On Friday morning, I glanced at the charts one minute after the live open. The Dow was up about 95 points, and the SPX, almost 11. That jobs report has assumed exaggerated importance in recent times, and we all know that if the reported numbers had stacked up differently, those indices could have fallen even more quickly than they had gained.
In past years, many of us gravitated toward trading options on the indices because they tended to gap at the open less often than individual equities. That hasn't been true lately. For example, one site lists IBM's beta as 0.72 as measured against the SPX. A beta below 1.00 means that the security is less volatile than the underlying against which it's being measured. Although IBM also gapped on Friday morning, its trading pattern has treated options traders more gently of late than some of the indices. That can change again, reverting to the former pattern, but these days trading index options is no guarantee of smoother trading experiences as it was in the past.
The hapless options trader caught in an SPX or other trade Friday morning was in a tough spot. I had cleared out of both September and October SPX iron condors already, accepting a much-smaller-than-usual profit because I didn't like the market action ahead of several upcoming economic releases, and I'm chicken these days. That didn't mean that I didn't feel for options traders in iron condors, butterflies or other trades that were hit Friday morning. Experienced option traders try to avoid adjustments during the first thirty minutes to hour of trading, since those first moves so often stall or are reversed and options are so often overpriced during that period. However, that's not always possible when the move has been so abrupt, perhaps bringing an option trade to a maximum loss or a must-adjust point. I heard from several traders who had to take off or adjust positions Friday morning. That move was wickedly strong.
With that in mind, how can options traders take steps to protect their positions from adverse moves at the open due to scheduled economic releases, moves that seem to happen with more frequency these days? It's hard to generalize because so many types of option strategies exist, but I thought it might be appropriate to talk about some ideas.
First, although I don't believe it's a good idea to trade based on news, it's still necessary to be aware of scheduled economic events that will likely prove market moving. In his presentations for the CBOE and various brokerages, former market maker Dan Sheridan suggests that options traders perform an end-of-day check sometime in the last hour of live trading. This check should include a calculation of the next day's one-standard-deviation period--or, my thought, Average True Range or ATR. Traders should then evaluate whether such a move would require an adjustment or bring the option trade past an adjustment zone. If the trader has access to a profit-loss or analyze-trade screen such as those provided by think-or-swim and some other platforms, studying the possible effect of a one-standard-deviation move should include raising the implied volatilities to study what will happen if the move is to the downside, and, sometimes, lowering them to study possible moves to the upside. I would counsel, however, that if that upside move is a sudden one in the first few minutes of trading, such as the move on Friday, the implied volatilities of the options may not decrease much, at least not in those first few minutes of trading. They may even increase. I wouldn't necessarily lower the theoretical IV if I were preparing specifically for a possible gap to the upside at the open, although I would if I were studying what would happen if the underlying's price rose under normal conditions over the next day or so.
Some other brokerages, some subscription charting services, and even freeware such as OptionsOracle will also allow you to view a standard deviation over a certain period of time, if you don't know how to calculate those for yourself. Some of those are clunkier to use than others. If such studies show that the normal noise of a trading day will likely prompt an adjustment or bring a trade into deep trouble, appropriate steps should be taken to lessen possible losses before the market closes, Sheridan suggests. When we know that an important economic event is due, particularly when it's coming before the market open, such action may become even more necessary. As Friday's action showed after the jobs number was released pre-market, that one standard deviation move can occur at the open, not after an entire morning's gyrations which allow one to make leisurely adjustments. Some may choose to study a 1.5 standard deviation move, as such moves can also occur during the first thirty minutes or so of trading. The SPX, in particular, moved up almost an entire standard deviation in the first minute of trading on Friday.
What kind of adjustments should be made if a standard-deviation move will bring the trade into trouble or into an adjustment zone? Possibilities that experienced traders have used include adding long puts or calls as a hedge, sometimes before the close on the day previous to the announcement and sometimes, in a bit more risky tactic, by setting a contingent order to buy them if the underlying's price moves to a certain level.
Adding long calls or puts of course means adding capital to the trade. This tactic may or may not be a good idea, taking into effect the profit potential of the trade, but it may be the best idea when you expect market action to be wicked. In current market conditions, with huge moves and lower volume, it has sometimes been difficult to adjust by adding or taking off spreads or other complex options positions. As volume dried up, I've literally spent days trying to get into or out of iron condors or individual credit spreads at reasonable prices over the last couple of months.
