The Art of Making Decisions when Trading

One of my basic tenets in teaching people how to trade options is that rules and guidelines should not be written in stone and that there are valid reasons for accepting or rejecting some of the ideas that I discuss.

When I offer a rationale or explanation or a suggest course of action, it is because I have found that this specific suggestion has worked best for me and my trading. I encourage all readers to adopt a different way of thinking when appropriate. The following message from a reader offers sound reasons for taking specif actions regarding the management of an iron condor position. My response explains why this specific reasoning is flawed (in my opinion).

The question

Hi Mark,

I have some questions on Chapter 3 (Rookie’s Guide to Options) Thought #3: “The Iron Condor is one position.”

You mentioned that the Iron Condor is one, and only one, position. The problem of thinking it as two credit spreads is that it often results in poor risk-management.

Using a similar example I (modified a little bit from the one in the book) traded one Iron Condor at $2.30 with 5 weeks to expiration:
– Sold one call spread at $1.20
– Sold one put spread at $1.10

Say, a few days later, the underlying index move higher, the Iron Condor position is at $2.50 (paper loss of $0.20):
– call spread at $2.00 (paper loss of $0.80)
– put spread at $0.50 (paper profit of $0.60)

I will lock in (i.e., buy to close) the put spread at $0.60 for the following reasons and conditions:
1. it is only a few days, the profit is more than 50% of the maximum possible profit
2. there are still 4 more weeks to expiration to gain the remaining less than 50% maximum possible profit. in fact, the remaining profit is less as I will always exit before expiration, typically at 80% of the maximum possible profit. so, there is only less than 30% of the maximum possible profit that I am risking for another 4 more weeks.
3. the hedging effect of put spread against the call spread is no longer as effective because the put spread is only at $0.50. as the underlying move higher, the call spread will gain value much faster than the put spread will loss value.

Is the above reasoning under those conditions ok? Will appreciate your view and sharing. Thank you.

My reply

Bottom line: The reasoning is OK. The principles that you follow for this example are sound.

However, the problem is that you are not seeing the bigger picture.

1. There is no paper loss on the call spread. Nor is there a paper profit on the put spread. There is only a 20-cent paper loss on the whole iron condor.

2. When trading any iron condor, the significant number is $2.30 – the entire premium collected. The price of the call and puts spreads are not relevant. In fact, these numbers should be ignored. It is not easy to convince traders of the validity of this statement, so let’s examine an example:

Assume that you enter a limit order to trade the iron condor at a cash credit of $2.30 or better. Next suppose that you cannot watch the markets for the next several hours. When you return home you note that your order was filled at $2.35 – five cents better than your limit (yes, this is possible). You also notice the following:

  • The market has declined by 1.5%.
  • Implied volatility has increased.
  • The iron condor is currently priced at $2.80.
  • Your order was filled: Call spread; $0.45; Put spread; Total credit is $2.35.

Obviously you are not happy with this situation because your iron condor is far from neutral and probably requires an adjustment. But that is beyond this today’s discussion — so let’s assume that you are not making any adjustments at the present time.

That leaves some questions

  • Do you manage this iron condor as one with a net credit of $2.35? [I hope so]
  • Do you prefer use to the trade-execution prices?

If you choose the “$2.35″ iron condor, it is easy to understand that this is an out-of-balance position and may require an adjustment.

If you choose the “45-cent call spread and $1.90 put spread” then the market has not moved too far from your original trade prices, making it far less likely that any adjustment may be necessary.

In other words, it does not matter whether you collected $2.00, $1.50, $1.20, $1.00, or $0.80 for the put spread. All that matters is that you have an iron condor with a net credit of $2.35.

3. You should consider covering either the call spread, or the put spread, when the prices reaches a low level. You are correct in concluding that there is little hedge remaining when the price of one of the spreads is “low.” You are correct is deciding that it is not a good strategy to wait for a “long time” to collect the small remaining premium.

If you decide that $0.60 is the proper price at which to cover one of the short positions, then by all means, cover at that point. (I tend to wait for a lower price).

