If you're feeling like a good friend just returned from a long trip abroad, you aren't alone!
Volatility with a capital "V" hit global equity markets in September and there's every reason to believe it could linger - at least in the near term.
After a historically quiet period in July/August 2016, equity markets finally picked up speed at the end of the Labor Day week as investors appeared to react to various comments made by members of the US Federal Reserve.
The sudden appearance of volatility is even more intriguing given that many broad equity indexes in the United States had recently hit all-time highs (Dow Jones Industrial Average, S&P 500, and Nasdaq).
It's possible that uncertainty hit the markets because investors are anticipating an adjustment in policy by central bankers. The surge in volatility may also be related to the upcoming US presidential election - or even the planned referendum in Italy.
It's also entirely possible that the uptick in volatility is due to a story that hasn’t fully materialized in mainstream media.
Regardless of the exact reason, it's important that traders closely monitor the risks deployed in their portfolios and adjust accordingly if current market conditions translate to an unacceptable level of exposure.
Sizing trades correctly is one important aspect of maintaining an optimal portfolio, and a recent episode of Best Practices underscores some important concepts to keep in mind when sizing your trades.
On the show, hosts Tom Sosnoff and Tony Battista walk viewers through some examples that help highlight why trade size is so important.
Looking at a simple strategy that involved selling one standard deviation puts and managing the positions at 50% of the initial credit received, Tom and Tony illustrate how any deviation from the appropriate trade size can adversely affect the entire strategy.
The graphic below shows 5 trades made consecutively that all received a $2.00 credit. However, the third trade size was 3 times larger than any of the other four. As illustrated in the slide, an adverse move on that single trade drastically affects the overall returns of the position:
Despite a win rate of 80% (4 of 5), the strategy deployed in this example resulted in a net loss because of the outsized trade #3. As you’ll see in the episode, Tom and Tony go on to illustrate that if trade #3 was sized the same as the other four trades, than the net profit from this strategy would have been positive ($200).
Another concept explored on the show indicates that sizing down when Implied Volatility Rank (IVR) is high can also be an advisable approach. This makes sense because environments of high volatility are generally susceptible to larger market moves. This was discussed in greater detail on a recent episode of Options Jive.
The above information is timely because if the current increase in volatility persists, it’s critical that traders size their positions accordingly. When selling premium in a high-risk market, one must have an adequate level of capital to either sustain losses and/or potentially sell more as volatility goes up further.
Appropriate position sizing is of course nothing new to long-time tastytraders - as noted in “The Tenets of tastytrade.” However, reinforcement of this key concept is of great importance - especially when market conditions shift abruptly.
If you have any questions on the current environment and sizing your trades appropriately we hope you’ll follow up with at firstname.lastname@example.org or leave a comment below.
Thanks for reading!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.