Question

Today Lloyd R. asks “I understand why someone would want to be long options, but why not use indexes for credit spreads? Stocks are so unpredictable and a news event (takeover, earnings pre-announcement, law suit…) can come at any time. The penalties are extreme”

Answer

Great question. Stocks do carry a surprise component and obviously, when you are long premium you want that to a degree. You don’t want random surprises where you are continually blindsided. Indexes are diversified and consequently they do not have “unsystemic risk”. They only have “market risk”. There is a statistical advantage to selling out of the money put spreads, on indexes and I do like that trade under the right circumstances. With the market near a seven month low and the implied volatilities (IV’s) spiking – that trade is setting up.

As you know from my prior blogs, I do not advocate Iron Condors or neutral trading strategies. There is too much slippage and one big market move can strip away half a year’s profits. These are very popular “seminar” strategies and they are typically index based. At $3000 per seminar, they’re the ones making the money.

On the topic of index call credit spreads, I do not feel I’m properly being compensated for the risk. As the market rallies, the IVs collapse and you have to get too close to the money to get any premium. Look at the OEX July 600 calls and the 530 puts. Both are 35 points out-of-the-money (OTM) and one trades for $.70 and the other trades for $4.40. The risk reward ratio is not there on the call side.

Indexes have so many eyes focused on them that I don’t feel I have an edge. Every large institution is analyzing the SPY, OEX, SPX and they are executing baskets of stocks and futures against their option positions. I won’t pretend that I know more than Goldman Sachs and its 50 Floor Traders. There is no edge for me. I could tell you stories about the sophisticated trading tactics I witnessed in the OEX pit 15 years ago. If ever there was “fair value” it’s the exact price of that product at any moment. In the end, when I trade indexes I’m forced to predict what the market is/isn’t going to do.

My edge lies in my ability to find relative strength and weakness within the market and I have a proprietary program that helps me find that. There are opportunities that large institutions are not interested in. They can’t get the size done to justify trading it. There is a large advantage to trading a balanced long/short portfolio of stocks with relative strength/weakness. Choose well and the strong stocks gain more than the weak stocks lose when the market goes up and vice versa. This strategy helps me reduce my market risk. I also feel that I can identify supply/demand imbalances in a stock and I know when someone is trying to move “size”. That comes from my chart reading skills and I like to shadow them. In a crowded arena like an index, that trail is masked by “noise”.

I have found that careful research and selection can help me navigate news events. For instance, I don’t do credit spreads on biotech stocks. The chance of a material, unscheduled news event is too high. When all of my research has been conducted only a quarter of my trades translate into option trades for liquidity reasons.

Getting back to selling options, when the stock or the market are uncertain, the IVs are high and I’m rewarded for selling premium. The credit helps me distance myself from the trade and I can keep my objectivity. The key is to watch for upcoming news events and to get intimate with the stock. Know what’s driving it. Just as I would go long or short a stock, the credit spreads are no more than a directional trade with a built-in buffer. Another way to throttle risk is to size the position accordingly.

Never start your search by looking for stocks with high IVs. That is suicide. Those big premiums are there for a reason. There’s a very high likelihood that a lightly publicized event is forthcoming.

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