After last week’s crazy ride in the markets, chances are you have quite a few questions. While I wish I could answer the magic $64,000 question – when (and how) will all the bad news end? – let’s confine ourselves to a few smaller, but no less burning questions. Why is this crisis coming to a head now?
A million reasons, of course, all stemming from the sub-prime mortgage market meltdown that began more than a year ago and culminating (so far) in the collapse of some of Wall Street’s most august investment banks and insurers.
But whenever there’s trouble brewing, it’s a little uncanny how it tends to bust wide open in September and October, more often than in other months. (After all, this crisis didn’t happen overnight – it could’ve come to a head at almost any time.)
True, October is earnings season once again, so maybe accountants’ facing the grim reality of an ugly balance sheet partly explains the surges in those two months. In the brokerage industry, we have a saying “Sell in May, go away” to account for the slowness in trading we usually see in the summertime. The January effect – the fact that stock markets tend to experience a bounce to the upside in January – is another example of cyclicality that, rationally or not, often holds true.
However you explain it, 1929, 1987, and 2008 – if a market’s poised to act crazily, chances are it’ll do so during Back-to-School season. Keep this in mind if you plan on wading in now.
(Incidentally, Mark Hulbert of MarketWatch took a crack at analyzing the seasonality effect on investing in 2005.)
What else should I be watching out for, trading-wise?
Other than losing your mind with worry and trading with too much emotion, beware the volatility crunch. I was reading a research report by industry analyst Rich Repetto at Sandler O'Neill + Partners. In a buy rating for Interactive Brokers (IBKR), he offers some interesting general stats on the options marketplace right now:
“Key drivers of IBKR earnings are at, or near, record levels in 3Q08. Industry option volumes (both in September and 3Q08 to date) are running at record levels, volatility (as measured by the CBOE's VIX) is surging (above 30% for the last 3 days) and 3Q08 to date is the second highest level in 3-4 years, and the ratio of actual to implied volatility is running at 1.14x (1.44x in September to date).”
In a nutshell, what that last line tells you is this: implied volatility on options is incredibly juiced up right, so much so that it’s outpacing actual price movement in the markets. Depending on what side of the market you’re on, this phenomenon could or could not have been beneficial to your current option position. Going forward, the relationship between implied and actual volatilities may not hold true, and you may run afoul of a volatility crunch on long (or bought) option positions. (I blogged about the volatility crunch phenomenon not too long ago.) Some of you may’ve experienced a little crunch first-hand last Friday upon expiration, so it’s worth reading up on the concept.
Bottom line: when trading in these volatile times, beware that options traders need to have to keep one eye on volatility as they are trying to pick direction.
Here’s another post I ran as part of the vol-crunch series that provides some good pointers for when IVs are near their highs and events are coming thick and fast. That one should get a few other questions cookin’ in your brain, like: why is it often sweeter, profit-wise, to be right on long puts than right on long calls? why not buy the stock, if it’s cheap enough? And why not consider long spreads for your OTM plays?
Have any trading ideas to consider in this environment?
I did a video spot on ONN.TV’s Options Cocktail last Friday outlining a few trading ideas that you might consider. And I’m glad to bounce ideas or questions around with you on this blog – comment away! I’m not traveling this week, and I’d be more than happy to help you sort these markets out.
Regards,
Brian (OG)
[image: IMG_0092 by aymlis on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.
