Options for Rookies

Elite Trader Forum

Mea Culpa.  As pointed out by Wayne of Sigma Options, I erred.  His comment is below and this post was updated Jun 9, 12:40 PM.

Elite Trader attracts a variety of posters to their forums.  Some are rookies, some are very experienced, some are professional traders, and unfortunately there are always those who try to spoil things for everyone else. But it is a worthwhile place to visit.

Here's a recent question that resulted in a bit of difficulty for the person who asked the question:

"Selling ITM strangles is equivalent to selling OTM strangles with the same strike prices: True or Not?  Why?"

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Here's my attempt to solve the problem.  I thought it may be of interest to readers of this blog.


Example:  Assume SPX is 900

ITM strangle:
  

Sell SPX Jan 850 call;   Sell SPX  Jan 950 put

OTM strangle:

Sell SPX Jan 950 call;   Sell SPX Jan 850 Put

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You are having a problem comparing these positions. Try this:

Consider the difference between the two strangles. To do that,subtract one strangle from the other.  For example, Add the legs from the ITM strangle and subtract the legs from the OTM strangle,

Take the four legs from both strangles.
Add them to make a single position.

Theat position is now a long box.

Long Jan 850 Call
Short Jan 950 Call

Long Jan 950 Put
Short Jan 850 Put

A box is a riskless (ok, there is pin risk) position that varies very slightly in price as time passes (or interest rates change) by the cost of carrying the position to expiration.

Next, break that box into a call spread and a put spread, instead of two strangles.  That gives you the SPX Jan 850/950 call spread and the SPX Jan 850/950 put spread.

It's easy to see that at expiration, no matter what the price of the underlying, the call spread plus put spread equals the distance between the strikes, or 100 in this example. Thus, the price of the box is constant.

If the value of the box is constant, that means the difference between the two strangles is also constant  the value of the box because that difference is a box spread.

Sell either strangle - and the P/L must be identical.  Why? Because the difference between the strangles remains constant.  So if one strangle loses $5,000 then the other must also lose $5,000.

This assumes you collect the value of the box as the extra premium when selling the ITM strangle.  In other words, you should collect almost $10,000 extra (fair value is $10,000 less interest through expiration) when selling the ITM strangle when compared with the OTM strangle. When expiration arrives and you are assigned one or two exercise notices on your short options, you will repay that extra $10,000 if you sold the ITM strangle.

Why a Single Trading Strategy is Insanity

I'm returning to one of my recurring themes today because I found a great blog post by The Pragmatic Capitalist:

"Nassim Taleb is the analyst community’s biggest critic.  He recently said: “We have to build a society that doesn’t depend on forecasts by idiotic economists.”  This goes back to our flawed system of thinking.  Too many investors have been suckered into the belief that one investment approach is the best way to invest.   Can you imagine if an Army General had ONE battle plan?   Every war is different and requires a unique battle plan.  Economic cycles aren’t so different [from wars].  Each cycle is different and each cycle is going to reward different assets in different ways.  But investors have been schooled to believe that you can apply one school of thought or one investment approach to each cycle...

The same can be said of buy and hold for many small investors.  Unfortunately, we’ve discovered over the last 10 years that buy and hold isn’t always applicable.    All economic cycles are unique and asset responses to each will vary widely.  Investors need to learn that a multi-strategy, flexible approach is the best approach."

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I believe the above quotation sums it up nicely.  Buy and hold was good advice as the markets soared from the end of the depression through 2000 - with some notable pauses along the way.  But for analysts to claim that the markets are bound to hit new recovery highs anytime in the foreseeable future are simply pie-in-the-sky wishes - as far as I'm concerned.  We can never know - in advance - which is going to be the best strategy going forward.  Thus, prudence, conservatism and insurance are essential for long-term success.  Why is that so difficult to understand? 

Investors should continue to invest - but only when their portfolios are insured against a disaster.  Without insurance it's just another form of gambling.  And if that insurance limits the upside, what's so terrible about that.  Isn't it better to be sure you have a next egg when you need it - even if it turns out to be a smaller next egg than it might have been had you not bought insurance - as opposed to being in need and not having the wherewithal to retire at all, let alone retiring comfortably?

