels rising and the Fed decisions making matters worse. Many traders took advantage of rich premiums during 2022 downtrends and used strategies like the bear call or the bull put to secure profits even amid uncertainties.
Using credit spreads is much less risky than naked options. Credit spreads involve receiving a premium from the sold options that is greater than the premium paid for the purchased options, which ultimately results in a net credit. The risks are higher with using naked options, specifically the potential for unlimited losses.
Volatility Plays
When the market conditions aren’t looking the best and there is talk of a crash on the way, traders and investors can be sure that volatility is going to begin ticking up. This is a great opportunity for executing some volatility plays that make money when the market swings drastically in either direction. Looking back on history, you did see a lot of traders and investors using long VIX calls in early 2020 when news of the pandemic was beginning to circulate in February.
Another common strategy for making money during a crash is a strategy referred to as “shorting VIX post-peak,” where traders will bet that volatility will decrease; they hope that volatility will revert to its average once the initial crash has occurred. Investors who pulled this move in mid- to late-March of 2020 were not disappointed when the market made a quick recovery following March 23, when it hit rock bottom.
Long-Term LEAPS Options
A long-term strategy that traders took advantage of during March 2020 was using some of their stockpiled cash or “dry powder” to buy up Long-Term Equity Anticipation Securities (LEAPS contracts) around the time of the market hitting rock bottom, knowing that these contracts were likely to increase in value once the market corrected. Specifically, buying LEAPS on quality stocks near the bottom in 2020 paid off big.
Due to the longer time horizon of three to five years on these contracts, LEAPS options allow for a lot of time for the asset to move in the right direction. In most cases, the environment following a market crash is likely to make LEAPS go up in value right away because the market has nowhere to go but up.
Lesson: Crashes are also buying opportunities—if you’re patient.
Common Mistakes Traders Made
What are some of the major mistakes that traders should avoid when trading options around a stock market crash or downturn? Keep reading to discover what you should and shouldn’t do with your investments when there is news of a market crash or a large downturn that will negatively impact your portfolio.
- Chasing Puts After the Initial Crash—While it is highly beneficial to chase puts options on your investments when the markets begin to dip initially, it isn’t a good idea to pursue them once the crash has happened. You don’t want to be caught betting on the market declining further around the time of the crash because there’s a good chance that it will begin to rebound, making the put options worthless.
- Overleveraging With Short-Dated OTM Options—There are several reasons why you don’t want to make this mistake around a market crash. First, there are magnified losses with this investment, even though there’s also the promise of much larger returns. Time decay accelerates at a faster rate with short-dated options when they get close to their expiration date. It can also be extremely difficult to predict market direction when the volatility from a market crash causes sharp and rapid price movements.
- Misreading Bounces as Full Recoveries—Don’t mistake a temporary upward movement as a sign that the market has made a full recovery. Some traders make this mistake, and they begin moving away from put options and into calls or LEAPs options, and then are severely disappointed when the market reverses and continues declining.
- Ignoring Position Sizing and Risk Management—Perhaps the biggest blunder that a trader can make during a market crash scenario is to ignore the fundamentals of their trading plan like correct position sizing (it’s ideal to keep all positions between 1% and 2% of your total capital balance for any position) and the basic risk management techniques of hedging, setting up stop-loss or take-profit levels, or using alerts/notifications for good active management.
How to Prepare for the Next Crash
Follow these steps to adequately prepare your investments and stock portfolio for the next time the market goes belly up. We have specifically drawn from lessons learned during the two crashes previously discussed to give you some realistic and practical precautions that you can take to make sure the next market crash doesn’t take you by surprise.
- Build a Hedging Plan When Markets Are Calm—Don’t let the next crash take you off guard with no plan in place. It is best to take a proactive approach and to form your hedging plan when the markets are stable or even going up. Begin by assessing your portfolio or business exposures to understand the specific risks that you would like to manage during the next crash. Next, think about your ability and willingness to take on risk, and you can start forming your hedging strategy around this and your investment goals.
- Monitor Key Macro Indicators—Keeping informed about the greater market landscape can be a great help toward forming a hedging plan during calm market conditions. Consider looking at macro indicators like their trends, such as VIX, bond yields, Fed moves, interest and inflation rates, consumer confidence, and GDP.
