Before getting in to the gory details of our March Supplemental Trades loss, I want to illustrate just how unusually volatile IBM turned in recent weeks. The chart below (click to enlarge) shows the price of IBM over the past two-and-a-half years (blue line), overlaid with its 10-day Average True Range and the 20-day slope of that ATR. Because it incorporates intraday volatility as well as volatility of day-to-day closing-price movement, I use ATR to gauge how emotionally a stock is trading—it reflects irrational intraday swings driven by panic buying and selling. The slope shows how quickly traders are being overtaken by their emotions. (I suspect high-frequency computerized trading distorts these numbers, but that’s a subject for another time.)
Naturally, we see regular, quarterly spikes in ATR and its slope around earnings, not to mention elevated levels through times of high volatility in the broad market. The Calendar Options strategy includes rules to help us avoid those. What the strategy doesn’t yet have is quantitative signals for when staying in a position becomes too risky because of unexpected corporate, economic or geopolitical events.
ATR might not be the best indicator to use for that purpose, because it doesn’t adapt to large differences in price over long time periods and from equity to equity. So I’m developing custom indicators to price-normalize ATR and figures derived from it (such as slope). But for now, one quick way to get a more adaptive reading on a stock that’s swinging out of control is to watch ATR relative to a Moving-Average Envelope.
The panel below the main chart includes a ±20% envelope around the 20-day moving average of 10-day ATR. The parameters chosen are just for a quick example—finding an indicator, or set of indicators, we can use to reduce risk without giving up long-term performance will take more research (not to mention backtesting)—but the plot clearly demonstrates that when short-term ATR exceeds a certain percentage over its recent average, that could be a danger sign.
When Life Gives You Lemons…
None of the above will undo the loss our Supplemental Trades suffered this month—but we have a lot to gain from the experience. First, the reckoning:
- IBM March/April Calendar Spread (165 puts): +33.83% return on capital risked.
- IBM March Butterfly Hedge #1 (150/160/170 puts): –37.58% return on total capital risked.
- IBM March Butterfly Hedge #2 (165/170/175 calls, adjusted): –31.73% return on total capital risked.
- IBM March/April Calendar Spread Hedge (170 puts, adjusted): –39.34% return on total capital risked.
- IBM March Butterfly Hedge #3 (150/155/160): +108% return on capital risked.
I’m hard-pressed to come up with a meaningful number to represent the net outcome, because most of the trades were hedge positions that started out in various sizes, and in some cases (e.g., a butterfly rolled into a condor) “total capital at risk” changed dramatically with adjustments. We decided to go through all the hedges and adjustments to provide examples of the many different ways calendars and butterflies can be used to keep up with a rapidly moving market; although, in hindsight, once you’re looking at a third hedge just for a single core trade, that’s probably another clue it’s time to walk away.
But few options traders get really good without the “opportunity” to learn from a few disastrous trades. I can picture the rotten tomatoes some members are hurling at their screens after reading that statement; nevertheless, I’ve come to recognize in my years of trading that three things are indisputable:
- Trading options involves risk, and all traders suffer losses at times,
- Right after a big drawdown is the worst time to give up on a strategy with a history of outperforming over the long term, and
- A good trader uses the experience of any unusually large loss to continually improve and adapt the strategy to changing market environments.
Our Recipe for Lemonade
Members who’ve subscribed for any length of time know what we do next: Analyze what went wrong and examine what, if any, strategy changes might have prevented it. And as long as the analysis doesn’t reveal a fundamental flaw in the approach, we continue to trade consistently, month after month, and not let a bad month scare us into missing the good ones. Options-selling is a kind of insurance business, and well-managed companies don’t shutter their offices and walk away after a Katrina or a derivatives meltdown. (Note: Readers can send their “No, they just get rescued by the Federal government” jokes, along with any other comments or questions they may have, to firstname.lastname@example.org.)
That said, there’s never a bad time to review capital allocation and make sure that risk is distributed appropriately among strategies. And—most important—that risk, in any one strategy as well as total capital used for investment, fits one’s individual risk-tolerance and investment goals.