Managing risk variables you didn’t know you could control—lessons learned in 2016 about direction, time, and vol, and what mistakes to avoid this year.
Well, 2017 is here. And it’s still a never-leave-the-house world (worse, actually). Your cat litter comes from, well, the cat litter place. You can get pizza at 5 a.m. if the bourbon wears off. Your shaving cream comes from your fav online retailer. Who needs outside? When it comes to trading in your pajamas around the clock, pretty much no one.
Don’t know about you, but for me, 2016 was at times a ride. Sometimes the market direction was confounding, or time went by too fast, or time drove me nuts and went too slow, or vol was in the basement for long periods but screamed higher often enough to keep me honest. Rather than being a deer in the headlights, I could often zero in on a platform to get some needed answers (the thinkorswim® platform was often a lifeline). Here are three lessons for what not to do in 2017, courtesy of 2016 and some of the blunders and challenges the year delivered.
In 2016, the market rallied relentlessly for a while. But that rally was mixed with some sell-offs that, while you were living them, could have been the start of a crash. Remember Brexit? Whoever said hindsight is 20/20 must have been a trader. Because a crash can only be identified after the fact. But what’s a “crash” anyway, besides being a big drop in the market? Is “big” a 5% drop? 10% drop? 20% drop?
Without getting too Zen, a big drop is one that creates losses on a long portfolio that are too large for your financial situation. A 10% drop in the $100,000 portfolio of someone who is living off that money in retirement is $10,000 that will be tough to replace. A 20% drop in the $5,000 account of someone who has other assets and a good job is $1,000 that could easily be replaced. So, a crash is in the eye (or account) of the beholder.
In practice, when the market is down for a given day, you don’t want to be scared out of a position. If you need to close positions for risk or margin purposes, do so wisely and base it on logic. Every night, fire up thinkorswim, go to the Analyze tab, and beta-weight your portfolio to an index that you feel represents it best, like SPX, NDX, or RUT.
Look at the Risk Profile (see Figure 1) and explore the profit/loss line for the following day. It’s there by default. Run your cursor over the live P/L line where the losses are. Look on the vertical axis to identify the loss that’s too big for you, then look at the horizontal axis to identify the index price where that loss might occur.
FIGURE 1: WHAT’S YOUR RISK PROFILE?
This graph helps you figure out how much loss you can expect in a trade. Below the horizontal zero line in the middle is your loss. Above the line is your profit. Is the loss too big for you to handle? If so, come up with strategies to better manage risk. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Remember, the P/L numbers are theoretical values, so you may not see the exact same P/L if the index reaches that price in the future. But these numbers are a good estimate on which to base your risk management decisions. In a word, have your risk management plan in place. If you’re holding mainly long stocks, then you could consider managing risk by buying index puts in a quantity that could potentially create profit. This would reduce your theoretical loss to an acceptable level if the market does crash.
If your portfolio is composed of short strangles or short puts, the short gamma of those positions is going to “manufacture” positive deltas as the market sells off. That’s not good. You may consider buying out-of-the-money (OTM) puts against short options to reduce the short gamma and make a sell-off less scary. At what strikes, in what quantities, and at what index levels you’d buy those puts, is something you can simulate on the Analyze page. Use it. Make it yours.
When you’re long and you’re wrong, every minute of a sell-off can bring a wave of selfdoubt. And in 2016, bearish positions made you feel that way. Bullish or bearish, when a trade is losing money, you often contemplate how long to hold the position. More time can bring a favorable move in the stock price, which could save you, or you might see a continued unfavorable move that could create bigger losses. You scratch your head. It’s true, traders need to be proactive.
Yes, you could have exited a losing trade and moved on. No argument there. But what if your opinion of the long-term direction of a stock or the market hasn’t changed? Think of having been bearish in 2016 as the market went higher. It hurt.
One way to reduce the pain would have been to finance that longer-term bearish position by selling OTM puts against negative deltas. If you were bearish, for example, and were long puts in a further expiration, selling OTM puts in a nearer expiration would have been one way to finance them. The short put with fewer days to expiration would have had higher positive theta, all things being equal, than the negative theta of the long put. If the short put expired worthless, it potentially improved the breakeven point of the long put. It let you hold that bearish position longer.
Traders pay their bills with trading profits. The bills come every month. A long-term directional strategy might take a long time to pay off. Attempt to create smaller, short-term profits to stay solvent, and give your longer-term positions time for potentially larger profits.
