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.
Director, SMB Options Training
The SMB Options Training Program is a twelve month 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].
You don’t mention whether the trader uses a limit stop or a market stop. Both are difficult to sue with options. Thus, I ask, how does your trader use stops?
A market stop order is not acceptable due to the wide bid ask spreads.
If it’s a limit order, how can he be certain it will be filled and that he will truly exit the trade.
Mark, that’s a complicated subject. Some traders have very elaborate systems for attempting to set limit orders and then a “fail-safe” market order. Most of the time the trader’s limit order gets filled, although rarely the “fail-safe” gets triggered. You, of course, can not be certain the limit order will get filled, thus the backstop is necessary.
Can you tell us about about some traders who have elaborate systems?
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