Hola Tackle Traders!!!

This week we are continuing on with the bearish market theme as not much has changed from last week in terms of a reversal.  The overall markets still look really weak and all the rallies have met with failure.  There has been little in the way of decent rallies at all.  At the time of this writing, it seems that the markets are waiting on the FED decision which a lot of folks believe is already priced in.  We will see if Santa Powell has something up his sleeve or whether he just toes the line and remains on course which according to the FED Rate watch tool from the CME says that there is a 70+ percent chance that he will do exactly what he said he would do and that bumps the rate another quarter point.  Although I would expect that this bump in rates would be good for the greenback, I am not convinced that it will turn these markets in the other direction at least not for very long.  So where does this leave us?  Same place as before, dealing with the characteristics of a bear market.  There were some very significant levels broken this week.  The 2600 level in the S&P 500 futures was blasted through after holding support for the better part of a couple of months.  This ramped up the volatility that we talked about in last weeks blog.  This brings us to this weeks focus and that is dealing with implied volatility when putting on protection in our portfolios or as the name of this blog suggests “TAMING the IMP!!!”

Before I launch into one of the more often expressed issues with rookie traders, I want to give some context about the IMP!  I am of course referring to implied volatility or the IMP!  There is another IMP that I think echoes how most new traders view implied volatility.  According to Wikipedia the IMP is “Imps are often described as mischievous more than seriously threatening and as lesser beings rather than more important supernatural beings. The attendants of the devil are sometimes described as imps. They are usually described as lively and having small stature.”  I think for newer traders implied volatility can be described in a similar manner, that is if one is aware of the concept of implied volatility, to begin with.

Implied volatility is part of a measure that is used to determine option pricing and it can work in your favor and against an option just as easily.  So why exactly am I talking about implied volatility so much well its because one of the most popular questions asked to me by rookies that are learning to hedge is why do the options suddenly get really expensive when the market starts to fall?  Well, my friends that is the essence of the IMP, or rather implied volatility.  When the markets start to fall implied volatility shoots up and options get a whole lot more expensive.  Now, this is great if you bought your protection before the fall but if you are trying to get some protection as its happening then one best get their checkbook out cause its gonna cost ya!  This all ties into what we talked about last week when we talked about buying protective puts when solid support levels are breached.  Last week we talked about how the market can fake one out with these breaches but the concept of buying protection remains the same.  So, is there something a trader can do to offset this spike in implied volatility?  Why, yes there is!

If we are buying an option then implied volatility is gonna hurt us but what if we are selling an option?  Does the IMP help us?  Yes, it can, however, selling can be fraught with issues of its own just like the mythological creature of the same name.   Think about this for a moment, if we are buying a put for protection, what is the opposite of that, or in other words what can we sell that will make us money as the stock price falls?  The first thing that comes to mind is selling a Call option, this play makes money as the stock drops but it has unlimited risk and smart traders don’t play that game.  Smart, experienced traders want their cake and to eat it too.  They want an unlimited reward for a defined risk.  This is always possible but we do whatever we can to create that situation.

So, is there something else we can do that will keep the IMP at bay?  I say there is.  We like to call that spread trading.  When trading a spread we are hurt by buying an option but we make up for that by selling an option as well.  That sounds like a decent compromise, wouldn’t you agree?  Below is the risk graph of buying a put option, check out to see the risk and the reward and then look at the second risk graph and spot the differences.  I want to see if you guys know what that second risk graph is?  In next weeks blog, we are going to go through that trade and what it means and how it can help us keep the IMP at bay!

So leave some feedback and let me know if you know what trade that risk graph is for, no cheating!

Happy Trading All,

Coach Holmes