No one would likely argue that the most important narrative in the financial markets heading into 2019 is the "trade war" between the United States and China.
A resolution of this ongoing economic conflict could potentially lift global growth forecasts for 2019 (and 2020 for that matter), and push worldwide equities back into "euphoria mode."
Beyond the trade war, another important theme to follow at the start of 2019 will be the upcoming "earnings season," which will begin during the middle of January.
Corporate earnings results released at this time should give investors a better idea of the ongoing impact of rising global protectionism (i.e. tariffs). Additionally, earnings guidance for the new year will provide valuable insight into corporate sentiment regarding the business climate.
If a trend emerges indicating that earnings expectations are deteriorating, further downside pressure on equity prices could materialize - especially against a backdrop of stalled trade negotiations.
Due to the importance of the next earnings season, and the unpredictable nature of equity markets during the trade war, it’s possible that premium sellers may be a bit more cautious during the next several weeks.
One reason for this is discussed on a new installment of Best Practices, which focuses on previous research produced by tastytrade on the subject of trade duration and associated targets.
As outlined on that episode, backtests conducted by tastytrade on historical data in SPY have shown that there may be optimal windows traders can target in terms of how long a position remains open (from trade entry to trade exit) as well as the number of days to expiration when the trade is initiated.
The findings from this research are summarized in the slides below, with "trade entry" depicted in the first slide, and "trade exit" shown in the second slide:
As you can see in the above data, this research indicates that the optimal window of "days until expiration" for trade entry is roughly 45, while the preferred window of time for trade exit is closer to 21 days left until expiration. That in turn means the average number of "working days" for a given trade is about 34.
Applying that approach to the current calendar (on the cusp of 2019), one can how the start of the earnings season could affect the approach of premium sellers in the near-term - especially those traders that subscribe to the “45 and 21” formula.
A big reason for treading lightly is the fact that earnings season kicks-off in mid-January, which means that targeting options with 45 days-to-expiration (DTE) would involve selling February premium - much of which will likely capture an earnings event.
For premium sellers that want to avoid the often unpredictable nature of earnings events that leaves basically three choices. The first would be to target short premium in February only for symbols that don't capture earnings - meaning the company reports on a date that falls within the January or March expirations.
Alternatively, traders could instead choose to target short premium with 45-days until expiration that is centered on ETFs or stock indices. A previous installment of Market Measures presented research which illustrated that the diversified nature of these products makes them much less susceptible to outsized moves during earnings season.
Lastly, if the trading environment does experience a significant updraft in implied volatility, traders could also consider targeting shorter duration trade windows. For example, January expirations that don't capture earnings. This approach was discussed on another episode of Market Measures entitled "Modifying DTE based on IVR."
Research presented on the aforementioned show suggested that extreme volatility environments (either very depressed or very elevated) may allow for a change in tactics. Specifically, traders can consider shortening trade duration when volatility is elevated, and consider lengthening duration when volatility is depressed.
Traders seeking to learn more about the research involved in producing these findings can review the complete episode “Modifying DTE Based on IVR” at their convenience.
No matter how you ultimately decide to approach the start of 2019 from a strategic standpoint, the most important thing is to ensure that every position you enter matches your outlook and risk profile. If you aren’t comfortable with a given position, you can always mock trade (i.e. paper trade) it and observe how it behaves. This knowledge can then be used when structuring/timing future positions.
If you have any questions about the upcoming year, don’t hesitate to reach out by leaving a message in the space below, or contacting us at @tastytrade on Twitter or by email at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.