DummySpots.com

Dow down 213. Nasdaq down 54. S&P down 24.

Not really that big of a move, historically speaking. But among the folks who have spent years trading options, Friday was one of the most memorable days ever.

First, a quick chart of the NDX:

The major indexes all pulled back well into the recent Nov-Jan trading range, and have therefore created a failed breakout. Without an immediate and fierce reversal to the upside, this is an ominous sign. All potential swing trades are off. My picky entry rules kept me from going long last week, and I couldn’t be prouder of them. Scribbling notes to yourself for years sometimes pays off!

The increased volatility should create some amazing day trades, and I’ll be actively watching for those each morning that I have the opportunity. As a matter of fact, check out the VIX (volatility index, used to be based on the S&P 100, now based on the S&P 500):

There’s a legend that some traders make their entire living off of one simple trade: anytime the VIX moves more than 10% away from its 10-day moving average, they go the opposite direction. For instance, if the VIX surges 10% above its 10MA, they go long (the VIX spiking up signifies a selloff). If it drops 10% below its 10MA, they go short. That last one is rare, as it’s hard for a “spike” to equal “decreased volatility.”

The VIX closed at 14.56 Friday (its high for the day, BTW). Its 10MA was 11.71, so that puts it over 24% above its 10MA. According to the above trading strategy, that would indicate a hellaciously strong buy signal.

Imagine jumping in and buying after the uncertainty created by Friday’s drop. Spooky, huh? Welcome to trading. Disciplined trade entry and money management rules are the only way to mitigate that fear and pull the trigger when necessary.

I won’t be attempting the “VIX fade,” as I call it. Not because it’s not legit, but because I haven’t studied it enough to know for sure. It sounds sensible enough.

“One of the Most Memorable Days Ever”

I love watching new traders’ expressions when they ask “What do you think the market’s gonna do” on expiration day (note: options expiration day, for trading purposes, is the third Friday of each month) and I answer “absolutely nothing.” I always chuckle when I hear lines on the idiot box about the “increased volatility due to options expiration” and especially the dreaded “triple witching.” Increased volatility? The indexes get pinned as expiration week progresses, and there are plenty of good trades to be had simply betting that an index will end up in the middle of the last few days’ range. As a matter of fact, I have a rule in my little notebook that says, “Don’t daytrade optionable stocks on Thurs or Fri of expiration week.” That’s because a day trade has much less chance of success on those days as the stock gets reeled back in from whatever move it tries to make.

By around lunchtime on Friday, I was surprised. By 3pm, I was stunned. I couldn’t remember the last time I saw a move like this on expiration day. This was big. Friday night, after getting the kids settled down, I fired up the ‘puter and did some number crunching. I’ve never actually seen any published statistics about expiration day and its supposed “volatility,” but I knew from experience that it’s unusual for expiry day to be anything but dead boring, movement-wise.

Here’s how I did my little impromptu volatility study:

• I downloaded historical data on the Qs (volume numbers more reliable than index volume) back to the beginning of 2000, so I could include the huge lurches the market made in ‘00-’02.

• Wrote an Excel spreadsheet to determine whether a given day was options expiration day (hint: use the DAY and WEEKDAY functions within a couple of nested “ifs”), then compared the volatility of that day’s range to the previous 20 days.

• I made this comparison by taking the average range of the previous 20 days, then the standard deviation in range over the same period, and finally calculating how many standard deviations away from the average expiry day fell.

  Using standard deviations from average factored out the confusion that would be created from trying to simply compare absolute ranges over the years, which would be apples to oranges. An expiry day in 2000 with a range of $4 wasn’t such a big deal if the Qs were $80 and the average range for the previous 20 days was $5/day.

The results of my study of expiration Fridays over the last 73 months are as follows:

• 50 expiration Fridays (68.4%) have been of average volatility (+/- one STD).

• 17 expiration Fridays (23.3%) have been significantly less volatile than average (more than 1 STD below average).

• Only 6 expiration Fridays (8.2%; less than one per year) have been significantly more volatile than average (more than 1 STD above average).

That’s right: fully 92% of expiration Fridays have been of average volatility or less . So much for the “increased volatility of triple witching.” But that’s not the clincher:

• Since January of 2000, only two expiration Fridays have had a range of greater than 3 standard deviations above the prior 20 days’ average:

  1. 4/21/01, which was 5.4 STDs more volatile than average, albeit on lighter than average volume.
  2. You guessed it, 1/20/06, which was 3.7 STDs more volatile, and on significantly increased volume.

No wonder Friday seemed so unusual. One thing is for sure- anyone who happened to be loaded with puts cleaned up like never before (or, almost never). Cheers to them.

What’s this mean for the future? I think that for certain it means we’ll be seeing wider price swings, which is music to the ears of daytraders. It may also mean that we’ve just reached some sort of major inflection point in the market. The new trend will emerge soon enough, and we’ll know for sure.