Followers of my Trade Alert service have noticed some unusual activity during the last two days. Instead of recommending put spreads, I have started advising the purchase of outright puts.
Coming on top of big declines in the S&P 500 (SPY), you may have thought that I have lost my mind, if I hadn’t already done so a long time ago.
My kids would agree with you.
However, there is a method to my madness.
The truly brilliant aspect to the option spread strategy that I have been using for the past four years was that the positions had an embedded short volatility aspect to them.
While you were long volatility with your long leg, this was offset by the short volatility in your short leg.
This gave you a net volatility exposure of close to zero, a great thing to have during a time of secular declining volatility, as we have seen since 2012. Think of the first eight months of 2015, when index prices barely budged.
It also meant that you could achieve your maximum profit when the underlying stock remained unchanged, or moved only a few percent against you.
The nice thing about this low volatility was that it gave time to followers to get in and out of positions before large price changes occurred. Moves of only a few cents before you received trade alerts were common.
By focusing on front month options I also took maximum advantage of accelerated time decay going into each expiration. It was like having a rich uncle write you a check every day.
The low volatility delivered only small changes in the value of your portfolio from the day-to-day movements in the market, tiny enough for the novice investor to live with.
This is what enabled me to produce huge, outsized double digit returns while most other managers were sucking wind.
Since August 24, we have been in a completely different world. The long-term trend in volatility isn’t falling anymore. It has been rising.
What this brought to my trading book was a series of stop outs on options spread positions, whether they were call spreads or put spreads, and painful losses.
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