We feel like we’re saying this every month, but it sure feels nice not to have any skin in the game come expiration day.  Options expiration surely had something to do with the intensity of today’s selloff, and this was a textbook case of why we never hold positions into expiration.

The fancy-pants phrase for the influence options expiration had today is “negative gamma.”  The practical significance of that phrase is that when we gapped down at the open, lots of traders who were short options that they assumed were going to expire worthless were suddenly holding contracts that were now at or in the money.  They have to take action to deal with the situation, and all that covering and hedging of those shorts only adds fuel to the fire.

We got a long, low-volume midday pause, but then the selloff resumed after lunch.  You know there were some unfortunate souls still holding short puts at SPX 1320 or SPY 132 who were sweating into their turkey sandwiches, hoping we would bounce or tread water into the close.  Sorry, guys.

Keep reading for more performance data and trade analysis… Read the rest of this entry »

We published the following bonus trade for our members back on May 2:

Buy to open XLE June 70 put
Sell to open XLE June 72 put
Sell to open XLE June 90 call
Buy to open XLE June 92 call
for a net credit of $0.47 or better.

Anyone following this trade should have already exited - remember, we want to be out of any front month short options by Monday of expiration week at the latest.  Negative gamma risk during expiration week is ever a clear and present danger.  If you’re still in the trade, you would exit here by buying back the XLE June 90/92 call spread for a net debit of about $0.25.

Analysis: The original rationale for this trade was that the big rally in energy through March and April seemed to be stalling, so we wanted to get neutral and sell some premium.  We were right (for about 2 weeks), but then XLE spiked up in mid-May to a high of 91.42, which induced raw panic among a couple people who were following this trade.

Our answer then was the same as always: play defense first.  Figure out how much capital you’re prepared to lose on the trade in question, and then size your position accordingly.  That way, rather than running away every time an underlying shows a little spunk, you can sit tight and let the probabilities work themselves out.  If the trade hits your maximum loss point, so be it.  Sometimes those losses will occur, and sometimes, as in this case, the underlying will practically bounce off your short strike and revert to profitability (see chart).

If you waited to exit until today (and hurry up, better to get out ahead of the inventory report at 10:30), you’re still looking at a return of 14.37% on capital risked.

We’ve actually made this point before, but it bears repeating: iron condors have hard stops already built in. They’re called “long strikes.” So risk management is incredibly easy when you’re trading condors - it’s simply a question of determining how much capital you’re prepared to lose on any one position, and then selecting the appropriate number of contracts for your trade. Then fire and forget.

You don’t need to set some arbitrary mental point at which you’ll exit the trade at a later date; you certainly don’t need to panic the moment the underlying touches the short strike of one side of your position.  Andy Swan makes a similar point about not using stops on his blog, and we would emphasize the fact that the probability of an underlying touching one of your short strikes will always be higher than the probability of that underlying expiring in the money, which means that if you bail out every time your short strikes get violated, you’re just setting yourself up for a lot of churn.

Some people feel uncomfortable with the idea of letting a trade hit its maximum loss point, or with not adjusting a trade that looks like it’s in trouble.  But those are just symptoms of deficient risk management.  If you’re only allocating 1% (or less) of your capital to any given position, then you can afford to let the statistics play themselves out, without worrying much about the final outcome in any one particular case.

Our VIX post from yesterday got picked up by two of the deans of options blogging, Adam Warner (shown) and Bill Luby:

The Big Question for the VIX
VIX Jumping the Shark?
VIX and VIX
(and thanks also to Abnormal Returns for the link)

Not much to add in response to all this, except to agree that the increased coverage of this one instrument doesn’t change the fact that it still definitely serves a purpose. When all you have is a hammer, every problem looks like a nail, right? But just because some people erroneously use the VIX as a catch-all proxy for fear doesn’t mean that that particular hammer doesn’t still have its purpose.

