Market conditions can have an effect on trading the Optionomics ‘Traders’ option selections. During normal times, the market has good volatility based on VIX which would be in the 20 to 30 range. In addition, it would not be in a prolonged upward or downward trend, often referred to as a ‘melt up’ or ‘melt down’. While the ‘Traders’ selections will perform in any market environment, normal market conditions are preferable.
The ‘Traders’ selections are based on two components: The mathematical certainty of the time decay inherent in options premiums (theta) and the price direction of the underlying stock.
VIX, which is a measurement of the market’s volatility is a key piece of the puzzle. When VIX is low, premiums in the weekly options are usually small. Since a major part of the ‘Traders’ strategies is selling credit spreads (premium), low levels of volatility (small premiums) can have a limiting effect on returns.
The second part of the strategy, projecting the underlying stock’s price direction is based on the Market Edge ‘Opinions’. which are either Long, Neutral or Avoid. These computer generated opinions have been the backbone of the Market Edge web site (www.marketedge.com) since 1992 and consistently have produced a better than 70% accuracy rate with the winners outperforming the losers by a 3:1 ratio. Since the bulk of the ‘Traders’ selections have a 2-5 day life span, the time periods used in the algorithms have been shortened to identify very short-term price moves.
When the market gets into an extreme condition, either a ‘melt up’ or ‘melt down’ projecting price direction can get tricky. A melt up occurs when the major averages continue to post new highs over an extended period without the hint of a correction. Sentiment is usually very bullish while everything is great and there isn’t a ‘Bear’ in site. Volatility (VIX) during these moves can drop to the low teens and on rare occasions can approach single digits as option premiums dry up. The opposite scenario occurs when the market is in a ‘melt down’ which is an extended downturn. Sentiment is very bearish, everything is terrible, and you can’t find a Bull on Wall Street. In this situation, VIX can edge towards 40 as premiums, especially in puts expand. (See below for a description on VIX). While premiums are high which is good, the computer will often go against the trend by fading the overbought or oversold condition which is the correct strategy but can have mixed results.
The good news is that melt ups and melt downs don’t occur very often nor do they last for very long. The market is usually in a normal mode, which enables the Optionomics ’Traders’ selections to produce good results in any kind of market environment. The ‘Traders’ selections result in winning transactions in four of five possible outcomes: The stock has a big move in the desired direction, The stock has a small move in the desired direction, the stock remains unchanged or the stock has a small adverse move. All of these scenarios will result in a winning trade. It is only when the underlying stock has a significant move in the wrong direction does the trade result in a loss.
Position Size: The win percentage for all of the ‘Traders’ strategies averages around 61%. The main difference between the strategies is the maximum dollar risk per spread. Blow Offs can have a maximum risk of $520 while a Bearish or Bullish Vertical Credit Spread may only have a maximum risk of only $130. The number of spreads that you position is up to you. Our published results are based on one spread per play. If you would like to balance things out, a good tactic would be to commit the same amount of risk capital per play. In the above example that would equate to one Blow Off trade ($520) and four Bearish Vertical Credit spreads ($520).
Exit Strategies: It is recommended that all of the ‘Traders’ selections be closed at or near Friday’s closing prices. However, there are a few exemptions. If a position doubles in price during the week, it is recommended that the profit be booked, and the position closed. This can occur with the Blow Offs, One Day Wonder, Earnings and SPY trades. In addition, if a Bull-Bear Credit spread drops to $0.05 or less prior to expiration, it is recommended that the trade be closed.
What Is VIX: VIX is the ticker symbol for the CBOE’s volatility index. VIX is a computed index based on the price of options on the S&P 500. It estimates how volatile those options will be between the current date and the option’s expiration date. The CBOE combines the price of multiple options and derives an aggregate value of volatility. VIX values greater than 30 are generally associated with a large amount of volatility as ‘Investors’ fear or uncertainty results in bidding up the price of puts. Values below 15 generally correspond to less stressful, complacent times in the markets resulting in a decline in option premiums.
Losing Streaks: If a trading system has a 50% win rate you can expect seven consecutive losing trades with a 99% confidence rate. Another way of stating this is that in a group of 100 trades, if you have a 50% win rate, you can expect losing runs of seven in a row, 1% of the time. As of the week ending 04/03/20, the Optionomics’ ‘Traders’ selections (286 trades) have experienced a 61% win rate since inception on 01/04/19. With a 60% win rate, you can expect losing runs of six in a row, 1% of the time. It sounds like a small percentage but rest assured it will occur. That is why you need risk capital when employing this and every other option trading strategy.