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Sep 1, 2016

The Mechanics of Low Volatility Markets | Truth or Skepticism

By:Josh Fabian

It has taken him close to a year, but Dylan is beginning to see the benefits of selling premium and managing his own trades. He booked a winner in crude oil and now that he has tasted victory, he’s hungry for more. Volatility seems like the place to be and he wants to know how to trade it.

Volatility has been on extended vacation. This is not the first time this has happened. Tom compared this current period with similar situations in 1986, 2003 and 2007. While no one can say with certainty how this will end, none of those three periods ended well. Maybe it is central bank interference, arguably, they bear some blame, but volatility cannot be tamed or domesticated. Eventually it reverts to its historical mean.

To take it a step further, volatility on volatility is currently trading 65% below its ten-year average. Volatility on volatility is a way of measuring premium in out-of-the-money options in VIX. Before that migraine sets in, just think of it as yet another indication of complacency in the market. We all see it. We all want to get long volatility.

Dylan is looking for a play on volatility. He posed a question many tastytraders have, in that he is looking for other possible ways to get long volatility. He asked about any potentially correlated assets that would benefit from a move up in volatility.

At the end of the day, getting long volatility means just that, getting long volatility. There are potential other plays that benefit when volatility moves up, like bonds. Tom even acknowledged bonds as the traditional flight to quality instrument when volatility rallies. However, Tom would likely prefer a strict kale diet to getting long bonds, as they too appear very overextended.  

For his part, Tom is long volatility futures (/VX). Because lowering cost basis is part of the tastytrade philosophy, he is also short calls in other volatility products such as VIX. In addition, Tom has some smaller long call spreads in volatility but the main volatility position is long futures and short calls to reduce cost basis.

Dylan also mentions having recently placed two trades, both of which went his way. What he was not clear on was, when to close a winner. So he just picked one. There really was no rhyme or reason for the one he picked and he wanted to know if there should be rhyme and/or reason.

There are rules for managing winners. Whether it is closing strangles when they have reached 50% of their maximum potential profit or closing straddles when they reach 25%. There is also a cheat sheet available from tastytrade providing optimal times to cover winning trades based on days in the trade and profit percent:

These rules for trade management help in maintaining proper trading mechanics and keep winners from turning into potential losers.

Managing losers is a bit different. Defined risk trades are not managed. They should comprise small portions of a portfolio and max loss on these trades should be something that will not cause too much pain. If a defined risk trade can be rolled for a credit or not paying a debit, there is no reason not to extend time in the trade and give time to turn into a winner.  

Lastly, what does Tom’s portfolio look like currently? Well, some things don’t change. He is short S&P and bond futures. He has small long positions in gold and oil, and he is long volatility. With the market still near all-time highs and volatility suggesting market complacency, Tom is trading for a pullback but he is using premium to avoid becoming too directional or dependent on being both right about a pullback and timing it correctly. Directional trading simply does not work. However, trading premium around an opinion on the market can work.

Josh Fabian has been trading futures and derivatives for more than 25 years.

For more on this topic see:

Truth or Skepticism with Dylan Ratigan: September 1, 2016


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