Afraid of the Whipsaw?

Unidirectional markets are treacherous for option traders who sell premium.  As a  buyer of iron condors (sell one call spread and sell one put spread), I've encountered difficulty with my positions in recent times. The decision to own portfolio protection has made a significant difference in my results.

But the topic for discussion today is: what now?  August expiration has come and gone and I'm sure most iron condor traders have already initiated new positions that expire in Sep and Oct, with some choosing Nov positions.

The big decision (at least from my point of view) is which puts to sell.  Under normal conditions, I sell spreads as far out of the money as I can – while still collecting my minimum desired premium.  While it's important for each trader to find his/her own comfort zone, I prefer to collect a minimum of $3 for positions that expire in three months and something north of $2 for two-month iron condors.

Followers of technical analysis would also use charts to help select strike prices.  They do that by selling calls above resistance and selling puts below support.  But, that's not my style and I seldom use charts.

The biggest psychological problem for me is remembering that I don't want to predict market direction and that it's usually best to trade iron condors based on today's market price and available premium.  Then I buy as much insurance as I believe is necessary to protect the position from incurring a disaster.

But – and it's a big but – I fear the whipsaw. Addendum: Whipsaw: To lose money in a volatile market by buying before declines and selling before rallies. In other words, if you lost money in the rally, it's the fear of losing again if the market reverses direction.]  Losing money is part of the game when trading options, and if you cannot accept those losses, then it's going to be very difficult to succeed over the longer term.  I'm willing to take those losses when necessary.  But, the worst feeling comes when I'm whipsawed.  Is that logical?  Probably not.  But for me, there's nothing worse than failing to do well during a big rally and then getting hammered – if and when the market reverses direction.

Bottom line:  That makes it difficult to choose puts to sell in today's environment.  RUT strike prices in the 500 to 530 range for October appear to be sufficiently  OTM that they can be considered as legitimate options to sell (as part of a put spread).  But, the market was recently much lower than these strike prices.  That makes it uncomfortable for me to sell,  because I just don't want to lose money on a downturn.  That fear of the whipsaw makes me uncomfortable, and can get in the way of making solid investment decisions.

What's the solution?  There are always choices.  I can sit it out for a while until I am more comfortable selling puts, or I can make the best trades I can right now.  Trades that suit my risk/reward requirements.  That's what I do – make the best possible decision considering all the circumstances.  Then, I buy extra insurance to provide not only protection in the event the market falls, but the opportunity for significant profits if a real debacle unfolds.

How about you?  Does the fear of a whipsaw affect your trading?  Are you afraid to sell puts after a big rally, or calls after a big decline?  Or do you make the best trade you can right now and ignore the recent past?  Or maybe you prefer to follow the current bullish trend and fear selling calls, rather than puts?

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4 Responses to Afraid of the Whipsaw?

  1. Mike S. 08/29/2009 at 7:33 AM #

    Is the selling of a call for a higher premium than it was bought for a covered sale? Here is the same question in a form of an example: An individual buys a call for $1. An hour later the premium goes up to $2. Can this individual sell the same call immediately (close by creating an offsetting position? Would it be a covered sale or a naked sale? And for simplicity, let’s consider that cash settlement is allowed on that call and it is below the strike the entire time. Thanks for your help. Mike

  2. Mark Wolfinger 08/29/2009 at 10:14 AM #

    Mike,
    1) No.
    2) A covered sale occurs ONLY when:
    a) You write (sell) an option you DO NOT own AND
    b) You already own enough shares, so that if you are assigned an exercise notice, you can deliver (sell) those shares to the option exerciser. You are NOT ‘covered’ if you do not own ENOUGH shares and must buy some to make delivery.
    3. Any time you own an option, you may ‘sell to close.’ There are no restrictions. It has nothing to do with the price of the option. It doesn’t matter if you have a profit or loss. It has nothing to do with being covered. In fact it has nothing to do with anything. You own it – you are allowed to sell it. Period.
    4. When closing you do NOT have an ‘offsetting’ position. You sell what you own. The position disappears from your portfolio. Hence the word ‘close.’
    When you buy stock and then sell it, do you have an offsetting position? Of course not. You just sell it. When you sell your home are you both long and short the home at the same time (offsetting position)? No. Options are the same. If you own an option, you may just sell it.
    5. It is neither a covered sale nor a naked sale. It is a ‘closing transaction.’
    6. Cash settlement is irrelevant. That settlement, by definition, only occurs at expiration. You are not holding this option to expiration. You are selling it.
    You can sell a European style option (cash settled) or an American style option (settles in shares). It makes no difference.
    It does not matter if the option is in the money or out of the money. It makes no difference. Whether an option is in the money only matters when expiration arrives. At that time, an out of the money option is worthless and and in the money option has value and should be sold.
    7. You are making this far more complicated than it is. When you buy an option, you own it, and you may sell at any time that the markets are open, as long as the sale occurs before the option expires.

  3. Alex S. 08/30/2009 at 10:25 AM #

    Mark, I’m a beginner. If I were writing an in-the-money covered call would the strike price need to be reached before the buyer would call away the stock shares?
    Thanks for your help.

  4. Mark Wolfinger 08/30/2009 at 2:00 PM #

    Reply is a separate post, Monday 8/31/2009