Downside and Fear is Priced In. Sell it? (…and the allure of old comfortable suits)

May 6, 2018

I’m going to disappoint the options eggheads with my opinions here, because I’m going on gut feel.

I haven’t done any exhaustive research. I haven’t done any volatility skew analysis or 3D modeling. I haven’t reviewed seasonality patterns, or dug deep into open interest imbalances.

No, I haven’t done any of that.

Simply trusting my gut, it feels to me fear of stock market risk is being overplayed and everyone who is scared of headlines, trouble in the White House, geopolitics, etc (which seems is nearly everyone) has already fully hedged their risk or has put on speculative short positions and are thus natural buyers into any dips to profitably cover their positions — which in effect helps to put a floor under equities.

Think about it.

Back in December, after a long multi-year stretch of positioning my personal account to be net short premium, my gut told me there wasn’t much money left to be made and the risks of being caught offsides on the next volatility pop far outweighed any profits I might make being short premium in the interim.

Notice that tweet only got two likes??

Turned out it was a brilliant move, but for the wrong reasons.

By middle of January, my position was fully long call and put options — long premium. Strangely, as $SPX went one way up through the majority of January, volatility also trended higher. A rare occurrence, but certainly a welcome development to my portfolio. So far so good.

Then, the market peaked in late January and we had a rather swift and somewhat scary one week-ish decline. During this decline, volatility SPIKED. It popped in a way few were prepared for. But with the benefit of hindsight, it has become clear that this volatility spike was a bit artificial as it was driven mostly by the unwind of some volatility derivatives ($XIV and $SVXY ETNs, for example) that the public had irresponsibly piled in to over the past couple years. Nothing really fundamental had changed in the market.

As the dust settled on this scary one-week event and the stories of huge winners and the devastated losers began to leak out and the blame game began, the refocus on protecting the downside renewed once again. This episode reminded participants of the “dangers” that are lurking underneath the markets (and rejuvenated the tinfoil hat conspiracy theorists and the liberal “the-world-is-ending-because-of-this-orange-monster” crowd) and now the result is we have more traders either fully hedged for downside protection, fully loaded on a speculative trade to participate in market chaos, or waiting by their computer screens with a twitchy trigger finger hovering over the sell button ready to pounce at every intraday downtick and frantically cover on every uptick.

This is not an environment where market crashes happen.

When everyone is prepared or waiting for a crash, it ain’t gonna happen. Anyone who’s been in this game for any length of time knows that the market rarely (if ever) accommodates the masses. It is almost as if the engine was cruelly designed by an evil scientist to frustrate the most amount of people for the most amount of time. Think about it: how hated has this stock market rally off of 2009 lows been by Wall Street professionals? This is easily the most hated bull market of all time – bar none.

As such, and urged on by the only evidence that really matters — my declining equity balance, I’m beginning to come around to the idea that we’re headed back to a more stable volatility environment. We might not see $VIX print new lows again, but neither do I think we will have any sustained further freakouts in the coming months and I’d be shocked if $VIX spikes higher than levels we experienced in early February.

This has me wanting to climb back into my old comfortable premium selling suit.

In the past, my premium selling strategies often hinged on holding short options all the way to expiration, trying to wring out every last nickel of profit I could. It often worked, but too often it didn’t and the short gamma exposure would be heartburn inducing.

One strategy idea that has been rolling around my brain since a conversation with a fellow options trader during my last trip to NYC a week ago is centered around broken wing butterfly spreads…

While the structure of the trade is important, to me the most intriguing part of this idea centers around an aggressive approach to taking profits, keeping gamma risk to a minimum, and constantly and consistently repeating the trades to get the number of occurrences up so that small edges can compound more quickly over time.

This is a work in progress. I’ll update you down the road after I’ve waded in, made mistakes, learned from them, and hopefully came out the other side better for it. It’s the only way I know how to do it.

~ Sean McLaughlin, @chicagosean