If you want to pay more to cover the “low-priced” portion of the iron condor when you get a chance to do so quickly, there is nothing wrong with that. However, do not assume that covering quickly is necessarily a good strategy because that leaves you with (in your example) a short call spread — and you no longer own an iron condor. If YOU are willing to do that by paying 60 cents, then so be it. It is always a sound decision to exit one part of the iron condor when you deem it to be a good risk-management decision. But, do not make this trade simply because it happened so quickly or that you expect the market to reverse direction. If you are suddenly bearish, there are much better plays for you to consider other than buying back the specific put spread that you sold earlier.

4. The differences in your alternatives are subtle and neither is “right’ nor ‘wrong.”

The main lesson here is developing the correct mindset because your way of thinking about each specific problem should be based on your collective experience as a trader.

Your actions above are reasonable. However, it is more effective for the market-neutral trader to own an iron condor than to be short a call or put spread.

You are doing the right thing by exiting one portion of the condor at some “low” price, and that price may differ from trade to trade. But deciding to cover when it reaches a specific percentage of the premium collected is not appropriate for managing iron condors.

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Volatility Indexes: VIX and RUT

Interesting story in today’s Wall Street Journal online.

Most people are familiar with the VIX, the CBOE Volatility Index. It uses options prices to measure the expected volatility of the S&P 500 index. A lesser known index is the RVX, the CBOE Russell 2000 Volatility Index. This uses the exact same formula as the VIX, but applies it to the Russell 2000′s stocks.

As you might imagine, the RVX has historically run higher than the VIX, given that it measures the expected volatility of an inherently more volatile small-cap stock index. According to Russell Investments, the “premium,” or the difference between the two indexes, has historically been around 29%. But in 2014, a year that was at first a wild ride for small-caps, and then a wild ride for everyone, the relationship between the two has been both historically wide, and historically narrow.

Read the whole story at the WSJ site

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Iron Condors and Soaring Option Volume

(Reuters) – Growing concerns about the economy and markets sent volatility soaring on Wednesday [Oct 15, 2014] and pushed trading volume in the U.S. options market to its highest level in more than three years, as traders moved to hedge their portfolios on fear of further market gyrations.

You can read the whole article at the Reuters site.

Is it time for Iron Condors?

The increase in implied volatility suggests that investor complacency may have ended and that fear has returned.

The question for traders is whether it is time to adopt premium-selling strategies (the iron condor, for example), or if it is better to wait for even higher volatility. One thing is certain: getting into this game before the volatility highs have been reached is a treacherous undertaking. I recommend waiting because it is better to avoid iron-condor risk when we do not know whether the current period of increased volatility is just beginning.

My advice: If you are an experienced iron condor trader, it is okay to nibble, but I would not want more than 20% of my cash (the cash set aside for strategies such as the iron condor) in play at this time.

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Free eBook Revised and Updated

Introduction to Options: The Basics has been revised and updated. It remains a very basic introduction to options, but now it has even more useful material. The book is still free, and you can download it or get it from your favorite online bookseller.

Volume 0: The Basics

Volume 0: The Basics

NOTE: DO not pay $0.99 at amazon.com.
It is free everywhere — except at amazon.

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The Rookie’s Guide is now an eBook

I’ve been asked to do it many times, and I am happy to announce that the Rookie’s Guide to Options, 2nd edition is available in eBook format.

At this time, the only versions available are Kindle and pdf.

The new eBook and the paperback version were updated (minor changes) Sept 11, 2014.

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My Take on an Advisory Service

As a general rule, I am not a fan of services that predict where the stock market is headed next. Nor do I believe that most advisory services can steer their clients into profitable trades. However, the quality/integrity of services differ and today I’d like to mention one that I think is worth consideration.

Please understand that past performance is no guarantee of future returns. Kim Klaiman runs SteadyOptions and it is clear to me that he cares about his membership and operates SteadyOptions with integrity.. His trades are transparent and he explains the rationale behind each trade. In other words, it is an educational service ion addition to being an advisory. He is willing to teach subscribers to make the trades alone and reach the point where his services are no longer required.

NOTE: SteadyOptions uses a non-directional approach. They seek opportunities that do not depend on predicting market direction.

SteadyOptions

SO is an options trading advisory that uses diversified option strategies and has produced positive returns under all market conditions. The stated objective is to target steady and consistent gains with a high winning ratio and limited risk. If this sounds like the typical iron condor advisory, I assure you that it is not.

