Updated: Aug 21, 2019
Introduction: Anticipate First, Then Look Out For Opportunities
When economic data spark a lot of volatility and heavy short-term market declines, we have to react in order to manage our short option positions and avoid unpleasant situations. Just a few weeks ago, I've talked about several ways to prepare yourself for corrections. Let me briefly go over some of the takeaways presented in that article.
First and foremost, assessing chart technicals and being on the lookout for potentially devastating negative divergence is by far the most interesting strategy we have to avoid steep losses and position ourselves conservatively.
Selecting low-beta stocks or companies that tend to keep up very well during tenebrous times is yet another way of we can anticipate the next correction.
Before we go any further into great detail on how to manage our portfolios when the long-awaited correction takes place, it's important that by taking a more conservative stance on the market outlook we do not time the market since we stay in the game and thus still generate appealing cash premiums.
Selling all of your stocks may lead to huge opportunity costs if markets don't correct but rally instead. Therefore I remain a big proponent of allocating at least half of your funds to low-volatility stocks as they will function as the perfect foundation for your stock portfolio and don't put you in a dilemma of whether or not to sell out all of your stocks.
Executing Option Trades In A Volatile Market
When we anticipate the next down move, we either sell options on defensive stocks or ETFs (to gain more diversification) or wait for the decline to occur. If we choose the latter, we want benefit from increasing volatility and therefore sometimes exploding option prices without being exposed to significant market risk. If we opt for the former approach, we split our funds allocated to option selling into two equal portions so that when the market finally starts to decline we have dry powder to sell options for a noticeably bigger premium. That's because when stocks decline, there's panic-selling and people (most of them being institutional investors such as pension funds) want to hedge their positions against even more calamities by buying puts.
Let me draw your attention to the following chart which represents the implied volatility for the SPY ETF.
As historical research has pointed out, the average historical volatility of the S&P-500 is around 15%, which doesn't imply that the forecasted volatility amounts to 15% (the realized volatility had more often than not been overstated significantly). Looking at the chart right above, you surely notice immense spikes in volatility.
As I've written in several articles, I have some guidelines as to when we should consider closing our short option positions. One of them is the 70%/80% guideline telling us we should close our trades when our maximum profit reaches the 70% (first half of the contract cycle) to 80% (second half of the contract cycle) threshold. In relation to volatility and depending on which security you're using, it may not always make sense to you to keep holding onto a position and waiting for it to reach max. profit. So, that's why I've decided to break this guideline down into three segments. Since implied volatility doesn't always give us enough colour on how cheap or expensive options are, I want you to also focus on the IV rank:
When the IV rank of the SPY is less than 30% (or the IV is less than 12% based on current data) and chart technicals don't show any negative divergence, I'd like to stick to the 70%-80% guideline. Use this instruction for individual stocks as well. I tend to use it when the market is up-trending.
When the IV rank of the SPY is 30-50% (or the IV is equal to 15% based on current data) with chart technicals being somewhat mixed or slightly bearish, you'd better go with the 50% guideline. Use this suggestion for individual stocks as well. I tend to use it when the market is moving sideways or slightly downtrending.
And last but not least, when the IV rank is higher than 50% (or the IV is higher than 15%) and chart technicals become bearish, you'd better go with the 50-% guideline. Use this guideline for individual stocks as well. I tend to use it when the market is moving sideways in a mid-term or short-term downtrend. Make sure there's no technical breakdown because we don't want to be contrarians when the market starts turning against us!
You should always keep in mind that we never ever sell options prior to an earnings report! The primary reason why we have to sum up rules or guidelines is to ban emotions and make our options trading activities a non-event. Knowing when to implement which strategy will remove ambiguities and avoid that things get out of our hands.
Of course, you'd like to know why I consider these three scenarios. When volatility is rather low with good momentum and strong chart technicals, there's nothing to worry about. We just want to capture most of our maximum profits after having sold. When volatility starts to increase, both call and put premiums will become worth more as well. However, volatility also impacts delta since the odds of a particular strike ending up in-the-money rise. In other words, we have to adjust our guidelines in order to control risk and maintain our high success rate. You cannot apply the same guidelines in every situation over and over again. Also, and this quite important as well (I'm going to lay the concept of taking profits out in an in-depth article), by waiting for your options to hit 70%/80% of max. profit the chances of your trades ending up in the red increases!