Before a long call or put hedge is added, the trader should have a plan for whether it will be removed and, if it will be, the conditions under which it will be. Because I come from a day-trading background, I have occasionally added a long call or put position to hedge overnight risk and planned to take it off the next morning. My thought was that amateur-hour shenanigans would hopefully keep options prices inflated enough that I wouldn't lose much. That's sometimes worked out well and sometimes not well at all, so it's an iffy thing. Certainly, Friday morning, if I'd chosen to hedge heavily with long puts, I would have lost considerably on the maneuver. Others have used debit spreads instead of long calls or puts to hedge such risks, taking away some of the adverse effects (and benefits, by the way) of volatility changes. However, we still come up against the problem of trading spreads in fast market conditions. If I expect those conditions, it may be easier to use long calls or puts to hedge because they're easier to trade than any spread--debit or credit, horizontal, vertical or diagonal--in such conditions.
Some traders keep such long calls or puts as part of the trade once they're entered, understanding that their cost will lower the profit potential of the trade. I usually do this with my butterflies, although not always with my iron condors.
In many cases, however, traders don't want to add extra capital to the trade. Other possibilities for hedging against an adverse move the next morning due to an anticipated economic release include taking off some or all of the position, planning to reposition the trade after the number has been released and the dust settled. I've even heard of some traders who just buy back some or all of their closest-to-the-money shorts. If, before the announcement, I've just bought back one side of my iron condor, locking in the profit on that side, then I'm heading into that important economic number with just one side of the iron condor. That means that I have a credit spread position that is now a directional trade. The reaction to the economic number could benefit or hurt such a directional trade. When facing such a possibility, I've often bought back one or more of my sold puts or calls in the remaining credit spread position. This lowers my risk, reducing the margin and lowering the delta- and vega-related risks. I plan on reselling the puts or calls if appropriate after the release. I have bought back portions of my sold calls or puts this way and for this reason. However, I've never just gutted an iron condor by buying back all the sold calls and puts the day before an important economic announcement, planning to put them back on at the same or different strikes after the dust settles. Therefore, I can't speak from experience about the pros and cons of such a step.
I have, however, lowered the margin and, therefore, my risks, in other ways. For example, in addition to my small live butterflies, I've been paper trading a RUT butterfly for the purpose of testing various adjustments. I'm trying to stay at around $5,000 margin on this trade. Any adjustments that I make will have to keep that margin at about that level. It's easy with a butterfly, with FINRA forcing brokerages to stick to antiquated descriptions of a strategy, for a butterfly's margin to rise rather quickly with adjustments if the trader isn't careful, so I'm testing how well this strategy works. I don't have the experience trading butterflies that I do iron condors, so I'm still trying to keep my margin at a manageable level so that potential losses aren't emotionally difficult to handle. When traders hike the margin on a less familiar trade too quickly, the size of the losses that are of course going to occur from time to time can prompt fear-based, inappropriate decision making.
As we headed into last week's GDP number, I had a more than 8 percent unrealized profit on a much-adjusted, now-multi-layered RUT SEP paper-traded butterfly. The delta of the position was actually rather flat, at -0.40, but the gamma was -1.41, meaning that the delta could change unfavorably (since gamma was negative, not positive) rather quickly. The vega was -97.75, rather too negative for my tastes for the size of the position. Because various adjustments had overlapped each other, taking out parts of my original positions and first adjustments, the position was then as follows: -1 SEP 600 Call, +2 SEP 680 Call, -1 SEP 580 Put, +1 SEP 650 Put, -2 SEP 600 Put, +1 550 Put, and +1 SEP 530 Put. My margin was $5,055.50. The shape of the expiration graph was still approximating the characteristic tent shape of a butterfly's expiration chart, although it looked a bit more like a circus tent than a Boy Scout's tent.
Because the profit-loss charting system I use is proprietary and not yet available to the general public, I can't show you the profit-loss chart, but my position was right in the middle of the rough tent shape that was my expiration chart for the position. The little dot marking my profit was right at the top of the arching "today" line. That was good, right? Well, maybe not when you consider that any move, either direction, was going to take the position into an area of lower profit. Both the "today" profit chart and the expiration one sloped down from the profit available at that moment in time as the close approached that Thursday before the GDP number.
In addition, I'd been forced into many adjustments as the RUT had whipped savagely from one side to the other over the fifteen days I'd been in the trade. I'd accrued lots of commissions in relationship to the profit target I had set. The more adjustments I made as a result of a huge move the next morning, the more heavily those commissions were going to weigh on the position.
With that background, I wanted to reduce my risks going into that GDP number. Reducing my risks in this case meant that I wanted to lower the money, the margin or buying-power effect, at risk. This was a paper trade, but I wanted to trade it as I would a live trade. I started searching for ways that I could take off part of the trade and lower the margin, the maximum loss of the trade in case everything fell apart.
