Last week's article presented a few ideas to consider, prompted by the levels the VIX and RVX were approaching. I thought it possible that volatility would return. I worried that the volatility indices could surge higher from support and the equity indices turn down. Another scenario was that the volatility indices would trend sideways at support while equity indices trended sideways at their highs. That scenario wouldn't have caused much angst, but the first one would and likely did. I wanted options traders, especially those who had been trying out new strategies over the last trending six months, to think about how they might adjust their trades in preparation.
Now we know that the volatility did indeed return, like a hurricane sweeping in. It's too late for preparations. Weather forecasters think the hurricane could be on its way out of our territory, but we have to react in case the hurricane strengthens. I have a few more ideas for traders to consider.
As of premarket Friday morning as I was roughing out this article, this steep pullback has so far done nothing more than test support, a test that was long overdue. Futures suggest a bounce attempt on Friday, although we have no idea how far or how long that bounce will last.
Daily SPX Chart:
We don't know what to expect next. This months-long supporting trendline may hold, and the SPX may bounce up to test recent highs, if not exceed them, or the SPX may fall through that support at some point, perhaps tumbling harder than it has now. Nothing on this chart tells us exactly what will happen next. We knew it was time for a pullback. We've had that. What happens next, after the bounce that's getting started even as I type as the market opens, will tell us more.
Here are ideas to consider. Consider trading smaller. I presented this idea for consideration last week, and it still holds true. Smaller contract sizes make the gyrations less heart-stopping, leading you to make clearer decisions. You can learn a lot trading through situations such as these, but you learn only panic if you're in over your head.
Take advantage of the moves to take off risk on the opposite side. On iron condors, I tend to close out my spreads and lock in profits whenever the spread narrows to $0.20. You can bet I've had orders in to buy back my sold call spreads for that amount, if possible. I've come close but so far market makers aren't taking my SPX orders, at least. Expanding volatility also kept those spreads wider than they would be if the SPX had loped down to those levels at a slower pace. You can bet I've also got orders in to close my put spreads, hoping they get filled on any bounce, especially if the volatilities pull in a little, narrowing the spreads. My tactic for the APR iron condors was to put on my call spreads on February 17. Only after the SPX had dropped more than 3 percent did I start adding in some put spreads, stepping into them gradually over this last week. I've still got only 10 put spreads to go with my smaller-than-typical 15-contract call spreads, making up an unbalanced iron condor so far. However, my iron condor now is stretched out with the sold calls and puts at least 275 points apart. The steep decline allowed me to swing them far enough away that I'm hopeful that any sizeable bounce will allow me to close them and lock in profit. Lest you think I'm a genius at market timing, I was worried about sinking volatility levels in MAR, too, and employed the same tactic, but with less success. The SPX's climb sharpened, meaning that I'll probably take a loss of about $250 on that trade. I'd still do it again, and this month shows why.
On my now-much-adjusted MAR SPY butterfly, I took advantage of the movement lower to roll in my long calls closer to the sold ones. I began doing that on Thursday, and did the same with the other half as I was typing this article. With the steep move down, those long calls were at a nickel, and I basically had uncovered sold calls since those longs weren't any protection any longer.
If you're a person who rolls into new, closer-in credit spreads once the originals are closed for a profit, be careful about that tactic in this environment. Relief rallies can be vicious, especially since that chart gives buyers a reason to buy. And, in case you didn't know it previously, you know now how vicious a downturn can be, when supposed support may not matter. Most people can draw trendline, and most of the trading public is watching that trendline shown on my chart. If it's penetrated too sharply or for more than a day, stops may be triggered. If you're going to roll into new, closer-in contracts once you've closed the profitable ones, consider reducing the size of those contracts.
Keep up with the deltas but don't over adjust. When the markets are cratering, we would feel more comfortable if our positions and portfolios were all very negative delta so that we benefit from the price movement. Being negative delta is especially important if our positions are butterflies and iron condors, negative-vega positions that get hurt by the expansion in volatility. However, don't adjust too heavily to get too negative delta. As Friday morning's rally shows, rallies can be sharp and can gap the markets up before you have time to adjust. In the same vein, on a day like Friday, adjust if your positions are being threatened to the upside, but don't over adjust. This is so far a relief rally, and we don't know how far it will carry and how long it will last. That's what we'll be finding out.
What's an "over" adjustment? Consider adjusting enough so that your position doesn't hit maximum loss due to a normal price movement for your underlying, if possible. That's not always possible, of course, and avoid going overboard. Don't turn the trade into a directional, momentum trade.