The idea of a VIX hiatus sounds about right - at least in terms of parsing and explaining it. Surely those who have ears to hear will have understood by now that statistical measurements do not exert causal force - that any cause-effect relationship between the S&P 500 and the VIX moves only from the former to the latter.

Finally, what about the other volatility products, you know? RVX, VXD, VXN, QQV - those guys deserve more love than they’re getting.

New complicated products

Two product launches of note:

1. Yesterday saw the announcement of the Merrill Lynch U.S. Forward Equity Variance Rolling (FEVR) Index, which “measures the performance of a long S&P 500 volatility strategy designed to be both tradable and efficient.” As to be expected from a press release, they don’t provide much insight as to what’s really under the hood, just the obvious remark that this index “efficiently tracks volatility using a strategy designed to minimize the carry cost associated with owning volatility” while still capturing the upside of being long vol. The claim is that being long 25% this FEVR and 75% the S&P 500 beats being long equities only. No mention of any retail-friendly implementation of this index, either now or forthcoming. But that’s Wall Street for you.
2. Felix Salmon notes the introduction of some index ETFs that handle your allocation adjustments for you. His concern is that paying 25bp for a quarterly rebalancing might not be a smart use of your money, and we have to agree. The sponsors (PowerShares) should set the rebalancing back to annual, and cut the fee to 5bp. We’d buy that, or at least might consider putting our cousins and neighbors in such a fund.

Portfolio Update

A quick note to our members: again today we didn’t get filled on the order we’ve been working this week. Premiums just fell off too sharply today, perhaps in advance of the long weekend, and we weren’t in the mood to give chase.

The good news is that the same premium suckage that kept us on the sidelines has been fantastic for our current newsletter positions. Our IWM trade for June expiration is currently up about 7% after just a week; our SPY position is up 10%, which is our upper target for these trades anyway.

Reversal Readings

DIA - 2.76
SPY - 4.51
XLY - Consumer Discretionary - 0.53
XLE - Energy - 8.53
EWZ - Brazil - 5.52
XLB - Materials - 5.25
IYR - Real Estate - 2.12

We’re making some changes to our monthly review - hopefully the structure of this new format will make it easier to follow along and compare our strategy with the relevant benchmarks. Going forward, we’ll include the following items in each monthly review: 1) a quick-glance overview of our monthly performance, in the chart at right; 2) a performance comparison of our positions for the month vs. the SPX, DJIA, and RUT, plus BEP, which is an S&P 500 Covered Call Fund. 3) more details about each of our positions, including any comments we may have; 4) links to important (non-trade) articles from the past month, in case you missed any of them.

Performance comparison

Here’s how the major market indexes, the S&P 500 Covered Call Fund (BEP), and the Condor Options trades performed over the past month:

• S&P 500: 2.52%
• Dow Jones Industrials: 1.07%
• Russell 2000: 2.78%
• S&P Covered Call Fund: 7.69%
• Condor Options: 12.62%
• Note: the period measured is from expiration to expiration, rather than from the start of the month.

May Iron Condors

• DIA 116/118/134/136: 30.46% return - This was a no-brainer; we closed out the 188 puts on principle (markets tend to crash down, not up) and let the rest expire worthless.
• DIA 113/115/130/132: (10.56%) return - We closed out this position fairly quickly as the rally gathered steam in order to reduce our overall risk. As part of a larger portfolio, it would have been easier to hold on and make an exit several days later for a small win/breakeven - some readers did just that.
• SPY 128/130/146/148: 17.96% return

May Reading

Here are some posts from the past month that are worth checking out if you didn’t catch them the first time around:

• Getting Your Fill
• Calendar Options: Five Things You Need to Know About Calendar Spreads
• Introducing Calendar Options
• How Vega Can Deceive You: Part I
• How Vega Can Deceive You: Part II
• 8 Hedging Ideas for Iron Condors, Part 1
• 8 Hedging Ideas for Iron Condors, Part 2 (Members only)

We’re already in two June positions and, if implied volatility picks up next week, may well enter two more. Hopefully this summer will be a bit more lively than usual!