What I chose to do was to take off an iron condor that was embedded in my position. I did this by selling 1 SEP 530 put, buying 1 SEP 580 put, buying one SEP 630 call and selling 1 SEP 580 call. This left me with a put butterfly (+1 SEP 650 Put, -2 SEP 600 Puts, +1 SEP 550 Put), hedged by a long SEP 680 call. In taking this action, I realized $390 in profit, locking it in, and reduced the margin to $1,561.50, the most the trade could then lose no matter what happened with the GDP number the next morning.
The delta was still a modest number, the trade would still benefit from time decay, and the vega was now higher, at only -34.49 rather than the much more negative number it had been. I wouldn't lose as much of that unrealized profit if the RUT dropped precipitously and volatility jumped. The "today" part of the graph, when reset for the next day, showed that the trade wouldn't go negative, no matter how high the RUT bounced, and that my profit would likely remain steady within a standard-deviation move either direction. I was free to add back in to the trade after the GDP was released or if the trade would again need adjustments, an action I did take.
Without being able to show you the graphs as they developed, it may be difficult to envision what I did. To summarize, I reduced the trade to a hedged butterfly, reduced the margin at risk, and flattened the "today" chart so that I would likely keep all or most of my profit potential through a standard-deviation move.
Unfortunately, it's not always a case of locking in some of the profit when you're looking at what might happen the next day when an important economic event is due. Sometimes the trade is a losing one with a maximum planned loss quickly approaching. These steps are even more necessary in this case, however.
Since traders don't know how the release will read ahead of time and don't know whether markets will react with a buy-the-news or sell-the-news reaction even if they did know the numbers, there's not always a magic solution I can suggest or you can devise. For example, when examining his portfolio Thursday afternoon, a trader might have noticed that his SPX butterfly would need an adjustment if the SPX were to drop a standard deviation the next day, but the trade would move up into a bigger profit if the SPX were to gain a standard deviation. If that trader evened out all downside risk on Thursday afternoon, he likely cut the trade's ability to profit from the upside move that did occur.
There's no one-fits-all answer to these types of conundrums for options traders. The tradeoff for completely flattening the risks is that such action sometimes cuts the overall profit potential, adds capital, or stretches out the time until the profit target is reached. Smoothing out the delta risk, the risk due to price movement, may be optimal, but does a trader want to cut that risk all the way to 0.00, flattening the delta completely? Not usually, Sheridan would counsel, and I would agree. My primary trades are iron condors and butterflies, which are negative-vega trades. That means that they're going to be hurt by a rise in volatility. I don't want a flat delta in most cases. I want a negative delta to balance that negative vega. That means that, if markets drop, I'm at least benefitting from the price movement, while the likely rise in volatility is hurting the trade. If prices rise, the price-related move may hurt the trade, but that is in many cases offset by the beneficial effect of dropping volatility. TOS, OptionsXpress, and many fee-based or freeware charting platforms allow traders to view the effects of various adjustments in price and volatility on the "today" graph.
These are far from the only adjustments that can be made to reduce risk before a potentially market-moving economic release. For example, in trades such as iron condors, the hedging longs can be rolled in toward the sold shorts to lower margin and reduce risk. For example, if I have an SPX iron condor with spreads ten points apart, I can roll the long calls and puts in so that they're only five points away from the sold calls and puts. That action reduces my margin or buying-power effect, the maximum amount of money I can lose in such trades since I have a REG T account.
That action also, of course, reduces the profit potential somewhat, illustrating the no-free-ride decisions that must be made in such cases. The many permutations, the very flexibility of options trades that is so beneficial to us options traders, also makes it impossible to devise a one-fits-all suggestion. Set up paper trades and experiment with such graphs outside of trading hours or when you're waiting through a day when it's not optimal to trade. Follow paper trades through many such potentially market-moving releases so that you know how much you want to flatten risks and how much adjustment is too much adjustment ahead of such numbers. While your live trades should be your primary focus, try not to forget about such paper trades when you get busy. Your work with them may teach you how much adjustment works best for you and your strategies and how much is overkill.
I am still working through the after-effects to my confidence of not managing trades well in March. I tend to jump in rather quickly with adjustments, which of course means that I adjust more frequently, pay bigger commissions, and suffer smaller gains. Still, my ability to flatten risks ahead of known potentially market moving releases is keeping me trading right now, putting me back in that proverbial saddle. My way might not be the right way for you and your strategies, but my choices are meant to boost my confidence again and manage trades in a manner consistent with my personality and financial goals.
Whatever your personality or your mix of strategies, be proactive when a market-moving economic release is due. We have enough geopolitical or economic surprises to manage. Don't let a scheduled release surprise you.