Why don't financial journalists jump on this bandwagon?  Why don't all financial planners and advisors see the merits of sacrificing some upsdie for a guarantee of no more heavy losses?  I know it's not that simple.  Even if everone were suddenly to decide that owning collars for all investments was a very sound, intelligent idea (which I believe it is), who's going to make all those option trades for the masses of individuals who need to make them?  that's the biggest hurdle. Educating people on how to protect their assets.

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"Golden Cross" or Crash. Is Either In Store for the Market?

As usual, the market provides a variety of signals, allowing investors to hop onto a bandwagon, believing that know what's in store for the stock markets of the world.

Recently, the NASDAQ gave a bullish signal, known as the Golden Cross (when the 50 Day Moving Averages crossed the 200 Day Moving Average to the upside) which is supposed to be a bullish sign.  You can read more about that formation in several places.

On the other hand, there are those who compare today's market with that of the Depression era in which a large market decline was followed by a substantial rally - only to sink to new lows. I don't want to publicize this opinion, but one prognosticator is looking for the Dow Jones Industrial Average to move below 3,000.

We know they can't all be correct, but the bulls and bears can go merrily on their way, each with 'evidence' to support his/her dreams.  The message I take from this is that it's possible that one of these views will prevail, but because I have no idea which is more likely (ok, I have an opinion, but will not wager on it's coming true), so it just encourages me to trade with a neutral bias,  However, I plan to continue to own enough insurance so that if we do see a significant rally or debacle, I'll survive in good shape.  I have no plan to bet on a long shot and thus, will not load up on cheap, OTM options - hoping for a miracle.  I'll settle for being prepared to prevent such a miracle (or nightmare) from demolishing my account.

How will you position yourself?

I Get Stacks and Stacks of Questions. Dear Mark...

Letters, we get letters, we get stacks an' stacks of letters . . .
Dear Perry . . .Would you be so kind, to fill a request, and sing the song I like best?

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Mark

I have some questions for you on managing risk and complementing IC positions with double diagonals. In you opinion is it smart for an IC buyer to also trade some double diagonals to offset vega risk? I am just getting the hang of IC trading and I don't want to over complicate things, but I thought I would ask the question and learn more about DD's.

Right now I am continuing with my weekly purchase of IC strategy. I am buying 2 contracts of a RUT IC for the 3rd month (SEP right now) roughly once a week. I choose short strikes with a delta of 10 and try to get $1.80 per IC. Right now I have a few put spreads (6 contracts) left from my August IC positions and have GTC orders on these offering 0.30 each. I also own 6 Sep IC's. For insurance I currently own one July 420 Put and one July 580 call. My risk curve is fine right now but once July expiration comes, I will lose the protection. At that point my current plan is to buy one Aug Put and one Aug Call (I don't want to pay for more protection right now, as the July Call and Put are still working. Does this make sense to you?). At the same time (after July expiration) I will switch to buying the October IC's each week, and put in GTC orders to close my September spreads offering 0.30 each (This is my autopilot early close plan that I really like. Of course if my short strikes are threatened or if time left gets below 3 weeks I will proactively close at higher prices).

What do you think about my risk management approach? Any suggestions to improve it? Will adding a weekly DD purchase allow me to avoid buying the call and put? I very new to trading IC's so I like the idea of keeping it simple. But I also wonder if there is a way to get better protection at a lower cost.

What do you think of my strategy as a whole? For getting $1.80 to start I realize I give up a lot of this to buy back the spreads and for protection. The math I did tells me that after paying to buy back the spreads at 0.30, paying for insurance puts & calls and paying for commissions I am left with a profit about $0.70 - and that is assuming that everything goes well and I don't have to adjust.

As an aside, I was intrigued by your latest video post where you mentioned you sold July put spreads with only two weeks left. I thought about doing the same thing a couple of weeks ago on the call side because my risk curve was so positive on the upside (when all my Aug Call spreads had closed automatically for 0.30). However I decided against it as I told myself I am still learning and didn't want the added complications of near terms options. Right now my game plan is "close any short spreads when less there is less than 3 weeks left" (My gut tells me that as a beginner this is prudent).

