I often stand looking out over the back of my property, have a quite cigar and contemplate the market. Over the past few months, I’ve contemplated our service and how changes in market conditions have affected our tradings strategies… and accordingly, our subscribers. We’ve seen volatility at higher than historical averages. Despite the conditions, we’ve maintained performance, however we’ve learned a few things that will result in some changes to our service, which I’ll cover at the end.
Elevated Volatility Means Elevated Costs
Since concerns around COVID first cause a market crash in Feb 2020, we’ve seen elevated levels of volatility which are now settling back to longer term average levels. As you can see in this chart below, the 12-month average of volatility, as measured by the VIX, spiked in 2020 and has remained above an average level of 20, which is higher than any average we’ve seen since 2013. Indeed, this elevated level of the VIX is higher than what I’ve experienced during my 25 years in the market, except for a couple of years during the GFC period.
These higher levels of Implied Volatility (IV) have been a result of the uncertainty from the pandemic conditions and government’s response to try and manage the economy. Throughout 2020 and 2021 to date, it has been anyone’s guess as to how world economies would react to the almost complete closure of certain sectors, the surges in demand in others plus government stimulus and the Fed’s money printing.
In conditions such as this, market makers have broadened spreads and inflated IV to reduce their own risk. Market makers are ensuring that they receive a premium for accepting trades, particularly in less liquid markets or smaller equities. This increase in IV, in-turn increases the price of options. Quite simply market makers are asking option traders to pay a greater premium due to the uncertainty they perceive in overall market conditions.
Changes In Our Mix of Option Strategies
This increase in option prices has led us to adjust the types of trades we use in our portfolio. We’ve had to do this to stay within the stated risk parameters for our subscribers. Several spreads that are our preferred options strategies have been difficult to set up at an acceptable cost.
Butterfly Spreads or Debit Spreads are preferred for our Impulse Strategy Portfolio, while Long Strangles are the mainstay of our Volatility Strategy portfolio. If we consider all the trades completed so far, chart below show that those strategies made up 87% of our trades in 2018, however in 2021 year to date, they make up just 32%.
The same chart also shows that the reduction in these strategies has been offset by an increase in our use of Long Calls.
Less Opportunity, Less Activity
Where the market conditions have been unfavourable for some of our strategies, we’ve had to be very selective about the trades that we do select, and this has seen a reduction in our level of activity. Our EWO Volatility Strategy has been impacted more than anything else as Strangles became expensive relative to potential returns. The chart below shows that since February months we’ve completed less trades than half the trades we’d usually expect to in that period.
Indecisive Markets Extended Time in Trades
Another result of the indecision that we saw in mid 2020 and early 2021 was markets tracking sideways. Our strategies require that markets move and with the lack of direction after the initial COVID crash and “v” recovery, many of our trades had to be rolled out or adjusted to achieve targets. This meant that we saw a large increase in the time taken to complete trades. As 2021 has proceeded, the market has gained direction and volatility has reduced. Accordingly, we are seeing a return to average trade durations that we have seen historically.
So, What Have We Learned?
As I mentioned at the outset, our overall performance has been good despite these head winds. However, we also learned a few things about how trading style can impact subscribers to our service… particularly those who are new to trading options.
- Having access to multiple strategies is Important
Each individual trading strategy will perform best in certain market conditions. Given that market conditions cycle as markets move from consolidating to trending, and from tops to bottoms, there will be times when a particular trading strategy doesn’t identify opportunities or perform as strongly. Consequently, we’ll be working harder to ensure that members have both our strategies so that when one is less active, they can take advantage of the other.
- Long trade duration & adjustments are hard for small accounts
Even though in many, many trades we’ve been successful in adjusting losing positions back to break even or significant profitability, I must acknowledge that this process ties up capital in open positions. We’ve noted that this is difficult for subscribers with smaller accounts who may run out of capital to take new trades while waiting for losing positions to be adjusted. Despite the fact that the overall result is that the capital is recovered, waiting through long trades and missing out on others due to lack of capital is frustrating for smaller account holders. Therefore, we’re looking to improve this experience by adjusting our risk management approach. We’re running numbers and expect to have an update on this in due course.
- Adding a non-directional strategy will benefit our members
Over the past couple of years, with markets often range-bound with uncertainty as discussed above, we’ve concluded that adding a strategy that performs in sideways conditions will be good for our members. This should help increase activity and also offset periods when directional strategies don’t perform. As you know, I’ve been exploring a strategy with Calendar spreads for this purpose for some time now.
So in line with the above, we’ve embarked upon several changes to our service that we hope will make a big difference to the experience for all of our members. I will be excited to officially let you know about these announcements in the not too distant future..
Take care everybody,
Chief Trading Strategist
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