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

Contrast these 2 days.  29 Sep, 2008: Dow down -7.50%, Nasdaq down -10.06% and S&P 500 down -9.63%.  Versus 13 Nov, 2008: Dow up +6.25%, Nasdaq up +6.11% and S&P 500 up +6.47%. 

Many retail option traders would have rushed to get their spreads filled on such big days, either to get short or long.  The discerning few, mindful that a +/- X% change in equities, is a day to avoid entry; instead, it is a signal to scale-off profits or reduce exposure, would have profited or limited losses on such days.

Here’s the logic for categorizing what type of day it is. If you theoretically priced a long Calendar or a short Iron Condor on a Big Day – be it up or down, it is likely the product’s price has moved near or outside 1 Standard Deviation, even if the order was filled at mid-price for that spread.

The following day, if conditions turned into a Dull Day be it up or down, let’s say the Futures did not even move more than a third within 1 Standard Deviation.  On the extreme day when you priced the entry, even though you were filled at mid-price, you still overpaid for the Calendar; or, sold more Theta as premium than is necessary to protect the wing span of the short Iron Condor, possibly increasing the risk of Gamma instability.  Alternatively, if you priced a directional spread on a Big Day, be it a Short Vertical or a Long Vertical you need a continuation in extreme days – after the Big Day that you filled the order on, for price to move.

If price has already moved 68% (1 Standard Deviation) on a Big Day, moving towards 2 or 3 Standard Deviations is not the problem. Here’s 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 occurrence.

Pricing spreads for entry under extreme conditions, places huge pressure on your orders to outperform.  That’s a tough way to trade.  You are punishing the Profit and Loss of the trading account unnecessarily.  Psychologically and visually, continually entering trades on Big Days makes you search for  “magical” chart patterns for another huge breakout or breakdown in price.  No, you won’t go blind.  Though, you will cultivate a trading habit that must be broken, if you plan to have consistent results with online options trading.

So, how do you work out the X% change, be it up or down to differentiate a Dull Day, from a Normal Day versus a Big Day?  Use the implied volatility of the front month’s options on the DJX, MNX and SPY – the mini versions of the Dow, Nasdaq and S&P 500 respectively, to categorize the market ranges of the day. For example, take the:

  • DJX: let’s say, the front month volatility is 27.38%, divide 27.38% by 16 = 1.71%. That’s +/- 1.71%, meaning IV representing the collective expectations of market participants trading that product, expect the DJX to move 1.71% up or down for that day. Your trading platform should allow you to add a column in the watch list called “%Change”.  That’s what we’ve just calculated.  So, a %Change below +/- 1% is a Dull Day.  A %Change between +/- 1% to +/- 2% is a Normal Day, take the lower whole digit of the calculation, in this case 1%; and, the higher whole digit of the calculation, in this case 2%.  A move 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 versus an absolute number, applying the meaning of +/- %Change remains valid for the Dow.
  • Repeat for the MNX: say the front month IV is 30.73%/16 = +/- 1.92%.  Dull Day for the MNX is where the %Change is below +/-1%. Normal Day for the MNX is where the %Change is between +/-1% to +/-2%. A %Change number bigger than +/- 2% is a Big Day for the MNX.  Same +/- %Change applies to the Nasdaq.
  • Repeat for the SPY: front month IV is 31.25%/16 = +/- 1.95%.  A Dull Day = %Change below +/- 1%.  A Normal Day = %Change between +/- 1% to +/- 2%.  And a Big Day = %Change bigger than +/- 2%.  Same +/- %Change applies to the S&P 500.

You can apply this calculation to the VIX, or any optionable product that you have identified a trade on.

Why divide the front month’s volatility 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 off).  There is no trading on weekends and exchange holidays, because prices cannot change on these days.  There are some years with 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 market ranges of the day (Dull, Normal or Big) for the DJX, MNX, SPY and the VIX at minimum. This is not to pick direction, as you will not know if the market will open to the upside/downside and STAY there, even if futures indicate an upside/downside bias. The calculation gives you a measured gauge, once the market opens to see if the trading range of the day is leaning towards a Dull, Normal or Big Day. Then, assess if it makes sense to theoretically price a spread, be it a Calendar, Iron Condor, Vertical, etc.  This guards you from chasing price near 1 Standard Deviation, to get your orders filled on a Big Day.  Doing this pre-market work, determines if you will be filling orders or scaling off for profit; alternatively, reducing exposure to losses, when the market opens.

Statistically, there are more trades to price on Dull Days and Normal Days than Big Days. Especially during mid-July till August, as many floor traders go on leave.  On Dull and Normal Days aggressively pricing the order 0.10-0.15 below Theoretical Price for a debit spread; or, 0.10-0.15 above for a credit spread just means it takes 1-2 hours more to get filled.  If your order is filled within 5 minutes, you were lax in working the entry hard; versus, getting filled in 1-2 hours.  Diligence does make a material difference in the trade’s price-performance.  In avoiding entries on Big Days, you are not missing out on not getting in, when most retail traders are chasing price to get filled.  One key factor of the consistency in your account’s P/L is the price you got in and out of.  The discipline of staying consistent is to get filled within a sustainable range of the spread’s fair value for that particular trading day.  Remaining in the business of online options trading requires as much sense to stay out of trades, as it does to get in to trades.