I look forward to hearing your thoughts, and suggestions. My apologies for the long post. If you prefer that I break it up on multiple posts I can do that.

Rgds

TR

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Hello TR,

1) I have mentioned the advisability of combining iron condors with double diagonals to minimize vega risk.  Where have you been, oh trusted reader?

My advice is to offset all or part of the vega risk when you believe vega is reasonably priced.  Own IC  (short vega)when you believe  IV is high (and not going much higher) and own DD (long vega) when IV is low (and you suspect it's not going lower).  If you don't want to express an opinion, then it's always okay to own a combination of positions and remain near vega neutral.

2) If you get $0.90 per side for an IC, don't you find that $0.30 is too much to pay when exiting?  It's fine when two months remain before expiration, but is 30 cents comfortable for you when closing Aug spreads?  This is a question, not a criticism.   It seems to me that giving up 1/3 of the premium and buying insurance and selling low-priced spreads is a tough road to hoe.  More below.

3) Yes, your insurance program makes sense.  But you have overlooked one aspect that requires a decision on your part.  You own the July 420 put.  If the market turns south and RUT is near 440 when expiration arrives, you will own no insurance and replacing it will be costly.

Thus, it feels right to postpone buying Aug insurance options because theta will make them less costly when you buy them later.   You already own insurance.  But, per the scenario I suggested in #3, waiting may turn out to be a costly decision.

Here's a compromise.  Consider trading 4 IC this week - collecting extra cash and use that cash to buy  a one-lot of Aug insurance.  Note the verb I used is 'consider.'  This may not feel right for you. 

4) The questions you must answer in your methodology:

a) How often will you earn that $0.70?

b) When you don't ern that 70 cents, what do you anticipate your average loss will be - if you have the time to exit the trade at your convenience (i.e., not in a panic)?

c) How frequently (obviously an estimate) will you be taking that loss?

d) How much will you lose, and how often, in your worst case scenario.  Perhaps there's a gap opening or perhaps you get stubborn?

e) Combining the above calculations, how much do you expect to earn in an average year?

f) Does the reward justify the risk?

That's your bottom line.  It doesn't matter what I think of your methods.  What do you think of them?  Is 70 cents going to do it for you?  This is like any business - you must have a business plan.  Can you survive on your numbers?  If 'yes,' go for it.  If 'no' where are you going to get that extra income?

5) Do you believe that 'better protection' is available at a lower cost?  That's not generally the way insurance works.

You should want insurance that works for your positions.  The truth is I don't know what that should be.  Owning extra options is 'best' when a very large market move occurs.  But it doesn't help much if there is an IV expansion that occurs without a large move.  I may be wrong, but my belief is that you do the best you can protect yourself.  But sometimes you'll just own the wrong protection and there's nothing you can do about it.  By wrong protection I mean you lose the cost of insurance and your portfolio also loses.

6) Adding some DD positions merely provides limited insurance against an IV explosion.  If the market moves too far, these embedded calendar spreads (DD = IC + calendar) will fail to serve their purpose. [Calendar spreads lose when both options move far into the money.]

7) Regarding my sale of July (front-month) put spreads: I clearly explained that I was selling some of those ONLY because I had just bought in a much larger quantity of July spreads than I was planning to sell.  I also went out of my way to mention that I had plenty of room - riskwise - to make those sales. 

I closed the same put spread the previous day.  So for example, if I covered 10 IC and decided to sell four put spreads, I obviously can afford that risk (or otherwise I would not have been able to hold the original 10-lot).  Please don't take this the wrong way, but details matter and you should not take sentences out of context.

8) Selling near-term put spreads would not be the same for you - simply because you had not just 'made room' to trade trade those spreads.  Yes, prudence is intelligent at all times.

Trading Near-Term Iron Condors

My post about the advisability of rookies using LEAPS was part of the blog carnival, Everything About Personal Finance.

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A day off from the markets.  Years ago I hated that.  I wanted to stand in those CBOE trading pits 24 hours per day.  That was a long time ago, and these days, I love the extra day off.

Happy holiday to all.