Market and Strategy Guide and Q & A
I have been receiving a number of questions in the last few weeks about what strategies work best in the current market environment. I think it’s important to remember that certain strategies ONLY work in HIGH Volatility (as represented by the VIX) and certain strategies works better in LOW Volatility environments.
When I say “High Volatility and “Low Volatility” as represented by the VIX it’s all pretty much relative however anything over 40 in the VIX would be considered “High” and under 40 is “Low”. But even then you have understand that a 30 VIX that is trending *higher* might only be useful for high vol strategies and a VIX of 45 that is trending down would be the ideal time for Low Vol strategies…
What strategies do I recommend based on the VIX? Here’s a quick guide on when to initiate a position based on the current VIX:
VIX above 40 and trending higher: Victory Spreads and Theta Scalping (using Calls, not Puts for credits).
VIX below 40 and trending lower: Calendars, Iron Condors, Put Vertical Credit Spreads, Call Debit Spreads, Theta Scalping.
VIX moving in a range between 25 and 40: Double Calendars, Iron Condors, Diagonal Credit Spreads, Vertical Credit Spreads
VIX Under 25: Gamma Scalping, Put Debit Spreads (if you think the VIX will go up) , Call Debit Spreads (if you think the VIX will stay this low), Put Calendar Spreads (Victory Spreads in anticipation of a VIX move higher.)If you follow the above guide it should keep you out of trouble as long as you use good money management.
The questions below may help you. They were submitted by one subscriber and many of the questions are the exact same one’s others have asked me as well and some are unique. So I am hoping that they will answer your questions as well.
It’s important to keep in mind that we are in historic territory here with regards to the markets (as of 11/22/2008). You cannot use history of other time frames in the market as a guide. I know – it would be so easy to do so, but no one can know the future. It might be the same or it might be different. Who knows for sure? No one.
Market history is being written day-by-day. Many commentators have said how much this is like 1929 or 1987 or whatever. The players, the circumstances the financial markets, technological changes are different this time but one thing remains constant: Human behavior. When people are scared, they sell. When they feel good about the future and are hopeful, they buy.
I found a really excellent video series on how mass ‘moods’ affect the stock market. It’s really interesting… whether it’s true or not I will leave to each person to decide for themselves. As a information marketer and trader of stocks and options much of what they have presented rings true. People buy based on emotion – whether it’s stocks or the latest marketing course. When fearful, they either sell or do not buy anything even if what is being offered is the deal of the century. In a report I did back in 1999 I said that “People buy based on emotion, then justify those purchases with logic.” The same is true with the stock market – the only difference is that it’s also easy to sell in the stock market not so easy to sell that marketing course you bought for $2000 a few months ago even though you might like to. People sell when they are afraid of the future, they buy when they are hopeful about the future.
The markets are a mirror of the mood of all participants in the market.
Anyway, I encourage you to signup for a free account and watch this video series – it’s free and I think you find a lot of value in it:
http://www.socionomics.net/sociosignup/ The video series is called, “History’s Hidden Engine”.
Here’s the Q& A I promised. Let me know if you need any clarification on any point. If so, send me an email and I will include them in this Q&A or answer them in my Daily Review videos.
================ Q & A ==================
QUES: 1. When doing Calenders do you always use 2 month out option on the long side or you go long 3 or more months out options like some people teach going out 6 months or even a year out while selling front month option on the short side?
ANS: #1) I don’t always use the 2nd month out, as I mention in the videos it depends on the Implied Volatility skew.
For example. If the front month Vol is 22% and the second month is 33% that is a negative skew which I avoid at all costs. If the front month is 50% and the 2nd month is 45% that is a positive skew and while it’s not ideal it’s ok. So for example if the first month in 50% 2nd month is 45% and the 3rd month is 25% then I’ll write the first month and buy the 3rd month. I usually do not like to go beyond the 3rd month because what most people who do these and/or teach do not understand is that the father in months out you go the less delta you buy for protection so your risk is much greater than you might realize – the only exception to that is a Leaps strategy where you are buying a long-term Leap and then writing calls against it every month until your Leap expires. But that is not a Calendar spread… that’s a different strategy altogether and has different risks.
QUES: 2. When doing adjustments with calenders how do you decide how many more calender contracts to buy to expand your profit range and do you buy only call calendars on upside adjustment and put calendars on downside adjustment or do u do both call an put calendars whether it is upward move or downward move?
