Many of our members understand the best times to trade options (i.e., higher IV setups when option premiums are expensive). But should we avoid trading during other market situations? I'll walk through the four general market situations I avoid aggressively trading in and explain why each type requires that you either sit on the sidelines or dramatically scale back your position size.
1. Buyouts and Mergers
- Buyouts and mergers can create huge price fluctuations in the underlying stock.
- The cause for concern is not necessarily the initial jump, but what happens when the deal falls through or gets held up?
- Most traders try to leverage the period where the stock trades sideways after the initial jump in price.
- This brings two problems:
- 1) The options market knows this as well — as soon as a buyout or merger is announced and the stock price jumps, IV all but disappears.
- 2) The deal may not go through, or it could completely change. If you position for the reversal, the deal may go through without a hitch.
2. Low Liquidity
- This is an environment where we would do almost no or minimal trading.
- Any trades would have to represent a very good opportunity that is just too good to pass up — five out of five stars.
- Low liquidity makes it very difficult to make trades that are worth it.
- It takes a lot of effort to get the trade filled, and there is no telling when you'll get out of the position.
- Since you are trading in such low liquidity, you have to have a large margin of potential profit because the lack of liquidity will eat into your potential profits.
3. Low Implied Volatility
- In this scenario, we will still be actively trading but just won't be doing it as aggressively.
- When we have low IV markets, we want to scale back our position size from 30-50% of your account to 15-20% of your account.
- You still want to be actively trading, laddering positions, and adding uncorrelated tickers.
- High IV will return eventually; so, it is better to be under-allocated headed into a rise in implied volatility.
4. Strong Rallies.
- Strong rallies have low IV, low liquidity, and a parabolic move in the stock price.
- These conditions set up a perfect storm for a sharp market correction.
- Even aggressively trading the direction of the rally is a “no trading zone.”
- The key is to practice patience and shift your mindset to not participate.
Conclusion:
- In these market conditions, scale back your position sizes and allocation to prepare for any unforeseen market changes.
- When these markets are present, this does not mean you should stop trading altogether--just don't trade as aggressively.
- Be really cautious of how you are trading in these conditions and prepare for sudden market corrections.
