August’s expiration is now behind us and we can turn our eyes toward September. Before we do, I thought it would be helpful if we turn our eyes back and review what happened between July 15th and August 15 in these rather volatile markets.
On July 15th, the DJIA hit a low of about 10,828 and rallied from that point to close friday, August 15th, at 11,660. That was an 832 point run, or a nearly 7.7% rise over a 30-day period. Impressive.
The lumbering S&P 500 marked a low of about 1,200 on July 15th, then rallied from there to close at 1,298 on Aug. 15th. A nice 8% pop!
How about the NASDAQ? Well, NDX had a low, also on July 15, of 1,761 and rallied to 1,957. That amounts to 196 points, or an 11% gain. Holy mackerel!
Get this, though. The RUT notched a low of 647 on July 15th and closed Friday at 753, for 106 points of upside gains. That’s more than 16% in 30 days!
Great news, right?
Well, before we continue our celebration I want to share with you what I’ve read in e-mails and posts from our message board. A lot of our members like to trade vertical credit spreads and/or iron condors on the indexes. I happen to be one of them...
There have been a lot of reasons to be bearish this month. I recently read in IBD, for the first time since I’ve subscribed to the paper, the word “stagflation” being used in the present tense. The dreaded condition of a stagnating economy and rising inflation, that we have not heard since the 70’s...
Jobless claims are up, consumer sentiment is low, the economic stimulus tax rebates are now memory, Georgia and Russia in open warfare, and the Chinese have more gold medals than us...signaling the decline of U.S. dominance in the world. The point is that if you were thinking about selling bearish call spreads a month ago, there was plenty of bad news out there to support your thinking.
Now, when the market began to rally the initial thought we all likely had was that this was that this was going to be another bear market rally off a relative low. To be expected, no doubt. A great opportunity to sell (more) call spreads!
Did I sell call spreads? Sure, I did.
But then the market kept on rallying. No matter, because there was little positive news out there supporting this rally so it will reverse any day now, taking pressure off my short calls. Sound familiar?
Yet, the market kept pushing higher...
If you had sold those call spreads without first establishing a defined trading plan, it is likely that you had an internal debate with yourself for much of the last 30-days. It probably went something like this...
July 23 - Wow. My short strikes are really under pressure. Should I roll? This rally can’t continue. I’ll hold on, wait for a pull-back and let theta do its job in the interim. Hmmm.
July 24 - Ah hah! We’re selling off. I knew I was right to hold on, and now we’ll head lower and I’ll keep my credit.
July 28 - Another down day. I knew that rally wasn’t going to hold. I should have sold more call spreads before it rolled over.
July 30 - Hey, yesterday took back all of those losses and today we’re up again. We’re supposed to be going lower. I hope that this market stays put because I really don’t want to have to roll my 740/750 call spread.
Aug. 4 - Oh, good. Selling off...
Aug. 6 - Oh, no. Another two up days. I’m no less than 15 points from my short strike. Maybe I should roll up, but I can’t get enough credit at the higher strike to offset the cost and I’d have to take a loss this month. Hmmm. I know this market is going to roll over and when it does I’ll have already taken the loss. Maybe I’ll just watch things because I know this market is going to start selling off.
Aug. 7 - Yes! We’re down, going down, oh yeah! Tomorrow’s Friday, it will be light, I’m sitting on this over the weekend and Monday I bet we’ll see it sell off some more.
Aug. 8 - Yikes. This can’t be right. Just 6 points away from my short strike? Okay. Um. Roll? Geez, why can’t this market just sell off for a couple days and give me a break here. This spread is far to expensive to buy back right now. It’s Friday. The weekend is two days, which means I just have a few days to survive next week until expiration. Theta is going to really be sucking on this spread. Oh, man. Maybe I should just buy it back. I’ll think about this over the weekend...
Aug. 11th - Oh, crap! Two big up days. I’m in real trouble, now. My spread is now in-the-money, where I never expected to be. I should have adjusted when I had the chance. What do I do now? Well, this market has to pull-back now. Maybe that was a climax run and it will all roll over tomorrow...
Aug. 12th - We’re down, just a bit, but at least we’re down. Still a little in-the-money, but with a little more selling tomorrow this whole trade might turn around for me.
Aug. 13th - Started lower this morning, but closed a bit higher. Just two days until expiration. This is a big mess. How’d I ever let my spread go in-the-money. Why didn’t I roll when I had the opportunity. Maybe if I post on the OptionClub message board, one of those guys could help me out...
“Dear Discussion Board, I sold an August 740/750 call spread on the RUT and it’s now at 747. What should I do?”
...I hope someone can help.
Aug. 14th - not much help on the discussion board...they just keep replying to tell me I should have had a plan...follow the plan...too bad, so sad... I need the market to reverse. Today’s the last day I can trade. Should I sell the spread and just take the loss? Maybe we’ll sell off in the afternoon. Let’s see... Oh, no! The RUT’s now above the strike of my long contract...my spread’s totally in-the-money! I can’t get out. I can’t afford a max loss. Maybe there’ll be some selling at tomorrow’s open. Yeah, I bet a lot of traders will want to take the profits before the weekend, so tomorrow’s open will be lower and the RUT will settle lower. Maybe it’ll even gap down a bit, maybe there’ll be some really bad new before the market’s open. It could happen. Man, I hope something happens...
Aug. 15th - Oh, no. The RUT’s settlement value is in...765! Disaster...
This chronology was a little work of fiction on my part, but for some, perhaps even you, it sounds uncomfortably familiar.
What went wrong?
The problem that occurred had nothing to do with the market, or even the selection of the 740/750 strikes for the vertical spread. It had a lot to do with that internal conversation our fictional trader had with them self, rationalizing their way out of taking a loss when the market rally materialized, instead hoping for a reversal to save their trade.
There are very few people who can make well reasoned decisions under pressure. That is why athletes, the military, law enforcement, etc., all train and respond according to predetermined plans of action. If
X happens, then I do
Y...
It also had a lot to do with a fundamental failure to understand what was happening with that vertical option spread. Once the credit spread was sold, theta was the primary driver behind our profitability. That positive theta needs to be balanced against negative gamma, though.
Holding the position into the days leading up to expiration, with the market closing in on our short strike, left our trader in a very vulnerable position. They were no longer in control of their risk, but relying on hope and prayer that the market would "give them a break."
This is where options tend to get a bad name. Someone puts on a large short position and gets bush whacked by the market. Let's blame the options. They're too risky.
Options are not risky, though!
It's no different than blaming the hammer for clobbering your thumb. So, hammers are dangerous? They are if you use them carelessly. Otherwise, they are very useful tools.
So are options. In fact, options were created to
reduce risk in an investment portfolio. The problem we faced above was that our trader was so focused on earning an easy profit, they forgot about the risk and then failed to take steps to manage it once the trade started going against them.
Tools, hammers and options included, can be dangerous when you do not know how to use them properly. Understanding how options work, understanding option "
greeks", understanding things like synthetic and embedded positions, becoming adept at position adjustments, etc. These are all part of trading options and if you're a little uncertain about one or more of these subjects, then it would really pay to spend some time studying those areas where you have questions.
You might consider taking a few moments right now to watch a video that demonstrates how options can be used safely, intelligently, and effectively for investing and trading.
Trade well,
Christopher Smith
TheOptionClub.com
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