Starting afresh in 2009 - Is it safe to trade out there?

What an amazing year we had in the markets in 2008. No amount of back testing could have prepared anyone for this incredible rollercoaster of a year. The last time we had such a big fall was 1987 and fewer investors were trading options back then. Platinum certainly doesn’t go back that far either! Record high Implied Volatility levels and the VIX (the CBOE Volatility Index) reaching almost 90 seemed beyond anyone’s wildest imagination even as near as 6 months ago.

So what can we do now? Well the first thing is let’s take a good look around us to see what’s left after the carnage. The VIX is currently at 45. Anytime earlier than 4 months ago, 45 would have seemed extreme for the VIX, but coming out of the market conditions we’ve just had, 45 seems low. Is it just all relative? Is trading dangerous or difficult with the VIX at 45? The answer to whether trading is dangerous or not doesn’t really lie in the level of the VIX. How much risk you take, where you put that risk, how large your positions are, how aggressively you trade and (at the end of the day) how you manage your money, are the factors that are going to make your trading risky or not.

But is trading difficult with the VIX at 45? Well the real killer to trading that we saw late in 2008 was the bid / ask spreads of the options widening. When there is fear in the markets, market makers widen up the bid / ask spreads of the options to take in more premium for the risk they’re taking on, taking the other sides of our trades. When they widen the spreads, we pay even more when we buy, and we receive even less when we sell. The way this makes trading hard is that when we get into a trade we pay a lot more than we normally would, all else being equal, and getting out of a profitable trade we receive even less than we should. Sometimes this can mean closing a profitable trade at a loss. When you have to close a winning trade for breakeven or a loss, because most of the profit is chewed up by the wide bid / ask spread then YES trading is now officially too hard! If you can’t win on your winning trades, how else are you going to make money??

Let’s look at the issue of the bid / ask spread in relation to the VIX in more detail. Below are the current ATM options of the SPY (S&P 500), as at January 12th 2009.

Looking today at the February 09 options, with 39 days to expiration, the closest to ATM (but still OTM) Puts and Calls are priced as follows:

Bid / Ask spread as a percentage of the option price: 1.2%

Now going back to October 9th 2008, in the middle of the market meltdown period, the October 08 closest to ATM (but still OTM) Puts and Calls are priced as follows:

Bid / Ask spread as a percentage of the option price: 7.7%

Now going back to January 22nd 2008, (when the market started to plunge in January), the February 08 closest to ATM (but still OTM) Puts and Calls are priced as follows:

Bid / Ask spread as a percentage of the option price: 2.5%

What does this information tell us? The example of the options in October 08 is just to show us how wide the bid / ask spreads can go with even the most liquid security, the SPYders. But really let’s look at the bid / ask spreads in January 08 when the markets started to plunge and there was panic in the air, compared with now when a lot of the dust has settled. As one would expect, the spreads were wider back in January 08, at 2.5% versus 1.2% now – more than double. But back then the VIX was only at 31, and now the VIX is currently 45.

This proves the point that although they are related, there is no exact correlation between the VIX and bid / ask spreads. So although right now the VIX is still high, and a year ago 45 would have seemed out of this world, trading (entering and exiting positions), all else being equal, should be easier now than it was back in January 08 because the bid / ask spreads are tighter again. The spreads of the SPY are a fairly good indication of the overall market, but always check the options chain of the individual Stock, ETF or Index you’re considering trading before each trade.

Manage your risk!

Matt Baker