ANS: #2) That’s a good question. It depends on 2 things:
1) How much risk you’re willing to take, and
2) How many contracts do you need to buy in order to maintain profitability and achieve your objective of making a “good adjustment” on your position… I try to balance the number of contracts with the profit picture so that I make a reasonable adjustment that makes sense when I look at the profit picture after the adjustment is made.
Using Puts or Calls depends on the trend of the stock. Is it going up, down or sideways? As you know Call Calendars make money when the stock rises to your short strike and Puts make the maximum money when the stock falls to your short strike as well so if the stock is in a down trend I would rather adjust with puts to give me a greater probability of profiting in a down market, if it’s in a sideways move I would do a Double Calendar, etc…
QUES: 3. With theta scalping where you adjust going long or short underlying stock it seems that adjustment comes at the wrong time when stock is bottoming u go short and when it is topping you go long? how do you address these circumstances?
ANS: #3) You are correct… that is exactly what happens. That’s what’s supposed to happen in theta scalping.
Your objective is NOT to make money on the stock purchases when theta scalping- your objective is to make money from the daily decay of the options you’ve sold. The goal is to adjust stock as infrequently as is possible to avoid a loss on the stock while at the same time trying to stay delta neutral to take full advantage of the daily decay of the option by collecting the maximum theta possible. You WILL lose money on the stock in most cases but the goal is to more than make up for the loss through option decay.
This is one of the more difficult ways to trade because it’s counter-intuitive. You lose money on stocks to make money on theta decay.
I like this strategy so much I am creating a few new videos on it that go into more depth as well as some advanced strategies.
If you want to make money trading the stock you should look at “gamma scalping” instead -however gamma scalping in a high volatility environment like now (when the VIX is over 25) is suicide.
QUES: 4. Are you still doing market neutral iron condors and double calendars under current once in a century type of market volatility?
ANS: #4) NO! As mentioned above, it’s too risky. For those who are just starting out with the course I have NOT recommended these strategies in several months. Once the Volatility as represented by the VIX went over 45 I stopped those types of trades – they are just to dangerous!
The only strategies working really, really well in this this environment are the Victory Spreads and “directional” Theta Scalping.
More on ‘directional’ Theta Scalping in future videos. But several subscribers sent me emails saying they are making a lot of money using the Victory Spreads. Here’s one email:
“Hi Dave, I am really excited about the victory spreads I have been doing on the qqqq and xlf the results over the past couple of months have been astounding. Is there anything I should be aware of, it seems to good to be true. Thanks, John”
The only caution I gave John is that they will probably not work as well after the VIX starts coming down and is under 40 again.
When the VIX is coming down and is under 40 it’s time for Calendars and Iron Condors again.
QUES: 5. What percentage of account equity should be allocated to this kind of strategy ( iron condor & double calenders) and theta scalping if I want to make lets say 5% monthly return on my entire account value? 20% of equity or less?
ANS: #5) Good risk management states that you should put cash or margin of less than 10% of your available capital in any one position. If you have a $30,000 account you should not risk more than $3000 in margin on any one trade. If you’re a bit more experienced and know how to manage you risk it can be more, but that’s what I recommend. But it does not mean you have to trade 1 position- you can trade several at a time but each position should not exceed 10% of your capital in margin. You should also set maximum losses stops as well accordng to your risk tolerance.
QUES: 6. Is it possible to construct delta neutral and gamma neutral but theta positive option strategy?
ANS: #6) Boy – that would be the perfect opportunity wouldn’t it!!? You would not have to worry about gamma moving your delta’s around – all you do is sit back and collect theta! The perfect trade! Unfortunately a trade like that does not exist. But I like the way you think
You can create and maintain a delta neutral position but you cannot create BOTH a delta and gamma neutral position in the time periods when it makes the most sense to place a theta positive position on. The gamma is the rate of change of the delta – there’s no way to neutralize the gamma – gamma increases the closer you get to expiration. That’s why Gamma Scalping works so well in low vol environments. So remember – gamma doesn’t move much the father out in time you go and increases rapidly the closer you get to expiration.
So if you wanted to be ‘neutral gamma’ you could buy options that are farther out in time (like 6months to 1 year), but what’s the purpose? If you wanted to profit from the theta decay by being delta neutral, well guess what? The theta decay is minimal the father out in time you go with your option writing. So you’ll have very little ‘gamma risk’ but you’ll also have very little time decay working for you.
In order to maximize theta decay you have to sell options – I’ve found that 50 to 40 days prior to expiration is optimal. Anything father out than that will be very slow to decay and expose you to a longer period of price risk without the reward.