This article will be short and not too sweet. I'm giving away my age with that reference to the campy 1960s television series, "Lost in Space." I may be giving away my age by being a worried fuddy duddy, too, but I'm enough of a motherly and grandmotherly type that I worry more about the well-being of others than about how others perceive me.
My warning is not so dire, anyway, and more of a caution than a warning. It's this: any time the VIX and RVX, volatility indices for the SPX and RUT, have sunk into the zones they occupied as of the middle of February, I grow more cautious. I start thinking in terms of what might happen next with those volatilities and how that will impact my options trades. Newbies to trading need to be aware that the SPX and RUT mostly move in opposition to their volatility indices, although that's not always true.
Weekly VIX Chart, As of February 11, 2011:
This chart shows that the VIX had approached an area from which is has several times found support. If the chart were widened to include several more years, that same area of support tended to hold in late 2007 and into 2008, although the VIX sank lower in early 2007. When the VIX reversed from these levels of support, equities markets tended to reverse from their previous rallies, too. The volatility indices are not good timing tools, but they can tell us when we might consider being more cautious in our trades.
The RVX, the RUT's volatility index, shows a similar setup, so it doesn't need to be shown here. Do I know that this support level is going to hold this time? No. As I type this on Sunday, February 13, 2011, do I know that equities are about to reverse. No. Am I scared? No. Will I stop trading? No.
However, out of the past, I'm hearing that robot calling, "Warning, warning, Will Robinson!" I tend to think in terms of probabilities and what's most likely. What's most likely is that, at some point, these volatility indices will bounce or go sideways and that equities will either reverse or go sideways, and that time is growing closer. The "go sideways" scenario wouldn't cause most of us too much angst, although it can cause consternation among momentum traders. It's the other scenario that's troublesome.
If you've been trading options less than two years, and especially if you've been trading options six months or less, you might consider some of the following tactics that I employ in situations such as these.
I may trade smaller. I'm currently scaled way down on my typical size of iron condors. If I'm in full-size trades and there's any profit in them, I may elect to exit part of the trade and lock in profit on that part while limiting my risk.
I may alter the composition of my trading portfolio. Although I'm not a huge fan of calendars, I will be diverting some of the money that normally would be risked in negative-vega trades such as iron condors and butterflies into the positive-vega calendars.
I may buy some put insurance, either for specific trades or for my portfolio in general. With iron condors, for example, I almost always buy put insurance when I first put on the trade. In this environment, I'm even more careful about doing so. I spend about 10-15 percent of the credit I collect on an iron condor on long puts. I prefer these long puts to put debit spreads for insurance.
Right now, I may even unbalance my iron condors, although that tactic has risks. I may sell more call credit spreads than I do put credit spreads. I could sell five-point credit spreads on the downside and 10-point ones on the upside, although that's not often something I do. Either way, I take in less credit and most of my risk is on the side of the trend, so this seems a backward way of doing things. However, as experience has taught me, managing iron condors can get ugly on a strong downside move. The expansion in volatility widens the value of the spreads, so the debit to exit a going-wrong put credit spread may be a lot bigger than the debit to exit a going-wrong call credit spread. One of the cons in unbalancing iron condor include that smaller premium, so that adjustments become even harder without that premium against which to balance the cost of adjustments. In addition, some brokerages treat unbalanced iron condors as if they're two separate credit spreads. Be sure you understand your brokerage's treatment of an unbalanced iron condor before you set one up, especially if you have a small account. You may be using up more margin than you thought you would, which can also limit the number and type of adjustments you can make.
I will be hyper-vigilant about the delta value of my trades. Downside moves, if they gain momentum, can barrel through stops, erasing days or weeks of gains. Especially if a trade is a negative-vega one, I don't want to let that trade get too high in positive deltas, and would prefer that it stay slightly negative delta. That way, if the markets should roll over and volatilities expand, the benefit of the price movement will help alleviate some of the pain caused by the expansion in volatilities. The gains from the price movement help offset the losses from the expansion of volatility.
Am I trying to scare everyone? Not really. We often have subscribers relatively new to options trading or experienced traders who have been successfully trading a new strategy for a number of months. A change in market conditions can radically change the trading outcomes. It pays to think in terms of being careful when potential turning points are approached. Consider whether you want to take some of the precautions I've outlined.
As I roughed out this article last weekend, I was looking at an SPX that was still bouncing from the 9-ema or 10-sma, whichever you watch. All skies looked clear ahead, so I'm certainly not making predictions of doom and gloom. The VIX did bounce on Friday, February 18, but it's in a congestion zone, and could as easily drop back down to support as climb higher. However, I always, always start being defensive when I see the volatility indices approach the levels they've just approached. Sometimes that defensive posture is needed and sometimes I'm left standing in a moon-like landscape together with Will Robinson's worried robot, my shoulders hunched against an imagined enemy, while happy traders romp past me on their Land Rovers and charge forward with trades that never get into trouble once. Me? I'm comfortable moving into a defensive posture a little more often than I need to do so. Instead of scaring me, it reassures me and keeps me trading, as I did this last week. You decide whether you want to heed that warning and hunch your shoulders a little, too, just in case.