I began my career working with options in early 2008. The equity markets had begun a retreat from all-time highs set in October 2007. There were rumblings about concerns in the mortgage markets regarding sub-prime loans but the equity markets were still faring well and equities on my watchlist were continuing to climb. Levels of implied volatility in the overall markets were off of their recent lows but a read of around 20 on the VIX was not terribly high or concerning. Fast forward a few months to late 2008 and early 2009 and you see a different story entirely. When the market bottom was put in place in March 2009, the SPX had lost over 40% of its value in a mere 6 month period of time. The VIX spiked as high as 90 at one point and, even after beginning to fall as the markets bottomed, was still at elevated levels for quite some time.
As a new student to spread trading, I found myself drawn to credit spreads for multiple reasons. I could be profitable on my trades in multiple trend scenarios and less accurate with my timing both in trade execution and adjustments. It seemed to be an ideal trade for a beginner in the markets. The other factor that made credit spreads attractive was the elevated level of implied volatility in the overall market and, therefore, for most individual equities. Generally speaking, when implied volatility is relatively high, the risk capital in options premiums is also relatively high making credits for selling these options “juicy”. The potential return on these spreads relative to the risk made these my trades of choice. I continued to trade with credit spreads as my primary trade until last summer. As I was working these trades during 2010, 2011 and early 2012, I began to find it more and more difficult to find the same kinds of opportunities for risk/reward as I had seen previously. Levels of implied volatility have continued to decline in the options markets – with the exception of a few months of time after pullbacks in the summers of 2010 and 2011. I really noticed a precipitous change in mid-2012 as the VIX fell to just under the 20 level. I simply could not find opportunities for credit spreads that looked attractive from a risk/reward standpoint. It was time to go back to my “trade toolbox” and get flexible!
Since levels of implied volatility have contracted, it makes sense to look at debit trades since options premiums are relatively low making these trades inexpensive. My skills in fundamental, technical and sentimental analysis have improved over the course of my trading career enabling me to be more accurate in trade execution and adjustment. These debit spreads have the drawback of limited trend possibilities for success as compared to the credit spreads, but they provide excellent risk/reward parameters when comparing them to credit spreads in this market environment. I can keep these trades very short term in nature utilizing weekly options or take a bit longer stance utilizing options with 45-90 day durations. Depending upon trade setup, these debit spreads can also benefit from an increase in implied volatility off of these very low levels. With my knowledge of trade adjustments courtesy of OptionsAnimal, I can also adjust these trades effectively when necessary.
What will the equity markets look like in respect to trend and volatility going forward? My “crystal ball” is broken in forecasting these changes. Fortunately, I have the flexibility to trade whatever the market gives me.
Karen Smith
OptionsANIMAL Instructor
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