This weekend's article will be short, and it will be early. I'm sending it out Friday morning rather than on the weekend so that options traders have an opportunity to think about how they'll approach the weekend if they have open trades.
We've seen many examples of emotion-based market action these days, with big up days and big down days alternating every other week since early in July. Such periods are dangerous for the option trader. I could show you charts, but what those charts tell me is that we don't know whether indices such as the SPX will climb back toward the early July highs or decline back toward the early June lows.
Whatever happens may happen quickly, so that's what this article will discuss. You'll have heard some of these suggestions from me previously, and some recently, but our circumstances right now warrant this reminder. I want to caution that I'm not trying to scare anyone but rather help traders think calmly. As you prepare for the weekend, I want you to be thinking about how you'll set your trades up for Monday morning. First, for those of you lucky enough to have profit in your positions, consider your choices when there's heightened risk of a big move without the direction of that move yet known. One choice I might consider is to lock in at least some of that profit and lower the risk in the trade. For example, if you have a four-contract calendar trade that's profitable, you might consider selling at least two or three of those contracts and locking in that profit. You're left with the possibility of making more profit and are also left with smaller risk in case the markets or volatility moves in an adverse direction for your trade.
What if your position isn't profitable? Your choice is tougher. I have a SEP SPX iron condor that isn't profitable due to a mistake I made entering an order. (Hint: when you're checking a trade order before clicking "Send," be sure you check where you put your decimal! It makes a huge difference!) You can bet, though, that I've already flattened out the Greeks of that iron condor so that it can weather a big move either direction without my account getting into dire trouble. I am doing that by buying in some of the sold options to keep the deltas slightly negative (about -10 to -18 deltas). This balances the negative vega status, in case volatilities explode. Doing this also lowers the profit potential in the trade, at least temporarily. I can resell those options or sell them at a different strike once I feel market direction has been determined. This tactic also requires a somewhat more active approach to trading iron condors, and it offers more opportunity for me to goof up. Therefore, I consider this an advanced technique that not every one will want to or should employ.
Some traders might elect to take off some of their contracts of a losing trade, just as they would with a profitable trade, lowering the risk still in the trade. This time, however, they're locking in a loss rather than locking in some profit. However, traders can then consider how to replace the trade when they feel that they understand the direction the markets will take. Again, no tactic is without risk, and the risk here is that markets will sit quietly all week next week, stalemated while debates continue in D.C. The theta-positive trades would have been gaining profit, although theta decay tends to slow if volatility remains pumped up due to uncertainty.
I've even known traders who control risk by buying in all the sold contracts, both calls and puts, with plans to replace them at appropriate levels after the risk has passed. You know your risk here. Vols might collapse, and you couldn't sell for nearly the cost you'd paid to buy them in. Another possibility is that when reselling, slippage would rob you of possible profit in the trade.
Other traders might control risk by buying a debit spread position in front of their threatened strikes, planning to remove that debit spread after the weekend passes. They don't anticipate much of a loss in the spread because buying a spread protects them somewhat against volatility risks. I don't often use this tactic, but I know plenty of traders who do.
Although I don't know the direction of the next market move and am not trying to scare subscribers, I don't think I'd go into the weekend without a catastrophe long put. I tend to buy OTM puts for this purpose when I first open my iron condors so I've already got mine, acquired before the volatility rose. If I hadn't already done that, I probably would be considering at least a cheap Weekly put. Depending on how your trade is set up, you might be concerned about the upside, but realize that if all is settled by Monday morning, the rapidly leaking volatility could sink the price of a call, even if markets rally. Some traders hedge with debit spreads to the upside, although that's a tactic that I don't often use, as I mentioned earlier.
What if your trade is on the edge of needing an adjustment but isn't quite there? I would adjust, at least partially. For example, I have a five-contract triple calendar in the SPY. If the SPY ends up at the edge of the downside adjustment zone and if my adjustment is normally to sell the upper calendar, I might sell at least two or three of those calendars. If it's on the edge of an adjustment but not there yet, I wouldn't make the full adjustment, though. I wouldn't sell all five contracts for the upper calendar, for example. That's because we don't know the direction of the next big move. It could as easily be to the upside as the downside, and a too heavy adjustment would put the trade in trouble more quickly with a strong rally.
What if you're considering entering a new trade? What if you assume that as soon as the economic releases were known this morning and then the debt crisis is resolved, all the volatility is going to come out of the market quickly? Maybe with such an assumption, you would normally want to sell volatility by opening a credit spread, iron condor or butterfly. Consider whether you want to do that before this particular weekend, and, if so, if you want to enter a smaller contract than you normally would under such circumstances. We've had several two-standard deviation moves over recent weeks. Those are hard to tolerate in a newly opened iron condor or butterfly, before theta has had a chance to work its magic on the trade and decay the costs of the sold options.
Here's the truth: no matter which side of the aisle you'd sit on if you were in D.C., no matter whether the decision made will be to your liking or not, no matter what your supposition about how market-friendly or -unfriendly you believe it to be, we don't know what the final reaction of the markets will be. It may be, as I suspect, that the attention centered on the debt crisis has somewhat masked concerns about a weakening economy, and those may come to roost once the debt crisis is behind us. It may be that even if the decision isn't made in a timely factor, earnings and economic releases next week will show that the concerns about the weakening economy were all for naught. Markets can sell on good news and rise on bad. We can have buy-the-rumor/sell-the-fact reactions and can have the opposite. A strong relief rally can be fueled by short covering, only to collapse within days. Prices can cascade lower, only to quickly reverse.
In a summer trading environment characterized by lots of uncertainty, we must admit that we don't always know what will happen next. I still think it's important to create a scenario for yourself that you can test to see if your premises are correct and make quick adjustments if they're not. However, the best thing to do right now is to consider how much risk you want to take into the weekend.
Then, go and have a calm weekend. I intend to do so. In a few hours, grandchildren will arrive for a movie night. Tomorrow, I'll go to a grandson's birthday party.
Whatever you do, don't talk about politics.