This Is Why You Don’t Sell Naked Options!
If you have been in the markets as long as I have, you know a couple of things. First, the unlikely occurs almost every day and second, the impossible happens at least once a month. The markets are a probability model. Forget earnings and new products. The option chain tells us all we need to know about the chances of an event occurring. Based on where the ATM ( At The Money) straddle is trading tells us about the chances of any event occurring before the front serial expires.
Folks that went home last Friday night short naked calls in the oil market learned that lesson in spades when the market opened Monday morning. Depending on how much of their portfolio they had invested in crude determined whether or not they were just nauseous on the opening Monday or whether they were physically ill. I have seen this movie so many times in my 43-years in the market that I can’t possible write about all of them in the space allowed.
In case you have been living in a cave, last Sunday, Iran decided they had had enough with the oil sanctions and the hardliners thought it was a good time to blow up Saudi Arabia’s production facilities. They launched some drones and rockets and they hit the mark destroying about 5% of the of the Saudi infrastructure. Boom! In ten seconds, the oil market was 15% higher. This time it was real, and the talking heads were predicting $80 oil in less than a month. When the equity markets opened Monday, small producers saw their stocks open up as much as 70% higher. It was time for The Duke Brothers to get in there and “Buy Wilson Buy” (a famous line from the movie Trading Places.)
Despite the move, veteran oil traders saw something that the guys on TV and small-time investors would never notice. In the U.S., Crude Oil is traded in monthly contracts that go out several years. The only contract that was higher was the expiring “spot” serial. The rest of the market was unchanged. This indicated that the big investors in the market not only felt that this was a panic move, but it was time for Wilson to start selling oil. The real risk was either owning spot oil that was unhedged or buying the suddenly overpriced equities. As the day went on and the shorts continued to bid up the price to cover their losses it became more evident that the near term price was going to collapse.
On Tuesday morning the shorts became the strong hands and the cash market swiftly moved south. Near the end of the trading day the spot market was actually lower than it was on Friday, but it did rally a little on profit taking to end slightly higher than it was on Friday’s close. None of this mattered to the naked call shorts. They were the ones bidding up the price on Monday to stop the pain. Price didn’t matter they just wanted out. They got out but the damage was done. Once again the folly of selling naked options was exposed. If you got caught in the mess, learn your lesson and move on. If you are a naked option seller but avoided this trap, it is only a matter of time until it happens to you. Do yourself a favor. Trade the Optionomics way. Sell spreads with limited risk and possible unlimited reward and this kind of catastrophe will never destroy your portfolio!
Ask Mr. Seifert
I am constantly asked questions about trading and how to exploit certain market factors to insure success. Each week I will answer one of those questions with a short paragraph which will cover the trading subject.
Question:
What is the VIX index and how is it calculated?
Answer: VIX is the ticker symbol for the CBOE’s volatility index. It shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options This volatility is meant to be forward looking and is calculated from both calls and puts and is a widely used measure of market risk and is often referred to as the “investor fear gauge”. The CBOE designed the VIX to create various volatility products. The VIX, however, was the first successful attempt at creating and implementing a volatility index. Introduced in 1993, it was originally a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, in 2004, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors’ expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility because of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.
The VIX is a computed index, much like the S&P 500 itself, although it is not derived based on stock prices. Instead, it uses the price of options on the S&P 500, and then 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, which the index tracks.
While there is not a way to directly trade the VIX, the CBOE does offer VIX options, which have a value based on VIX futures and not the VIX itself. Additionally, there are 24 other volatility exchange-traded products (ETPs) for the VIX, bringing the total number to 25.
The Wise Guy Report: The View From The Floor
Each week I talk about what I think the Wise Guys (floor traders) are up to with the Big Three commodity contracts: Gold (GC), Crude Oil (CL) and Long-Term Interest Rates (ZB). I also track the Market Edge (www.marketedge.com) ‘Market Posture’ which has a twenty-six year record of forecasting the intermediate-term direction of the stock market as measure by the DJIA with around 70% accuracy.
T-Notes
After making near-term lows last Friday the market rallied steadily on the thought the FED would cut rates this week. The FED did make another quarter of a percent cut but it was already built into the market and produced little price action. I think the market will continue to trade in a large congestion area at this level. I am happy to sit on the sidelines until there is some definitive price action.
Crude Oil
Bang! Zoom! these are the markets you live for. Over the weekend Iran decided it was a good time to blow up Saudi Arabia’s production facilities, so they launched some drones and missiles and took out about 5% of their capacity. The worldwide oil market went into complete panic and everything jumped about 15%. The talking heads from the Far East said that it was almost certain, given the economics that oil would hit $80 a barrel in the next two months. Fortunately, I was long oil from $56.65 and when the price hit $60.50, I took a nice winner and got flat. But when the shorts continued to race each other to puke out, it became obvious that this was a once in a decade time to sell and get the rebound. I sold at $61.80. You never sell the top or buy the bottom, but I felt safe based on what was happening at the COMEX. The deferred contracts hadn’t moved so even though I was underwater I felt secure. As it turned out the big investors were correct and on Tuesday, crude got hammered. I covered my short at $58.50 and got flat. That is the thing about blow offs that most retail investors don’t understand. You can make 90% of your money in 5% of the time. Even if I had been backwards to start the trade I could have recovered my losses on the blow off and still made money . We are now flat waiting for the next move.
Gold
Gold reacted strangely to the attack in Saudi Aribia. At first there was a big rally which is what you would expect on the fear that it generated, but when it became obvious that the rally in oil was a panic by the investors that had been caught short it collapsed. After making a blow off bottom at 1490 it rallied the rest of the week and finished slightly higher. The market still appears to be in a large congestion pattern and until we get a direction I will stay with my short position.
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The Big Three Commodities Contracts
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The Market Edge Market Posture
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The Market Edge ‘Market Posture’, which has been Bullish since the week ending 09/13/2019 (DJIA 27219.52) remains Bullish at this time.
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