Last week I heard a live presentation by a successful hedge fund manager on the topic “Today’s Markets and How To Trade and Invest In Them”. He started with his assessment of the state of today’s markets. The first phenomenon he discussed was unprecedentedly high volatility. Although not an options-centric trader he actually showed a graph of the VIX to support his point. Not only, he said, was the VIX at historically high levels but it had remained at those levels for longer than in previous times of high volatility. The second phenomenon he discussed was the breakdown of certain established relationships between prices. His first case in point was the negative relationship between the stock market and the price of oil. Many professionals had traded on this relationship only to see it reverse to a positive relationship after July 2008. He continued on to discuss several other breakdowns of hitherto established relationships.

Eventually he arrived at his recommendations. He recommended buy-and-hold investors stay out of the market. No surprise there. Buy and hold is broken, at least in the near term. However, his recommendations for traders completely took me back. He recommended they stay out as well. The breakdown of established relationships, he argued, meant that the markets were too uncertain to trade in. If one did trade, use smaller positions than usual. I agreed with his analysis but not with his conclusions. On that basis, here is my trading plan for these times,

First, going back to basic principles, the corollary to ‘buy low, sell high’ is ‘sell high, buy low’. If volatility is high, let’s sell it. Second, if established relationships have broken down or are in a state of flux then don’t try and guess market direction, trade in a direction-neutral manner. What does this amount to in practice?

I sell stock index and stock options with the intention of either buying them back after some time decay or, my preferred route, letting them expire worthless. The simplest position that would implement my objective of selling volatility would be to sell a put or a call that is sufficiently out of the money to be ‘sufficiently likely’ to expire worthless. What determines what is ‘sufficiently likely’? My risk preferences. For example, I may be willing to accept a 5% risk of the option that I sell not expiring worthless. Other investors will have different risk preferences. Also, since risk increases the longer I hold a position, I will choose options from the nearest expiration month. SPX monthlies provide an instrument that is sufficiently liquid to get good spreads and is not subject to the such shocks as earnings announcements that affect individual stock prices. According to my options trading software the March call option that is sufficiently close to my desired 5% probability of expiring worthless is the 795 strike. Assume the bid is shown as $1.85. Similarly, the March put with a 5% probability of expiring worthless is the 585 strike, which is listed at $2.70. While either of these achieves my objective of selling volatility, they are not the best trade that I perceive. If the market does go above 795 my potential loss is infinite. So I will purchase a higher priced call in the same series to cap my loss. The purpose here is insurance. Typically, I will buy a call one strike further out than the call that I have sold. In this case that is the 800 call which costs, we assume, $0.80. This caps my upside loss at the difference between the strikes ($5) minus the premium taken in (1.85-0.80 = $1.05), or $3.95 per share. This is $395 per contract. Likewise, on the downside, if the market goes below 585 my potential loss is huge so I buy insurance by purchasing a 580 put for an assumed price of $2.60, limiting my downside capital at risk to $490 (100*(585 – 580 + 0.10)). If I sold the call spread the money in my account increases by the amount that I sold it for. However, if my account is subject to simple margin my buying power goes down by the maximum amount at risk, $395. However, selling the call spread is not the best trade I can do. If I also sell the put spread I receive an additional $10. Now my broker is one of the enlightened option brokers. They do not assess me margin on both sides of this trade since, by construction, only one side can expire in the money. In fact, they subtract the $10 taken in and reduce the buying power reduction to $385. In other words, the put spread is free in terms of its margin cost. As a result, whenever I decide that a call credit spread is a good strategy, I should also devise a desirable put spread as the margin cost is nothing.

I am now selling an iron condor, but I didn’t set out to do this. Rather, I backed into it. My objective was to sell volatility: a naked option. However, the risk of the price going outside the strike (the option market equivalent of being pooped on by a black swan) made the insurance provided by a spread desirable. At that point, margin rules made it costless, in buying power terms, to bring in more income by selling both a credit spread and a debit spread on the same option series. Thus, my strategy for volatile times doesn’t involve staying out of the market, or reducing my positions. Rather, I choose a different strategy. One that sells what is expensive (volatility) and doesn’t depend on a directional bet. I trust the model that says the probabilities are 5%. One in every 20 months the price will go outside the short strike. At that point I must have an adjustment strategy. Although rarely needed (about once in every two years) that adjustment strategy is so important I will cover it in detail in a future article. I also assumed my account was subject to simple margin. Different rules apply to accounts subject to portfolio or SPAN margin. I will cover these in future articles.


Andrew Chalk is a private investor based in Plano Texas. He has a Ph.D. in Economics from Washington University, St. Louis, USA and has taught in the Finance Department at Southern Methodist University in Dallas, TX. He has published in numerous professionally refereed academic journals.