Does that mean our win rate will take a beating? Not necessarily. Going back to our short strangle strategy (which I currently finetune even further), other research (from 2005 to 2017) has found that selling SPY short strangles with 16 delta with 45 days to expiration (DTE) posted a win rate of 90% in all cases and a succes rate of 88% when the IV Rank exceeded the 50% threshold. Though, selling short strangles when the IVR was higher 50% resulted in the realized average credit received of $150 compared to $133 throughout the whole cycle.
50-% guideline: why?
Why should we consider closing out our trades at 50% of max. profit during volatile times? We as option sellers only have one mission: generating a constant, positive amount of cash flow every single month of the year while lowering our cost basis, thereby throwing the odds of investment success drastically into our favor. When implied volatility peaks, there's a very good chance that the options we sold are way too expensive and thus an implosion in volatility thereafter will destroy the option value, allowing us to buy them back much faster than we would normally do. The cash is then freed up to secure another put or call trade. So, when markets are volatile and you'd like to benefit from rapidly decreasing volatility, it's better to stay flexible and turn around your portfolio pretty frequently than you would normally do in a steadily up-trending market where your intention is not primarily shorting Vega.
In case you want to trade more actively during volatile times (and you should do in order to keep track of your market exposure and benefit from falling volatility), let me show you a real-life example I just did with arGEN-X three days ago on August 15, 2019 and on Aug 5, 2019 as described in this article.
When markets turn volatile, we obviously see huge spikes in equity prices and inviting volatility to our option selling party, things become even more lucrative from an active trading perspective.
On Aug 5, 2019 I sold the €118 puts on arGEN-X expiring on September 20, 2019 for €8.25. The rationale for this? The IV amounted to a humongous 52% and the IVR was 93%. So, first and foremost, it was a bet on a normalizing IV from 52% to 45%. Also, shares were heavily oversold and stood at the lower end of the Bollinger Band and the Stochastic Oscillator did also show oversold readings. One week after I wrote those options, the put value had already shrunk to €3.95 or less than 50% of its original value. As shares didn't break through the middle Bollinger Band, it was time for me to close out this trade. Mission accomplished! In contrast to looking for perfect stocks in terms of technical and fundamental analysis like the ones I've highlighted in previous articles, I now trade more actively to capture high premiums while eyeing trades where I don't have to ride out the entire contract period thereby minimizing adverse consequences of changing Greeks and lowering my market risk exposure.
But, just a few days after that investment success I executed another trade utilizing the same underlying on August 15, 2019. I sold the €116 puts expiring on that very same September 20, 2019 for €5.75. The following day, the option value had diminished to €3.96 (or a 31% gain). How come there was such a devastating impact from a recovering share price?
On August 15, 2019, the IV was 47.8% with an IV Rank of 46%, allowing for some implosion in volatility. The Vega was then 0.155 indicating that the value of the put will decrease by 15.5 cents if the implied volatility drops 1%. The following day, IV declined to 45.2% so there's been a decrease of 2.6% in volatility representing a drop in put value of 2.6 times 15.5 cents or 40 cents. But there's more, share value increased from €119.8 to €123.5 or €3.7 and because of a negative delta, an increase in the underlying's share price will affect the options we sold. In this case, the delta was -0.35 when I sold the option, thus another €1.30. And last but not least, there's always some time value erosion of 10 cents per day. So these factors caused our short puts to drop 31% in just one day and a half!
Quick and easy profit you may think? During volatile times we have to carefully watch out for boobytraps. If one sold an out of the money put option on a stock which had a rather low IV rank, spikes in volatility would force us to hold onto our short puts because at that point in time, we only have time value erosion (theta) on our side. Selling options when volatility is high relative to its 52-week range allows us to participate in quicker profits as Vega is then our ally. While our main focus lies on capturing time value every single day, huge spikes in volatility we could have foreseen (based on technical analysis and thus anticipating future corrections) will make it tougher to exit our trades and go with a big opportunity cost if our capital could have been deployed much better. Gauging how expensive options are and what the markets are doing today in order to minimize risk and take profits more quickly is definitely something you have to reflect on for a moment.