The Story of an Arrogant VIX Trade
When I think about times where I have seen new option traders lose a lot of money, there are a few that come specifically to mind. Early in the process, we work very hard to teach our option mentoring students proper risk management. Some of it is simple; it doesn’t take long to show someone how throwing money at a problem is not a good way to solve the problem. However, some will drive my option mentoring student’s nuts. One of the hardest to teach is killing a trade that is only modestly a loser but has changed assumptions in the trade.
In 2011, one of the trades that I personally got beat on was the Congress trade. While I never doubt how silly congress can be, I generally assume that in the end they will get the minimum done to succeed (like a D student). Thus, as IV rallied into the end of July, I began to slowly build a short position in VIX. All the way to the day when the deal got done. It was then my assumption that IV would cave in. That day is in yellow...IV did not cave in:
Livevol (r) www.livevol.com
It was then my assumption that traders were waiting to see if congress would pass the budget deal. It passed the house and the senate, but didn’t cave in (I circled the two times I thought the VIX should have dropped,). I should have known something was up, but I was arrogant. I thought, well, they are just waiting for the weekend or something. We all know what happened next; the US got downgraded, the financial markets blew up on Euro crisis, and the VIX went to 48. On a personal note, I got burned badly.
What was my big mistake? The big mistake I made was not recognizing that my assumptions were wrong. I assumed that when a budget deal got done, the VIX would fall. It did, and the VIX did not. I should have killed my trade. Then both houses passed the bill, and my assumption was wrong again. I should have killed my trade. Well, 3 strikes and I am out, because the VIX blew up.
Now, here we are again. The VIX has been rallying on what we thought was the Fed meeting this week (read our thoughts here):
Livevol (r) www.livevol.com
The VIX didn’t drop so assumption 1, us wrong. We also have thought it could be the Spanish bond auction and Non-Farms on Friday. However, Andrew and I are not going to wait around to find out if we are right. At this point, our smart assumption has turned into a big gamble with the Cash-Sep spread tight, and a couple of big economic numbers this week... The VIX rallied, but not because of Jackson Hole, and possibly not because of US economic numbers. We appear not to know something and are killing our VIX trade (we are keeping a few other short vol positions with more edge).
Lesson learned, we are not going to be arrogant traders this time. We may not be happy with our decision in the short term (who knows), but we are certainly going to be happy over the long haul trading this way, and so will you. Thus, if you make a trade under one assumption, even if you aren’t losing much (like us), kill the trade, it will pay off.
Gold classes are filling up fast October is already mostly full. If you are interested in learning how to trade options this is a must.
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