VTS Community,

Wow, amazing response to yesterdays blog.  I was a busy guy reading through everyone’s emerging market EEM options ideas.  I responded to as many as I could and I’ll continue today and tomorrow so I apologize if you didn’t hear back from me yet.  To be honest I just wasn’t expecting that but good stuff!  It was so popular I’m going to try to make a video on this topic as well for a general audience.

So before I get into some of the ideas people had I do want to be clear, there are no right and wrong answers here.  I have my own style, rules, indicators that I use and I’ve been very successful at this over the years but there are more ways than just one to make money.  What matters most is that it works for you.

Long Calls

The most popular response by far.  It seems many of you are contrarians and feel EEM is set for a recovery, and a long call does seem to make some sense if that’s your trade thesis.  However, there are 3 problems that I see with long calls:

1)  They are completely directional.  Now there’s nothing wrong with taking a directional bet, I do it myself quite often.  If this was it’s only disadvantage then no big deal, but it’s not.

2)  Not only do you have to be right on the direction, but you have to get the timing right as well.  Call options are theta negative which means the trade will be bleeding capital for every day that nothing happens.  Even if you’re right and EEM does recover, if it takes a few weeks before that happens then you can still be stopped out for a loss.

3)  Long calls are Vega positive trades meaning they profit if volatility rises.  As I showed in the chart though, EEM volatility right now is in its upper half of values for the past year, and in its upper quarter for the past two years.  The odds favor volatility declining and that’s going to hurt the call.

In this case, and in most cases with respect to long calls, you’re probably better off just buying the underlying stock.  If it goes up you’ll make your profit, but if it stays flat for a while you won’t be bleeding any capital and you also don’t have to worry about volatility declining.  And if it’s leverage you want, most brokers do allow for that and then of course there are leveraged emerging market ETFs.  They do have their own set of risks, but overall I think long stock is better than a long call.

 

Long Straddles

Quite a few responses for long straddles as well which is good to see.  People are starting to look for ways to avoid being directional which is something that only options trading allows.  The long straddle is a good way to capitalize on movement in either direction because it’s both a long call and long put opened simultaneously so it solves the first problem of directionality that the long call only suffered from.  However, it still has the other two problems.

Long Straddles are both theta negative and vega positive.  We can’t fix the theta issue because all long options will be negative, but the vega we can control by only buying long straddles in low volatility environments.  As an example, a long straddle would work much better right here on the S&P 500.  I feel it’s about 50/50 on whether stocks continue higher or are due for a pullback, but S&P volatility is low enough that a long straddle would make sense.  But on EEM, not right now.

 

Calendars  (full explanation coming next time we open one)

Directionless, check.  Theta positive, check.  But still vega negative and quite sensitive at that.  Calendars can get stopped out by just volatility decreasing so I typically only do these when volatility is in it’s lower range already, somewhere around the 0-20% of its volatility readings.

* We haven’t done any calendars yet because volatility has been all over the place this year, but if this strategy was running for the past few years we would have done many.  Calendars are great for low volatility and saw a lot of action for me personally in 2016/17.

 

Bull Put Spread

Yesterday morning when I sent the email this was my trade of choice.  Right now though, the EEM has bounced pretty substantially since then so it’s not as attractive a trade right at this moment.  But the way I would have set it up yesterday  (short 40 put and long 38 put)  it was ideal.

It’s directional, hoping for a short-term recovery in EEM, but it’s also theta positive and vega negative meaning if the price did nothing we could still profit.  Bull Put Spreads and Bear Call Spreads are very good trades and I use them often.  They allow us to make a directional play, but potentially still make a profit if we are wrong.  Again only options trading allows for this level of margin for error.

* Surprisingly there were only about 5 people that emailed with bearish trades, but all of them were for bear call spreads.  They are the same as bull put spreads just the opposite so for anyone thinking EEM will continue to crash this would be the best trade to go with.  For me personally I’d play neutral or recovery, but not for me to say.  Maybe you think EEM has further to fall…

 

Iron Condors / Iron Butterflies

For anyone looking for a directionless trade on EEM, these are the best choices for trade selection in my opinion.  Now it’s no secret Iron Condors are my favorite options spread and for good reason.

–  Directionless always makes things easier, especially since our other investing strategies  (Balanced and Volatility)  are trend following.  The more neutral and uncorrelated trades I can add to my portfolio the better the diversification will be.

–  Theta positive means we now get paid when nothing happens, and as we know that is the default position of markets.  Humans are conditioned to think something really good or really terrible is just around the corner, but the majority of the time markets just chop around sideways not really doing anything.

–  Vega negative.  The natural state of volatility is to be lower and we can see that by comparing the mean median and mode of the VIX index.  Long-term the values are approximately mean 19, median 16, mode 13.  Although volatility does spike making the average reading higher, lower values are far more common so it maximizes our probability to remain vega negative whenever possible.

However, the reason I didn’t open an Iron Condor on the EEM yesterday is that the downtrend has been so strong and it had not yet seen any recovery.  I don’t like to open my condors in situations like that because if there is a bounce, they can be very strong and put the Iron Condor in jeopardy almost immediately.  There’s nothing more frustrating than having an Iron Condor stopped out in 2-3 days so I tend to wait until the price shows the first sign of stabilizing first, then jump in.

When I sent the email yesterday that hadn’t happened yet.  It’s starting to and an Iron Condor is a far better choice right now than it was in early trading yesterday.  Still not quite there so let’s see what tomorrow looks like.

 

That’s the great thing about options trading is there are so many options  (pun intended)  and if you miss a trade window, wait a day and more great setups present themselves.

 

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