One of the most common ways that options traders lose money is a sudden, unexpected drop in historic or implied volatility. When this happens, strategies that once made money start losing money. And at the same time, risk from unforeseen “Black Swan” events can go way up, with much less premium to cushion potential losses.
A collapse in volatility is a legitimate way to lose money. It falls into an entirely different category from sloppy trading, ignoring risk controls and losses that can be eliminated by exercising disciplined trading practices.
Since a volatility collapse cannot be prevented, the best medicine is preparation. The goal should be to minimize losses and not throw good money after bad when volatility changes direction.
An informal checklist of strategy returns vs. current market VIX levels provides a clear way of knowing when to back off, or conversely, knowing when to add to a position. Here is the list we use to determine the active strategies in the SpreadHunter portfolio:
- VIX Below 14: Long Butterflies, Condors on Low Volatility Stocks
- VIX Above 14: Short Butterfly Spreads and Short Timespreads on High Volatility Stocks
- VIX Above 18: Tactical Directional Trades using Vertical Spreads
- VIX Above 21: Tactical Trades to Capture Drop in Implied Volatility
The checklist does not have to represent hard and fast rules. For example, it may be a good idea to do trades that do not fit the criteria in very small quantity. The information gained from small, exploratory trades is often worth far more than the losses incurred. Over time the checklist will change and evolve based on hard data.
A quote by options trader Nate Nesnick from the 1970s sums up the best approach to dealing with this kind of ambiguity:
When in doubt, do some.
-David A. Janello, PhD, CFA