- Keep Cash or Dry Powder for Opportunity Buying—it is key to have access to cash reserves or liquid assets that can be used quickly for investment opportunities during a crash or for unexpected expenses. Keeping cash or liquid assets on hand just in case functions as a strategic hedge against possible market volatility and can provide traders with a lot of stability during market downturns. Traders can also engage in some opportunistic buying during these periods, as well, thanks to this stockpile of assets.
- Use Lower-Risk Strategies like Defined-Risk Spreads—Using strategies like these during market crashes is beneficial due to the fact that they can cap potential losses. This can come in handy when the market is characterized by unpredictable and extreme price movements. Other perks of using defined risk spreads and low-risk strategies are to maintain flexibility and to reduce overall margin requirements that can lead to better capital efficiency.
Tools That Helped Traders Stay Ahead
Be sure to use these specific tools and resources for keeping ahead of market crashes and making moves that can take advantage of the situation to work it to your benefit. Stay well ahead of the volatility and uncertainty by using these tools to plan your next move.
- VIX & IV Rank Indicators: Looking into market volatility daily and pairing that with market news is a good way to spot the early signs that a market crash could be heading your way. It is best to spring in market volatility when a pattern begins developing. This can allow traders to enter long VIX calls or buy long puts at favorable prices and give those investments enough time to ride the decline and become profitable.
- Option Flow Tracking (Unusual Options Activity): This tool helps traders monitor the moves of institutional investors or smart money traders to get a rough idea of market sentiment. When you see these traders making moves that look as if they’re preparing for rough economic conditions, you can check out other technicals and market news to begin planning for the crash or a severe downturn.
- Trade Journaling and Scenario Planning Tools: Investors should keep a log of all the trades they conduct during the market crash to get insights into what they did well during that time and what could have been done better or improved upon. Along with trade journaling, investors should also use profit calculators and other scenario planning tools to figure out what the best- and worst-case scenarios are when trading around a market crash.
- Reliable Trading Platforms with Fast Execution: To work quickly around mounting IV and the prospect of a market crash, traders should be using quick and reliable brokerage apps that let them submit their trades as efficiently as possible. As always, it is best for traders to also be dealing with liquid tickers for the best results.
What Veteran Traders Are Doing Differently Now
The crashes from 2020 and 2022 taught traders a lot of lessons on top of the knowledge and experience they already had from previous crashes in previous decades. In some cases, prior principles and techniques have simply been reinforced by recent events and have resulted in many veterans taking a more proactive and cautious stance in their trading patterns.
- More Proactive Hedging—One of the big lessons learned during the 2020 crash was the idea of proactively hedging in moderate or bull markets so as not to get caught off-guard by a “black swan event.” What we have seen since that time is that many veteran traders are putting a larger emphasis on hedging their investments even when the markets are looking stable, as the world continues to get more and more unpredictable by the day.
- Wider Diversification of Strategies—Both market crashes have continued to solidify the idea of using a wide range of trading techniques and approaches. Recent market crashes have brushed up a lot of traders on the best strategies that take advantage of higher volatility levels and declining stock prices.
- Prioritizing Capital Preservation Over High Returns in Unstable Times—Veteran traders seem to have gone through a shift away from pursuing high returns in unstable and unpredictable markets and have moved toward prioritizing preserving the capital they have. On top of the basic principles of diversification, correct position size, and implementing loss orders, experienced traders are also placing a priority on hedging strategies like covered calls, spreads, and protective puts to safeguard their investments.
Final Thoughts: Crashes Aren’t the End—They’re an Opportunity
If you read through the entire guide, you’ll be fully aware that a market crash isn’t the end of the world, but something that simply needs to be faced with patience and some solid hedging techniques. Plus, there are opportunities to make money during these events that seem like they have no silver lining. There’s a wealth of moves traders can make to secure profit during a market crash, including long VIX calls and buying long puts to profit from stocks and other assets declining in value.
Market crashes are an inevitable part of the economy, but it isn’t something to be feared if you learn from history and discover the techniques needed to keep your investments afloat during the chaos. Begin trading smarter before and during a market crash. A good place to start is to make some strategic hedging decisions while the markets are calm and to check large order flows, market news, and technical indicators to spot possible downturns or crashes earlier rather than later.
Key Takeaways
- Markets crash—it’s inevitable. Options can protect or punish you depending on your approach.
- The biggest winners were prepared before the crash started.
- Learn from 2020 and 2022—don’t let history repeat itself at your expense.
- Smart traders use options to control risk, not chase it.
