Two of my favorite indicators are acting up, and they influenced my options trade choices this week.
On Thursday, the VIX sank to test a long-term potential support level.
How Low Can the VIX Go?
How low can the VIX go? Obviously, it can go lower. Also obviously from this chart, it can linger near the horizontal blue support line. If we were to extend this chart back into the summer of 2006, we would see a time when the VIX broke through that support and dropped all summer and fall, hitting a low of 8.60 in December, 2006 before it began a climb that was going to end up being disastrous for those holding long positions in equities.
That may not be the appropriate question for options traders to be asking themselves, however. It might be more appropriate to ask what happens to our options trades if the volatility should bounce up hard, although we can't count on that happening. Once again, we're at the point at which we ought to be thinking defensively about our trades. The low VIX and low implied volatilities in many equities mean that you may not be able to get much premium for trades such as iron condors. That brings the expiration breakevens and the points at which adjustments would have to be made in close to the action at a time when the volatility could be getting ready to expand rapidly again. Nothing on this chart guarantees that it will, of course, and we could instead be seeing the setup for a summer like that of 2006's. Still, in my own case, I'm thinking about risk and I'm thinking specifically about volatility risk.
I'm not thinking that I know what will happen next, and I'm not thinking that I should shoveling out a shelter in my back yard. I'm not thinking I should be scared, but I am thinking I should be wise about risk.
You've heard this from me before: in such situations, consider your comfort levels before you decide which trades and what size trades you'll enter. Plan ahead. Consider trading smaller if you don't feel comfortable handling a sudden expansion in volatility or, conversely, if you don't know how to handle the changes that would occur if vols were to firmly break below that long-term support and sink way lower all summer. That long-term long call you bought if you're a bullish directional trader will see extrinsic value sink, too, as the volatility sinks. The two situations certainly call for different types of trading, but the sharp expansion of volatility requires more agility.
Make sure your vehicle is liquid and there's enough volume and open interest in the options to allow you to get out or adjust in fast-market conditions. For example, you could ratchet down your trades from SPX to SPY ones or from RUT to IWM ones if you're a newer trader and have never traded through an expansion of volatility. If you can't monitor the markets all the time--and I don't suggest that anyone should be riveted to the screen all the time as that leads to obsessive overtrading--make sure you have alerts and/or contingent orders in place in case the market suddenly explodes upwards or pushes lower. Consider adding cheap OTM just-in-case catastrophe long puts to trades such as iron condors or butterflies. Some people use call debit spreads to hedge upside risk, although I tend to hedge to the upside when I need it and not when I enter a trade, unlike the way I set up insurance puts at the beginning.
Consider calendars to balance volatility risk if you're any good at them. Don't put them on automatically just because they theoretically are good for balancing vega risks, if you have no experience with them. They get hit by sharp price moves, too. I'm not an accomplished calendar trader. The things just defy me, and I have a spotty record with them despite diligent efforts on my part. However, some experienced traders manage vega risk in conditions such as these by adding calendars to counter some of those negative vegas from their butterflies, credit spreads and iron condors.
The other chart I'm watching in situations like these is the TED Spread's chart. For those who haven't been reading my articles for a while, the TED Spread is the spread between our considered-less-risky Treasuries and considered-riskier Eurodollars. When the spread widens (the line rises), default risk is considered higher. That's not typically good for equities, and so equities tend to move in opposition to the TED spread. It is not, however, an exact market-timing tool.
How High Can TED Go? TED Spread Chart from Bloomberg:
Earlier in the week, I was watchful of the TED spread's action. Although the spread had remained in the noise of the descending channel shown here, it had attempted a breakout above resistance. Equity traders don't generally want to see a breakout, particularly above a rectangular consolidation band we see at the top of this chart, a band that formed after a climb. The TED spread pulled back into the channel after this week's test, but with all that's going on in Europe, I'll be watching for another breakout attempt. If you want the quotes for yourself, just go to Bloomberg's site and type in ".TEDSP:IND" in the quote section.
Summer trading patterns produce light volume, which means it's easier to push equity prices around, particularly in our high-frequency-traders environment and particularly with what we're seeing in overnight futures' action the last few months. In this situation, I don't find technical analysis to be as reliable a tool as it is in other times. I know that this environment has proven treacherous the last couple of weeks for even experienced options traders. After many attempts to adjust my AUG iron condor, that thing had an ugly chart as my maximum acceptable loss was approached at the same time as another adjustment level approached. Other adjustments could be made, but the trade had degenerated into a speculative directional trade. Not only that, but I was riveted to the computer monitor, which is a sure sign that the trade is getting out of hand. When I looked at that trade and asked whether I would put on a new trade that looked like that, on that day, I of course drew the conclusion that I would not. It came off, at my maximum preset acceptable loss. It was actually a little greater than that loss because of slippage as I exited the trade, but I take that into account as I set these levels. I decided it was far better to take it off than keep wrestling with it, and then reset it when conditions seemed appropriate to do so. A day later, I started doing just that.
However, other experienced traders kept battling, and some of them were then hit hard by this week's gaps. If a trade is already embattled, it can't survive gaps like that. I speak from experience when I say that it's better to take the loss and reset a trade when itâ€™s appropriate to do so than to wrestle with a truly ugly profit-loss chart and put yourself and your trading account at too big a risk. Take a day off so that you won't be tempted to put on a "got to make up the loss trade" out of desperation. Then rethink it. I am not a bit worried about the loss I took this week, one of those casualties of the trading life and already partly made up for by the trade that I reset. I am still impacted by the much bigger loss I took in the spring of 2010, when I mishandled some trades. I keep harping on that loss in the spring of 2010 because I don't want readers to experience such losses.
If it's too late for that and you're facing a hard weekend, do know that others of us have been where you are. Give yourself a break, do something comforting, and then ask yourself before the weekend is over if you should take off the in-trouble trade. Be ready Monday.
If you're thinking about new trades, consider the risks--a long summer of flattening volatilties balanced against the possibility of an explosion higher. Plan accordingly. If this were another time of year, I would be fairly confident that we would soon experience a sharp climb in the VIX and other volatility measures, coupled with a market pullback if not worse. However, this is this time of year. I don't know which we'll get.