I had an interesting meeting yesterday evening  with SMB’s options trainees  reviewing yesterday’s meltdown and the affect  it had on their options positions.  We spent the whole meeting dissecting trades that the options trainees had made during the day. breaking down what went right and wrong with each one and why.    It was a great meeting–real traders faced with the real issues that impact options spread traders on monster moves like yesterday’s historic sell-off.  Day’s like yesterday are rich with lessons that we can all draw from.

One of our trainees, Rob,   unable to trade manually while the market is open 95% of the time due to the nature of hisjob. He must operate through contingent orders placed with his online broker. This trade  management technique can work fine, but it takes some extra work, care and analysis.  Yesterday, Rob placed a stop order on one of his  iron condor positions assuming that his stop would be hit when the $OEX index hit 545. The dollar loss that would have resulted according to his analysis was within our guidelines  given the success rate and average gain that is typically made using this trading technique over the course of a year.

Unfortunately, by the time  his contingent order was actually triggered, Rob’s trade had exceeded, somewhat,  the acceptable loss level.   Rob was interested in why his analysis was apparently inaccurate.  The answer was simple, but not obvious on the surface.

An iron condor is a negative vega trade.  In English,  that means it responds well to drops in volatility and poorly to increases in volatility. Well it just so happens that yesterday’s meltdown generated  the sixth largest rally  in the history of  the  $VIX. Needless to say, when Rob was analyzing where to place his stop, he did not consider that to be a very likely outcome of the trading day.

So as a group we went through the process of how to incorporate bumps in implied volatility in a sell off into the analysis process for setting up a stop on a negative vega trade before the market opened. It turns out  that the stop, with reasonable volatility assumptions would have actually been five points sooner than Rob had anticipated. We then went through a simulation together of that actual   trading day using that volatility  assumption and, sure enough,  the stop would have occurred about five points earlier–saving Rob some money.

So the lesson is this: when setting stops on options spread trades, you must not only consider  the amount of the move on the stock or index  that you are trading, but the likely change in volatility which  that same move would bring about   in the implied volatility of the entire position.

This is a  really important issue  and can make the difference between a timely stop and blowing well past a tolerable  level of loss.

Seth Freudberg

Director, SMB Options Training

The SMB Options Training Program is a program designed for novice and intermediate level options traders who are seeking an intensive training process to learn how to trade options spreads for monthly income. For more information on this program contact Seth Freudberg: [email protected].