Author: Clinton Lee.
Contrast these 2
days. 29 Sep, 2008: Dow down
-7.50%, Nasdaq down -10.06% and S&P 500 down -9.63%. Versus 13 Nov, 2008: Dow up +6.25%,
Nasdaq up +6.11% and S&P 500 up +6.47%.
Many retail option
traders would have rushed to get their spreads filled on such big days, either
to get short or long. The
discerning few, mindful that a +/- X% change in equities, is a day to avoid
entry; instead, it is a signal to scale-off profits or reduce exposure, would
have profited or limited losses on such days.
Here’s the logic
for categorizing what type of day it is. If you theoretically priced a long
Calendar or a short Iron Condor on a Big Day - be it up or down, it is likely
the product’s price has moved near or outside 1 Standard Deviation, even if the
order was filled at mid-price for that spread.
The following day,
if conditions turned into a Dull Day be it up or down, let’s say the Futures
did not even move more than a third within 1 Standard Deviation. On the extreme day when you priced the
entry, even though you were filled at mid-price, you still overpaid for the
Calendar; or, sold more Theta as premium than is necessary to protect the wing
span of the short Iron Condor, possibly increasing the risk of Gamma
instability. Alternatively, if you
priced a directional spread on a Big Day, be it a Short Vertical or a Long
Vertical you need a continuation in extreme days - after the Big Day that you
filled the order on, for price to move.
If price has
already moved 68% (1 Standard Deviation) on a Big Day, moving towards 2 or 3 Standard
Deviations is not the problem. The
issue is – can the price action sustain a 2 or 3 Standard Deviation move day
after day, after the extreme day? It’s not an impossible event, just an
infrequent occurrence.
Pricing spreads for
entry under extreme conditions, places huge pressure on your orders to
outperform.
That’s a tough way to trade. You are punishing the Profit and Loss of the trading account
unnecessarily. Psychologically and
visually, continually entering trades on Big Days makes you search for “magical” chart patterns for another
huge breakout or breakdown in price.
No, you won’t go blind.
Though, you will cultivate a trading habit that must be broken, if you
plan to have consistent results with online options trading.
So,
how do you work out the X% change, be it up or down to differentiate a Dull
Day, from a Normal Day versus a Big Day? Use the implied volatility of the front
month’s options on the DJX, MNX and SPY – the mini versions of the Dow, Nasdaq
and S&P 500 respectively, to categorize the market ranges of the day. For
example, take the:
❑ DJX: let’s say, the front month
volatility is 27.38%, divide 27.38% by 16 = 1.71%. That’s +/- 1.71%, meaning IV
representing the collective expectations of market participants trading that product,
expect the DJX to move 1.71% up or down for that day. Your trading platform
should allow you to add a column in the watch list called “%Change”. That’s what we’ve just calculated. So, a %Change below +/- 1% is a Dull
Day. A %Change between +/- 1% to
+/- 2% is a Normal Day, take the lower whole digit of the calculation, in this
case 1%; and, the higher whole digit of the calculation, in this case 2%. A move of +/- 2%, would be a Big Day
Up/Down for the DJX. Even though
the DJX is the mini version of the Dow, because we are using a % calculation
versus an absolute number, applying the meaning of +/- %Change remains valid
for the Dow.
❑ Repeat for the MNX: say the front
month IV is 30.73%/16 = +/- 1.92%.
Dull Day for the MNX is where the %Change is below +/-1%. Normal Day for
the MNX is where the %Change is between +/-1% to +/-2%. A %Change number bigger
than +/- 2% is a Big Day for the MNX.
Same +/- %Change applies to the Nasdaq.
❑ Repeat for the SPY: front month IV is
31.25%/16 = +/- 1.95%. A Dull Day =
%Change below +/- 1%. A Normal Day =
%Change between +/- 1% to +/- 2%.
And a Big Day = %Change bigger than +/- 2%. Same +/- %Change
applies to the S&P 500.
You can apply this
calculation to the VIX, or any optionable product that you have identified a
trade on.
Why divide the
front month’s volatility by 16? As
you know, volatility is expressed as an annualized number. So, to get the daily volatility number,
we divide it by the square root of the number of trading days in a year, which
is 256 (rounded off). There is no
trading on weekends and exchange holidays, because prices cannot change on
these days. There are some years
with more or less than 256 days, but using 256 is the norm. The square root of 256 = 16.
As part of your pre-market
preparation, calculate on a spreadsheet the market ranges of the day (Dull,
Normal or Big) for the DJX, MNX, SPY and the VIX at minimum. This is not to
pick direction, as you will not know if the market will open to the
upside/downside and STAY there, even if futures indicate an upside/downside
bias. The calculation gives you a measured gauge, once the market opens to see
if the trading range of the day is leaning towards a Dull, Normal or Big Day.
Then, assess if it makes sense to theoretically price a spread, be it a
Calendar, Iron Condor, Vertical, etc.
This guards you from chasing price near 1 Standard Deviation, to get
your orders filled on a Big Day.
Doing this pre-market work, determines if you will be filling orders or
scaling off for profit; alternatively, reducing exposure to losses, when the
market opens.
Want to see a consistently profitable portfolio that prices
entries on Dull/Normal Days but takes profit/limits losses on Big Days, at
work? View Consistent Results, to
see a retail online option trading portfolio that practices this daily
discipline.