What I like about this service is that it offers a combination of a high quality education along with actionable trade ideas.

What makes SteadyOptions different?

    Impressive performance – a track record of making money in any market.

    –The track record includes every trade, both winners and losers. They hide nothing.

    –Complete transparency – the performance is based on real fills, not hypothetical performance.

    –A complete portfolio approach. In other words, trades are not initiated without considering how they fit in with the entire portfolio.

    –First priority is capital protection.

    –The performance of the model portfolio reflects the growth of the entire account including the cash balance. Some services consider a $1,000 gain on a $1,000 investment to be a 100% return when the whole account is worth $10,000. SO considers this to be a 10% return — and that is the honest way of doing the calculations.

    –All trades are shared in real time, including entry, exit and adjustments. This is the real deal with no fudging of results.

Members voted SteadyOptions #1 ranked newsletter on Investimonials.

The SO newsletter manages three different strategies:

    –Steady Options trades mostly option volatility, making plays on stocks around company earnings.

    –Anchor Trades manages a fully hedged long ETF investment portfolio.

    –Steady Condors manages few different and unique iron condor strategies on index products.

I understand that people tend to pay maximum attention to performance, but do know that SteadyOptions puts a lot of emphasis on options education. Each trade is discussed before it is executed. SteadyOptions is not a get-rich-quick-without-efforts kind of newsletter. It requires time and effort on the part of subscribers. There is a learning curve to become familiar with the strategies.

All subscriptions include a 10 day free trial. Click here to start your free trial.

Full disclosure: I do receiver a referral fee for new subscribers (please use this link), but this advisory service is run in a manner that appeals to me and my strong belief in a sold options education.

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Repeat: Options are not Stocks.

Hello Mark,

I have a question that is not related exclusively to options, but, given the time decay element built into them, it may be particularly relevant to them.

The question is this: are there any general rules that you use for exiting trades that start to go against you, especially if they are not based on an anticipation of a specific catalyst? For instance, do you tend to liquidate your positions in the event of a general market correction that sends a particular stock lower than the general indexes, in the event of your position losing a given amount of value (say, 50% or 33%), in the event of a clear-cut technical trend being broken, in the event of a combination of these and/or other elements, or with the use of some other methods altogether?
Jakub

Jakub,

1) The problem is that your questions are those of a trader who plays the market and they are not specific to options. That may seem to be a trivial point, but it far from trivial. It is also one reason that so many newer option traders get into trouble.

When using options, you must (my opinion) trade as if you own options and not stock. That requires a different mindset. Bullish stock owners can ignore timing, they do not have to be concerned with volatility, and there is no concern over whether the options are priced fairly (or are too expensive to purchase). None of that matters — unless you own an option position.

Bull Market Symbol

Bull Market Symbol

When trading options, you want to think as an option trader thinks to gain the benefits that come with option ownership.

2) Yes, I have such rules. They are not written in stone, but are general guidelines.

If If you have a “long” position, it must be based on your expectation that the stock price will move higher – even if you do not know what the catalyst will be. I would liquidate that position at ANY TIME that you no longer expect the stock to move higher. Sure it can be when the stock price declines by a certain percentage (perhaps 6 – 10%). Yes, it can be when a technical indicator tells you that the buy signal for the stock market or the individual stock is no longer valid.

However, if you own an option, then there is an additional consideration: Can the stock price change occur quickly enough to generate a gain when you own an option position? You would not look at the percentage decline in the price of your call option because that is not the crucial factor. If you still believe that owning that specific option (and that means you must evaluate the time to expiration and whether the option is ITM or OTM), then you can hold. The only important factor is your outlook for the stock in the time period from now to expiration — and whether that expectation makes it a good idea (or not) to own the option that you own. If it is a bad idea, then get rid of the option. Do not believe that owning “any call option” will generate a profit when the stock price rises. When IV gets crushed, you option may lose value, even in the face of a rally. When time passes, the ATM or OTM option can lose all of its value if the rally comes too late.

Any time you are playing the market, you should have a stop loss. And it can be based on anything that you want. However, in my opinion, it is foolish to buy a wasting asset (call option) when you do not know when the stock price will move higher. It would be better to sell an OTM put spread or by an ITM call spread so that if the stock does not move higher right away, you still earn a profit from your position (the put spread goes to zero when both options remain OTM, or the call spread goes to its maximum value when both option stay ITM).

