Contrast these 2 days. September 29, 2008: Dow down -7.50%, Nasdaq down -10.06% and S&P 500 down -9.63%. Compared to November 13, 2008: Dow was up +6.25%, Nasdaq was up +6.11%, and S&P 500 was up +6.47%.
Many retail options traders would have rushed to fill their spreads on such important days, either going long or short. The discerning few, aware that a +/- X% change in stocks, is a day to avoid entry; instead it is a signal to scale profits or reduce exposure, you would have had limited profits or losses on those days.
This is the logic to categorize what type of day it is. If you theoretically priced a calendar long or condor short iron on a big day either up or down, it’s likely that the product price moved close to or outside 1 standard deviation, even if the order It was completed at average price for that spread.
The next day, if conditions turned into a dull day, either higher or lower, let’s say the futures didn’t even move more than a third within 1 standard deviation. On the extreme day you priced the ticket, even though it was filled at the average price, you still overpaid for the Calendar; or sold more Theta as a premium than was necessary to protect the Iron Condor’s short wing span, possibly increasing the risk of Gamma instability. Alternatively, if you priced a directional spread on a Big Day, either a Short Vertical or a Long Vertical, you need a continuation on extreme days, after the Big Day you filled the order, for the price to move.
If the price has already moved 68% (1 standard deviation) on a big day, moving 2-3 standard deviations is not the problem. Here is the problem. Can the price action sustain a 2 or 3 day to day Standard Deviation move after the extreme day? It’s not an impossible event, just a rare occurrence.
Price differentials for entry in extreme conditions put a lot of pressure on your orders to outperform. That is a difficult way to negotiate. You are punishing the trading account profit and loss unnecessarily. Psychologically and visually, continually entering trades on the Big Days makes you look for “magic” chart patterns for another big breakout or breakout in price. No, you will not go blind. However, you will cultivate a trading habit that must be broken if you plan to have consistent results with online options trading.
So how do you calculate the change of X%, either up or down to differentiate a dull day from a normal day versus a great day?Use the implied volatility of the previous month’s options on DJX, MNX and SPY, the mini versions of the Dow, Nasdaq and S&P 500 respectively, to categorize the market ranges for the day. For example, take the:
- DJX – Let’s say the volatility for the previous month is 27.38%, divide 27.38% by 16 = 1.71%. That’s +/- 1.71%, which means IV represents the collective expectations of market participants trading that commodity, expect the DJX to go up or down 1.71% that day. Your trading platform should allow you to add a column in the watch list called “%Change”. That’s what we just calculated. So a % change below +/- 1% is a boring day. A % Change between +/- 1% to +/- 2% is a Normal Day, take the lower whole digit of the calculation, in this case 1%; and, the upper integer digit of the calculation, in this case 2%. A move of +/- 2% would be a big up/down day for the DJX. Although the DJX is the mini version of the Dow, since we are using a calculation of % vs. an absolute number, the application of the meaning of +/- % change still holds true for the Dow.
- Repeat for the MNX: Let’s say the prior month IV is 30.73%/16 = +/- 1.92%. Boring day for the MNX is where the % change is below +/-1%. The normal day for the MNX is where the % change is between +/-1% and +/-2%. A % change number above +/- 2% is a great day for the MNX. The same +/- % change applies to the Nasdaq.
- Repeat for SPY: Prior month IV is 31.25%/16 = +/- 1.95%. A dull day = % change below +/- 1%. A normal day = % change between +/- 1% and +/- 2%. And a Big Day = %Change greater than +/- 2%. The same +/- % change applies to the S&P 500.
You can apply this calculation to the VIX or any optional product in which you have identified a transaction.
Why divide the volatility of the previous month by 16? As you know, volatility is expressed as an annualized number. So, to get the daily volatility number, we divide it by the square root of the number of trading days in a year, which is 256 (rounded). There is no trading on weekends and exchange holidays, because prices cannot change on these days. There are some years with more or less than 256 days, but using 256 is the norm. The square root of 256 = 16.
As part of your pre-trade preparation, calculate on a spreadsheet the market ranges for the day (Dull, Normal, or Big) for DJX, MNX, SPY, and VIX at a minimum. This is not for picking direction, as you will not know if the market will open higher/lower and will STAY there, even if the futures indicate a higher/lower bias. The calculation gives you a measured indicator, once the market opens to see if the trading range for the day is leaning towards a dull, normal or big day. Then, assess whether it makes sense to theoretically price a spread, be it Calendar, Iron Condor, Vertical, etc. This protects you from chasing the price by close to 1 standard deviation, to fill your orders on a big day. Doing this pre-market work determines whether you’ll fill orders or cut orders for profit; alternatively, reducing exposure to losses, when the market opens.
Statistically, there are more trades to quote on dull days and normal days than on big days. Especially from mid-July to August, as many floor traders go on vacation. On normal, boring days, aggressively price the order 0.10-0.15 below the theoretical price for a debit spread; or, 0.10-0.15 up for a credit spread just means it takes 1-2 more hours to fill. If your order is completed within 5 minutes, you were negligent in working hard at the gate; versus, fill up in 1-2 hours. Diligence makes a material difference to the price-performance of the trade. By avoiding entries on Big Days, you’re not missing the opportunity to not enter, when most retailers are price-chasing to fill up. A key factor of consistency in the P/L of your account is the entry and exit price. The discipline of staying consistent is filling within a sustainable range of the fair value of the spread for that particular trading day. Staying in the business of online options trading requires as much common sense to stay out of trades as it is to enter trades.