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Stock Option Trading – Paradox – More Trades on Dull Days and Normal Days Than Big Days

Contrast these 2 days. September 29, 2008: Dow Jones down -7.50%, Nasdaq down -10.06% and S&P 500 down -9.63%. Compared to November 13, 2008: Dow up +6.25%, Nasdaq up +6.11% and S&P 500 up +6.47%.

Many retail options traders would have rushed to fill their spreads on those big days, either to get short or long positions. The shrewd few, aware that a +/-X% change in stocks, is a day to avoid entry; instead, it is a signal to cut profits or reduce exposure, would have profited or limited losses on those days.

Here is the logic for categorizing the type of day it is. If you have theoretically priced a long calendar or a short Iron Condor on a big day – whether up or down, it is likely that the price of the product has moved near or outside of 1 standard deviation, even if the order was executed at the average price for that propagated.

The next day, if conditions turned into a boring day, either up or down, let’s say the futures didn’t even move more than a third into a standard deviation. On the extreme day you priced admission, even though you were filled halfway, you still overpaid for the schedule; or, sold more Theta as a bounty than is needed to protect the Iron Condor’s wingspan short, possibly increasing the risk of Gamma instability. Alternatively, if you’re pricing a directional spread on a big day, whether it’s a short vertical or a long vertical, you need continuation on the extreme days – after the big day where you executed the order, for the price to move.

If the price has already moved 68% (1 standard deviation) on a big day, moving up 2 or 3 standard deviations is not the problem. Here is the problem. Can the price action sustain a 2 or 3 standard deviation move day after day after the extreme day? It’s not an impossible event, just an infrequent event.

Price gaps for entry in extreme conditions put enormous pressure on your orders to outperform. It’s a hard way to negotiate. You are punishing trading account profits and losses unnecessarily. Psychologically and visually, continuously entering trades on big days forces you to look for “magical” chart patterns for another huge breakout or price breakdown. No, you will not go blind. However, you will cultivate a trading habit that must be broken, if you expect to have consistent results from online options trading.

So how do you calculate the X% change either up or down to differentiate a boring day from a normal day versus a great day?Use the first-month option implied volatility on the DJX, MNX and SPY – the mini versions of the Dow, Nasdaq and S&P 500 respectively, to categorize the day’s market ranges. For example, take the:

  • DJX: Say first month volatility is 27.38%, divide 27.38% by 16 = 1.71%. This is +/- 1.71% meaning that IV represents the collective expectation of market participants trading this commodity, expect the DJX to rise or fall 1.71% on the day. Your trading platform should allow you to add a column in the watch list called “% Change”. This is what we have just calculated. So a % change of less than +/- 1% is a boring day. A % change between +/- 1% and +/- 2% is a normal day, take the lower whole number of the calculation, in this case 1%; and, the upper whole number of the calculation, in this case 2%. A movement of +/- 2% would be a Big Day Up/Down for the DJX. Even though the DJX is the mini version of the Dow, because we are using a % calculation relative to an absolute number, the application of the meaning of +/-%Change remains valid for the Dow.
  • Repeat for MNX: say month before IV is 30.73%/16 = +/- 1.92%. Dull Day for MNX is when the percentage change is less than +/-1%. The normal day for MNX is when the percent change is between +/-1% and +/-2%. A %Change number greater than +/- 2% is a great day for MNX. The same +/-% change applies to the Nasdaq.
  • Repeat for SPY: month before IV is 31.25%/16 = +/- 1.95%. A lackluster day = % change below +/- 1%. A normal day = % change between +/- 1% and +/- 2%. And a Big Day = %Change greater than +/- 2%. The same +/-% variation applies to the S&P 500.

You can apply this calculation to the VIX or any optional product on which you have identified a trade.

Why divide the volatility of the first month by 16? As you know, volatility is expressed as an annualized number. So, to get the daily volatility number, we divide it by the square root of the number of trading days in a year, which is 256 (rounded). There is no trading on weekends and holidays, as prices cannot change on those days. Some years have more or less than 256 days, but using 256 is the norm. The square root of 256 = 16.

As part of your pre-market preparation, calculate on a spreadsheet the daily market ranges (Dull, Normal or Big) for the DJX, MNX, SPY and the VIX at a minimum. It’s not about picking a direction, because you won’t know if the market will open up/down and STAY there, even if the futures contracts show an up/down bias. The calculation gives you a measured gauge, once the market opens, to see if the day’s trading range is leaning towards a Dull, Normal or Big Day. Next, assess whether it makes sense to theoretically price a spread, whether it’s a timeframe, Iron Condor, vertical, etc. This saves you from looking for a price close to 1 standard deviation, so that your orders are executed on a big day. Doing this pre-market work determines whether you will fill orders or cut spending for profit; alternatively, reduce exposure to losses, when the market opens.

Statistically, there are more trades to value on dull days and normal days than on high days. Especially from mid-July to August, because many traders go on vacation. On dull and normal days, aggressively set the order 0.10 to 0.15 below the theoretical price for a debit spread; or, 0.10-0.15 above for a credit spread just means it takes 1-2 hours longer to fill. If your order is filled within 5 minutes, you have been lax in working hard for entry; cons, fill up in 1-2 hours. Diligence makes a material difference in the price-performance ratio of trade. By avoiding entries on big days, you are sure not to get in when most retail traders are looking for the price to be filled. A key factor in the consistency of your account P/L is the price at which you entered and exited. The discipline of staying consistent is to be filled within a sustainable range of the fair value of the spread for that particular trading day. Staying in online options trading requires as much sense for staying out of trades as it does for entering trades.

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