In his last discussion, Dylan focused on an idea only being as good as a market’s liquidity. We simply cannot execute on an idea if the market lacks easy access into and out of a trade. This week’s discussion expanded on when to execute ideas and how implied volatility factors into that decision.
When markets fall, chaos and fear peak. Instinctively, investors run for the doors at the same time. Fear is like a fast spreading virus and once one person becomes infected, it spreads exponentially. As investors and traders, we succumb to herd mentality and the belief the world may be ending. So far, at least as of this writing, the world has not ended.
They say the first step on the road to recovery is admitting you have a problem. Despite being a professional trader with substantial experience, Liz is the first person to tell you she is the George Costanza of directional trading; whatever she does, do the opposite. However, it's not just Liz. In aggregate, as Tom pointed out, investors tend to de-lever and reduce market exposure when markets near their bottom. Conversely, investors lever-up when markets top - the opposite of what we should be doing.
Selling premium into fear is a tastytrader’s happy place. We take in greater amounts of premium during times of elevated fear. There is a correlation between fear and how much investors are willing to pay for an option contract. That correlation is like a hanging slider with Kris Bryant at the plate (hey, we gotta give the Cubs a shout out) - it’s our chance to aggressively attack.
Not only do we take in more money, but high IV can be used to help manage directional trades. For traders such as Pete, who trades futures, options are relatively new. Previously, Pete was dependent on trading direction. Incorporating the use of futures options has changed his approach. Take the recent volatility in currencies. Using options against his futures positions gives Pete an ability to manage his deltas, or, his directional exposure. By taking advantage of theta decay, Pete can extend duration in a bad trade, giving price a chance to come back in his favor.
No one says selling into panic is easy. Psychologically, it is very challenging. As Liz and Kai pointed out to Dylan, repetition is key. The more often we do something perceived as uncomfortable, the easier it becomes. Just look at how much easier Bat deals with Tom after five years being on air together.
The simple fact is, the best things in life do not come easily. Fear, trepidation, voices in our head, old school mentality, whatever; they all make stepping into a chaotic environment challenging. When we overcome those obstacles we position ourselves for the greatest mathematical probability of success. We collect greater amounts of premium for taking risk. Using options to hedge against a directional position improves costs basis and extends duration. The underlying product can be an individual stock, country or currency ETF, futures contract, it simply does not matter. High IV translates into greater probability. It can give us clues as to where directional risk lies. If liquidity is what allows us to enter and exit a trade, high IV is a landmark for when to execute.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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