It’s not Easy Being Disciplined

As explained by Kermit, "it's not easy being green."


Kermit-two1


Right now, I find that it takes real discipline to not get over-extended.  Implied volatility for the Russell 2000 Index (RUT), as measured by RVX, stands above 36. 

By historical standards, that's very high – and it's tempting to open positions with short vega.  For me, that suggests iron condors.  Although there are other strategies for traders who prefer something different.

The problem is that RVX was significantly higher – not too long ago.  Most of us recognize that implied volatility tends to be mean-reverting (moving towards its average level, after moving away from that level). 

As with everything else associated with trading, there are no guarantees.  I have a full plate and do not want to take on any more risk – despite the fact that profit potential looks attractive to me.

I may give in and add a very small number of iron condors to my portfolio, but I've decided that it's just not worth the risk to go 'all in.'  To succeed over the long term I believe it's best to give up some profit potential – after all, profits are not guaranteed – rather than take on additional risk.

We each have our own perspectives, and I'm sure some traders feel this is the calm before the volatility storm, while others seek to take advantage of these 'high' option prices.

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9 Responses to It’s not Easy Being Disciplined

  1. Mark 06/29/2010 at 10:11 AM #

    Assuming you did open a some RUT spreads. Lets say you have some on the books around the 580 level. Market gets crushed today. Shorts double. 12 days to expiration. Still some breathing room but been stung before.
    Adjust now and quick big loss. Wait for market to bounce and adjust/close down the road. Wait and market falls, suffer more.
    When do you mostly make your adjustments?

  2. Mark Wolfinger 06/29/2010 at 10:42 AM #

    Mark,
    Excellent question that goes right to the heart of risk management.
    Please let me reply tomorrow in a separate blog post.

  3. Brandy 06/29/2010 at 11:55 AM #

    Good to hear your day to day thoughts, insights, worries about managing your own trading positions.

  4. Mark Wolfinger 06/29/2010 at 1:12 PM #

    Thanks Brandy

  5. Shaun 06/29/2010 at 10:59 PM #

    Mark,
    How would you use options to protect a portfolio? If I have over 20 large cap stocks without any put protection currently on any of the stocks, I’m thinking of buying index puts (SPY) for hedging the portfolio. Should I buy puts outright, and how far out in both time and strike price should I get the puts if I want continuous hedging? Thanks.

  6. Mark Wolfinger 06/29/2010 at 11:24 PM #

    Shaun,
    If you are asking for my preference, I would initiate collar positions. That means choosing an appropriate put to buy and an appropriate call to sell.
    This strategy provides the protection you seek, but it does sacrifice much of the upside on a rally.
    However, buying puts (without selling the calls) is a VERY expensive proposition. So costly that I believe it’s far better to take the risk of a down market than pay the high prices being asked for those puts.
    That is merely an opinion, and some people do buy puts to protect a portfolio – no matter the cost. Be prepared to pay a lot of money. Especially after a day like today. The time to buy puts is when markets are clam and no one wants to buy them. That’s when they are cheap.
    Back to your question: Index puts may be good enough, if your portfolio correlates reasonably well with the index. I’d prefer to buy SPX to SPY just to save on commissions (one SPX put equates to 10 SPY puts). But that is going to depend on the size of your portfolio.
    Which puts to buy is a nightmare of a question:
    1) When IV is elevated (and right now is it VERY high), longer term options are extra expensive. You do not want to buy options that have lots of vega when IV is high. Long term options are loaded with vega.
    2) That pretty much forces you to buy near-term options. The bad news there is that time decay (theta) is rapid.
    3) The two items above pretty much tell you that this is a terrible time to be buying puts. But, if you need them, then you need them.
    Do consider the cost and figure out where your stocks must move to earn a profit on the upside and how much you will lose on the downside. You will be very unhappy with either result.
    4) Which strike price to buy is a personal decision. How much protection do you want? How much of your portfolio value can you afford to lose? If it’s 10%, the you want puts that are about 10% OTM. If you can tolerate a larger loss, choose a lower strike price.
    This is a difficult decision, especially when puts that don’t offer as much protection as you want are so very costly.
    5) Buy puts outright? Is there an alternative? You can buy put spreads. That reduces cost by an enormous amount, but your potential protection becomes limited. That’s not what most people consider to be protection.
    6) Continuous hedging involves never allowing puts to expire. That means always owning some puts.
    I believe you will discover that it costs north of 20% per year to get any reasonable protection. Wouldn’t it make more sense to sell some of your holdings rather than needing a 20% rally just to break even? I cannot answer that question for you.
    But I can tell you this: If you plan to be a put buyer over the years, you cannot afford to wait until everyone else wants to own puts. You have to get them when they are affordable. Then perhaps you can buy longer-term puts.
    Good trading and thanks for the question.

  7. Shaun 06/30/2010 at 12:10 PM #

    Mark, thanks a lot for your reply – lots to think about. I know simply buying puts would be expensive, and I’m trying to figure out the cheapest way to have protection. I’m already doing covered calls on the stocks, so in a way I would be collaring by buying puts. Thanks again.

  8. Mark Wolfinger 06/30/2010 at 12:56 PM #

    The nice part about writing calls is that you collect the premium.
    However, the VERY NOT NICE part is that protection is so limited.
    Regards

  9. Shaun 06/30/2010 at 2:12 PM #

    Very true. Because my stocks are the well known large cap stocks, I’m hoping that in a rebound mine will be one of the first to bounce back, but you never know. Thanks again.
    Shaun