Look on the Trade page to find options to sell. Drill down into the nearer-term expirations, and find the OTM options that have a good balance of premium versus theta. Compare the premium to the price you paid for the longer-term position. How much premium improves the breakeven point? The decision isn’t whether to give a trade more time. It’s whether you can collect enough premium to make a dent in the breakeven point. You want to still cover commissions by looking at further OTM options that have a higher probability of expiring worthless, than closer-to-the-money options that have higher premium but lower probability of expiring worthless. That’s the decision a trader has to learn to make.
Yes, 2016 was a year when volatility imitated a whack-a-mole game. Look at the VIX. The times it stuck its head up, it was often knocked back down. The year was a good example of the inverse relationship between the market direction and volatility direction. The market dropped, and the VIX popped. The market rallied, and the VIX … what rhymes with “rallied”? Traders know higher vol isn’t a bad thing. It raises option prices and can create more flexible strategies. Overall, for long stretches of 2016, that wasn’t happening.
When vol is low, we might have a tendency to get bored and experiment with trading styles we haven’t thought through. Like scalping futures or stocks. Unless you’ve proven to yourself you can be profitable scalping, it’s not smart for an option trader to abandon those option skills just because vol is low. Instead, know what vol is. Adjust your strategy for a stock or index based on it, or find a different stock or index with a higher vol.
For example, are you bullish when vol is high? If so, a short put could be a possibility. Are you bullish when vol is low? In that case, a long call vertical might be worth considering. Alternatively, maybe you love trading ABC when its vol is high, but it’s not high right now. Maybe XYZ has higher vol and you can trade your high-vol strategies in that stock. But what’s high or low volatility? Funny you should ask.
Log on to thinkorswim and check out the “Today’s Options Statistics” at the bottom of the Trade page (Figure 2). Open it up and you’ll find all sorts of volatility goodness. Look at the “Current IV Percentile.” That compares the current overall implied volatility (IV), which you can also see, to the 52-week high and low IV numbers. IV percentile would be 100% if the prevailing IV were at its 52-week high, and would be 0% if the prevailing IV were at its 52-week low.
FIGURE 2: IT’S ALL RELATIVE.
“Today’s Options Statistics” displays all sorts of vol stats —52-week implied and historical vol highs and lows, IV percentile, HV percentile—all helpful for figuring out if vol is high or low. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
So the IV percentile can tell you if the prevailing IV is high or low for a specific symbol, and that can tell you whether you should consider adjusting your strategy. But what if you want to find another symbol with a higher IV percentile?
If you go to the MarketWatch tab and load up a watchlist of symbols, you can change one of the columns to IV Percentile (Figure 3). Then you can sort the list by ascending or descending IV percentiles. To find it, click on the little gear icon in the upper right-hand corner of the MarketWatch tab and select “Customize.” Then scroll down the list of metrics, find “IV Percentile,” and add it as a column for MarketWatch. You can then click on the top of that column to sort it. This makes finding symbols with relatively high or low IV faster.
FIGURE 3: WANT TO TRADE SOMETHING WITH A HIGHER IV PERCENTILE?
You can sort your symbols in a watchlist by IV percentile and identify those symbols that have the higher values. Source: thinkorswim by TD Ameritrade. For illustrative purposes only.
Now, IV and IV percentile are just tools. You’ll need to drill down into the options of whichever symbols have the IV percentile you’re looking for to evaluate different strategies. Use this information to change what you trade, not how you trade.
The most important lesson of 2016, which encapsulates all other lessons, is to be proactive with your portfolio. Stay engaged with the market, analyze mistakes, test your approach, and push yourself to learn more. How do you aggregate enough profit to have the pizza made right inside your house? When it comes to trading, practice, practice, practice.
Most traders know what their portfolio is made up of, but often don't see it from a "big picture" view. This is where beta-weighting comes into play.
1. How do each of your positions move with relation to the market?
Look at each component of your portfolio and see how you can standardize it by relating it to a benchmark index. For example, if you have a tech-heavy portfolio, you may want to standardize it against a tech-heavy index like the NASDAQ composite.
2. How much do you want your portfolio to move with the market?
That’s really up to you, but if the beta of your portfolio is positive, it means that if the market moves up, your portfolio will likely also move up. A negative beta means if the market moves up, your portfolio will likely move in the opposite direction. A smaller beta value means that if the market has a large move, your portfolio—you guessed it—likely won’t move much.
3. Does your portfolio have a bullish or bearish tilt?
If you look at the individual components of your portfolio, you may not be able to tell if your portfolio is bullish or bearish. But if you beta-weight it against a benchmark index like the S&P 500 on the thinkorswim platform, you’ll see what the total weighted delta is, and that could tell you if your portfolio is bullish or bearish.
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