By: Steve Smith
There’s a well-worn saying in options trading that “the trend is your friend until the bend at the end.” Depending on your outlook, this either means that everything is fine until it isn’t, or that you should go with the flow and be prepared to reverse course.
The most obvious change recently has been the pick-up in volatility, which I think will persist. For options trading, this means you should look at buying rather than selling, to take advantage of the larger price swings.
Indeed, yesterday was another wild ride for stocks. In the thirty minutes following the FOMC minutes release, the Dow rose 158 points, only to fall 470 points into the close. Nobody knows when or how or why stocks will return to a period of small changes, but it’s very clear what sort of regime we’re in today.
Michael Batnick provides a nice analysis showing how past shifts in price patterns have led to a more persistent change in trends.
The past 12 months are a perfect sample to support Mandelbrot’s claim that “large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.”
Using rolling 30-day periods, from January 2017 through January 2018, there were 120 readings where the S&P 500 did not have a daily change of greater or less than 1%. To put into context how quiet last year was, from 2000-2016, there were only 59 readings where the S&P 500 did not rise or fall by 1% over the previous 30 days.
Small changes were followed by small changes, until they weren’t. The S&P 500 went 94 days without closing up or down 1%, but in the last 17 days, it has done this 10 times.
Another way of saying large changes follow large changes is that volatility tends to cluster. For example, look below at the 25 best (green) and 25 worst days (red) since 1970. What you’ll notice is that the red and the green tend to happen very close to one another. Furthermore, every single one of these 50 readings has occurred in a period of above average volatility. The average 30-day standard deviation since 1970 is 0.92%. The average 30-day standard deviation of the 50 most extreme days is 3.2%.
It seems clear we are entering a higher volatility environment. What remains to be seen is whether the decline in stock indices is the ‘bend in the end’ of the bull market.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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