“You can’t roller skate in a buffalo herd.” These words were from that sage old philosopher, Roger Miller. Other quotes along these lines include:
“You can’t go fishin’ in a watermelon patch” – Roger Miller
“It’s like tryin’ to drink whiskey from a bottle of wine” – Elton John
“Give a small boy a hammer, and he will find that everything he encounters needs pounding.” – Abraham Kapla
“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” – Abraham Maslow
The theme that all of these quotes share is that it is human nature to prefer a familiar environment, even to the point of imagining that one exists where it does not and to over-rely on familiar tools.
The way this connects to option trading (no, I haven’t forgotten that that is the subject here) is that some people tend to stop adding tools after the first hammer. That is, they hear about a particular option strategy, and then try to apply it all the time. They try to use those roller skates even when the sidewalk leads into a buffalo herd.
For example, let’s say you see an ad for a seminar on Iron Condors. You take the seminar, and are dazzled by the possibilities. You race home and start applying Iron Condors left and right. Some work out as you’d planned. But some of them stubbornly refuse to. After a couple of nasty surprises, you realize that one trade gone bad can wipe out the profits of several perfect trades.
This experience is not limited to Iron Condors, by the way. There is a whole cult, and mini-industry, built around almost every option strategy. There are people who sell the idea that Double Calendars are that easy road to riches. Likewise Diagonals, Verticals, and just about everything else. Somebody somewhere is able to convince people that each of these is the One and Only Answer. Of course, none of them is. Anyone who tries to apply any strategy all the time soon finds this out.
The problem is not with the strategy. Each one has its place and can be profitable when used correctly. But we must know when to use it.
This comes down to two questions:
- What is your outlook as to future price movement? Up, down or sideways, and a little or a lot?
- What is your outlook as to changes in Implied Volatility? Do you expect it to increase, decrease, or neither; and do you expect a little change, or a lot?
With these two pieces of information in hand, you can choose a strategy. Here are some general guidelines.
First, If you are bullish, use a bullish strategy; if bearish, a bearish one. If you believe that prices will move in a range for a while, use a price-neutral strategy.
This sounds trivial. But it actually knocks out whole classes of strategies. If you strongly believe that the price of a stock is going up, for example, then you should not use a price-neutral strategy. Those Iron Condors we talked about earlier fall into this category.
Iron Condors are a short strangle (short an out-of-the-money put and short an out-of-the-money call), enfolded by a long strangle (long an even further OTM put and a further OTM call). They make their maximum profit when the stock price remains in a range between the strikes of the short strangle, so that all four of the options expire worthless. They are hurt by too much movement, either way. If that movement happens, they can lose far more than they can make.
Another neutral strategy is also sold as the end-all of strategies, the Double Calendar. Like the Iron Condor, the Double Calendar is a price-neutral strategy that makes its maximum profit when price remains in a range.
Using either of these neutral strategies is just the wrong thing to do when you believe that price has a chance to make a big move. If you believe that a big move is likely or even probable, then a better choice would be a directional strategy, such as a single-legged option, a vertical spread, or a diagonal spread. The same is true in reverse – if you believe that price will be range-bound, then a neutral strategy will be the right choice, and a directional strategy will be the wrong one.
Even if you do believe that price is going to remain in a range, so that you consider only price-neutral strategies, these are not all created equal. In fact, any situation that would be appropriate for an iron condor would be wrong for a double calendar, and vice-versa. If a range-bound situation is correctly identified by the seminar-goers of both camps, and both apply their neutral strategies, only one of those two groups is going to win big. If the Iron Condors work out well, the Double Calendars won’t, and may even lose money. And vice-versa.
This leads to our second rule, buy implied volatility low and sell it high.
This is every bit as important as rule one. Along with actual price movement of the underlying in the present, option prices are also affected by expectations of what that movement will be in the future. The measure for the degree of those expectations is what is called Implied Volatility (IV). When expectations for the amount of future movement are high, people pay more for options, even if little, or even none, of that movement has happened yet. When no one expects a stock to move, they will not pay much for its options. And when expectations change, option prices will change, again regardless of any actual price movement in the stock (or lack of movement).
Of our two neutral strategies, the Iron Condors involve selling a great deal of time value, while Double Calendars involve buying time value. Time value is high in price when crowd expectations are high, as shown by the level of implied volatility. When IV is high, we get paid a lot for selling the iron condors, which makes them a good bet. For the same reason, Double Calendars would be a bad bet at that time – we’d be paying too much. In a low-volatility situation the opposite would be true – then the Double Calendars would be a good way to go.
Implied Volatility changes can sometimes overwhelm the changes brought about by actual price movement. We can be right about the direction a stock will take, and still lose money. For example, say that we know a company is releasing earnings tomorrow. We think this stock will move big, one way or the other, since it has a history of doing that on earnings dates. So we buy a Straddle – an at-the-money call together with an at-the-money put. If the stock moves either way far enough to pay us back for both options, we win, and our potential profit is unlimited. What could go wrong?
Next morning earnings are announced. Sure enough the stock races higher. We check our position and find that we have not made a lot of money; in fact we have lost money! Not only did our losing put option lose almost all its value, but the price of the “winning” call option has barely budged. What happened?
What happened is that the uncertainty regarding the earnings announcement has now been resolved. That uncertainty was at its peak just before the announcement, and both of the options we bought had already priced in a big movement. Now that the announcement has been made, expectations for further movement are now a great deal less. As a result, the value of every option that exists on that stock is pushed down to some degree today by the reduction in expectations. We violated rule 2: we bought implied volatility when it was already high. Now that IV has crashed, we are left holding the bag.
- Use directional strategies when your outlook is for a big price move (even if your “favorite” strategy is neutral).
- Buy volatility when it’s cheap, and sell it when it’s expensive. When IV is cheap, use a strategy that is long time value. When it’s expensive, use a strategy that is short time value. And when it’s neither, use a strategy that is relatively unaffected by IV changes (more on that one next week).
Using these rules means that you do not have a favorite strategy. You simply use the one that will work best in the current environment.
For comments or questions on this article, contact me Russ Allen at firstname.lastname@example.org.