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Progression Through Option Strategies

Mark,

You mention in your response to Aldo that you would recommend “credit spreads” as a top suggestion for new traders (assuming they are comfortable). Do you have a kind of progression through strategies you would suggest?

I’ve traded covered calls, naked puts and bought calls/puts based on a course (similar situation to Aldo) and I’m looking to expand my trading strategies into spreads.

Thanks,
Patrick

Hello Patrick,

Good question.

I do have a recommended progression. However, it is not because the trader moves from one strategy to something that is “better.” I recommend beginning with covered call writing (CCW) because it involves stock trading and many option newbies have stock-trading experience. That makes it easier to begin using options.

I also recommend writing covered calls because it is a hedged, reduced risk strategy – when compared with stock ownership. One more important point: CCW positions earn profits more often than straight stock ownership, although profits are limited. I want traders to make money with options, and CCW produces far better results than simply buying/selling options (the method taught in the course you took). In fact, I hate the idea of brand-new option traders trying to make money by buying options. There is far more involved than predicting when a stock price will change. One must have a good idea of whether the options are reasonably priced (that requires an, understanding of implied volatility) and which options to buy (avoid OTM options). And the brand new trader knows nothing about any of that.

Option traders should learn about options and not about reading charts.

Next I encourage the sale of naked puts because it is equivalent to CCW. By switching strategies, the trader must learn about equivalent positions. That knowledge is very important to an option trader.

I then encourage traders to understand a collar position (a covered call plus the purchase of a put option) because it demonstrates how options can be used to limit losses. I’d love to get the new trader interested in learning to limit risk from day one, but it is important not to overwhelm a trader with too much new information at one time. Thus, I begin with a risk-reducing (and not a risk-limiting) strategy.

I consider those three strategies to represent the “Three Basic Conservative Option Strategies.”

Next I encourage the use of credit/debit spreads as a method of taking on far less risk.

The call debit spread can be looked at as something similar to a covered call, but instead of owning stock, one buys a call option. This is where the trader learns the difference between buying calls and buying stocks — each combined with the sale of a call option (essentially the ‘covered’ call).

The credit spread is a high-probability, limited profit strategy and is ideal for most traders. Sure there are other strategies that accomplish specific needs, but for the trader who has a small bullish or bearish bias, these plays are far superior to buying options.

Continuing with the discussion of equivalent positions, the trader should next learn why credit and debit spreads are equivalent strategies. To be more specific: Selling a call spread is equivalent to buying a put spread when the strike prices and expiration are identical. That must be mentioned repeatedly, otherwise some people may believe than selling any call spread is equivalent to buying any put spread. Thus, I’m careful to mention that essential requirement as often as necessary to be certain that it is well understood.

Basically that’s it. Once a trader has those strategies in his/her arsenal, more advanced strategies come from combining one or more credit/debit spreads into something that appears to be more complex. The other more advanced concept is understanding implied volatility and the importance it plays in selecting option strategies:

    –Condors, butterflys — vanilla or broken wing varieties; vanilla or iron varieties are just the purchase or sale of one vertical spread and the purchase/sale of another.

    –Then there are strategies that involve volatility more than just price changes. For example, Calendars and diagonals — single and double fall under the volatility umbrella.

NOTE: A vertical spread involves two calls or two puts on the same underlying with the same expiration date. Both credit and debit spreads are vertical spreads.

Bottom line: I do not suggest learning the next strategy is done because it is a “better” strategy. What I urge traders to do is understand something basic and then move on to something that requires a bit more knowledge. We learn strategies to learn more about how options work – and not specifically as a way to make money. Whenever a trader discovers a strategy that suits his/needs and is comfortable to trade, I suggest pausing and getting some good experience using that strategy before moving on.

Patrick, there is one more concept that is crucial (in my opinion): We all want to adopt strategies that have a good probability of meeting our requirements. In other words, strategies that we understand how to use and which make money. However, it is the trader’s ability to maintain discipline and manage risk that is far more important in determining a trader’s success/failure rate. Choosing “a good” strategy for ourselves plays a role, but it is dwarfed by the need to skillfully manage risk.

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