Consider adjustment methods that take off risk. For example, some iron condor traders might adjust a threatened credit spread by taking off the spread for a debit, and then rolling out further, selling more credit spreads than originally held to make up the debit paid for the threatened spread. I used to do that, too. It's not a tactic I like for this market environment when we've had so many morning gaps. Now, I tend to manage the delta by buying back individual sold strikes or spreads, not by rolling. For example, if I have a 15-contract put spread that was being threatened by a downside move, I might buy back one or two of those sold puts, easing the delta-related risk. Instead of putting more margin at risk, this reduces my margin and my maximum possible risk. Similarly, a butterfly trader might be used to adjusting by adding butterflies, which adds risk. That trader can instead take off risk by closing some of the spreads that make up the butterfly or buying back some of the sold calls or puts.
Traders employing these methods must understand the pros and cons. These tactics reduce the profit potential of the trade. In the iron condor, in particular, the profit percentage isn't high, so these tactics can reduce the ability to make anything. However, you could find yourself in a situation in which a gap has left you vulnerable, losses are increasing rapidly, and you must switch to survival-of-your-account mode. Then, it's about saving your account, not making money.
Consider taking profits early. You could consider taking off part of the position and locking in some profits on that part, also reducing risk.
Losses are inevitable. Accept the possibility that you may not be able to save your position. I've been back testing iron condor methodology on an unfamiliar underlying going back for a couple of years. What's strikingly evident is that, beginning especially in 2008, we started having a lot of morning gaps. Those can ruin trades. A big move one direction one day can force an adjustment, only to have a gap in the opposite direction the next morning bring the trade to the point of no return. You can't do anything about situations such as that one. It's the luck of the draw sometimes. Take it from a trader who put on a 60-contract iron condor the day before the Flash Crash: sometimes the unlucky trader who puts on a trade one day suffers a loss while the trader who put it on two days later rakes in the planned profit. Your primary job as a trader during weeks like the last week is to preserve your trading capital. Times exist when it's best to wait out a big move, especially one occurring in the first thirty minutes to an hour of the day. However, traders who performed their best impressions of deer in the headlights were not rewarded Monday.
We just cannot afford to let losses grow larger than our accounts or our emotional and financial well being can endure. Do not discount the emotional toll that it takes when you let a loss grow too large. Sometimes market action, especially morning gaps, happen that we can't prevent, but the losses that we don't prevent hurt our confidence level as traders. A 10 percent loss may be hard to take: a 30 percent one proves devastating.
I'm not leaving out momentum traders. Consider trading fewer contracts. Moves can be both sudden and big, so even if you've done your best job at analyzing the next move and have set appropriate stops, prices can break through suddenly. The best way to control your risk is to trade smaller. You can't control market behavior, the quickness with which your triggered trade is filled, or other such outside factors. Consider putting on trades in which your investment amount is also the amount you're willing to lose, rather than counting on stops, your technical analysis skills or your own trustworthiness to pull the trade to control your loss. Consider taking profit as soon as it's offered. If you've never traded through this kind of environment, consider trading it on paper.
Again, I am absolutely not trying to scare traders. As I said last week and as my own recounting here shows, I haven't been too scared to trade. I didn't know with any certainty what would happen, and we might have had a month in which indices went sideways for three weeks while iron condors and butterflies quickly reached planned profit levels. However, I do believe in trading defensively. Be sure to run these ideas through an analyzer on your brokerage or through freeware such as OptionsOracle before you enact them. Some may be appropriate for you, and some may not. I may be eyeing my APR iron condor, theoretically showing a profit above 4 percent, and being the conservative fuddy duddy that I am, thinking that if it gets up to 5 percent today and if I can get the orders filled, that may be enough for me in this market environment. Others can scoff at that idea, pointing out that if I cut my profits so low, those profits won't cushion the losses that I inevitably will take in other months. You have to consider what works best for you.
To review, keep these tactics in mind. Trade smaller. Keep up with the price-related risk but avoid over adjusting. Look for adjustments that reduce risk rather than add to risk. Take profits quickly or take partial profits, reducing risk. Realize that you're not going to be able to rescue all trades, no matter what your skills. Take losses when necessary, and if markets reverse and you would have profited, pat yourself on the back for being able to trust yourself to take losses when needed. That will serve you best in the future. Believe me, when I look back on my years of trading, I never think with regret of the losses I took when markets then reversed and the trade would have been profitable. I think with regret of the time last spring when I overextended myself, was hit with a family emergency, and did not take the losses I should have taken, leading to a mistake that cost me many months of carefully garnered profits and a big chunk out of my carefully honed confidence in myself as a trader.
Good luck to all traders, whatever your style and whichever way you're leaning with your trades.