Options for Rookies

How Kite Spreads can Become Embedded Back Spreads

James and I have had a back and forth discussion regarding whether certain positions are back spreads.  The discussion began here and there's an interesting aspect that's worth consideration:

How can a kite spread - in which you own a limited number of long options (on top) turn into a position with back spread properties?

First, some definitions:

a) A kite spread is generally purchased as insurance when an iron condor or credit spread threatens to move into the money.  It's either a bullish position using calls, or a bearish position using puts.  It's constructed by buying one option (the kite string) and selling (usually) 3 or 4 farther OTM vertical spreads (the kite sail).  A more detailed description is available.

b) 'On top' means closer to the money.  It's a call option with a lower strike  than the options being protected.  Or it's a put option with a higher strike than the options it is protecting.

Example:  Please note:  These are randomly selected fictional trades, generated today, with RUT @ 675.  I don't have prices for these 'old' trades. The discussion involves the appearance of the portfolio, how it came to be constructed and says nothing about profitability.

Assume you sold 20 call spreads:  RUT Apr 650/660 when RUT was trading below 600. 

As RUT moved above 620, you became concerned about the position and decided to make an early adjustment (a Stage I adjustment). The trade you chose was to buy 2 RUT Apr 640; 670/680 kites [This is the C4 variety]

Adjustment I:

Buy 2 Apr 640 calls

Sell 8 Apr 670 calls

Buy 8 Apr 680 calls

You now own 2 Apr 640 calls and are short a total of 28 call spreads

The market continues to move higher, and when RUT passes 635, you are very uncomfortable with your position.  It's time (you decide) to get out of some of those 650 calls.  The simplest trade is to buy back a few of the Apr 650/660 [typo corrected] call spreads, but you decide to buy kite spreads instead.

You buy 5 Apr 650; 670/680 C3 kites.

Adjustment II:

Buy 5 Apr 650 calls (to close)

Sell 15 Apr 670 calls

Buy 15 Apr 680 calls

Comment:  Increasing position size is usually a poor choice.  The reason it's acceptable with a kite spread is that the adjustment trade (as a stand-alone position) adds no additional risk to the upside, other than the debit incurred when placing the trade.  It does provide plenty of upside profit potential when RUT is not near 680 at expiration.

When RUT moves past 640, one reasonable trade is to sell the 640/650 C spread.  This feels counterintuitive, especially when the upside is where risk lies and making the upside worse doesn't feel right.  But if you sell this spread between $6 and $6.50, the maximum loss is only $350 to $400 per spread and it does make the down side better.

The true rationale for selling the call spread is to use the proceeds to buy more kites, reducing my short position on the 650 line.

Adjustment III

Sell Apr 640/650 spread 2 times

Buy 3 more Apr 650; 670/680 kite spreads

The position now looks like this: [with errors corrected]

- 10 Apr 650 calls

+20 Apr 660 calls

-32 Apr 670 calls

+32 Apr 680 calls

James calls this a back spread and I'd prefer to describe this position as one that contains a back spread within.  The characteristic that gives this backspread-like properties is the fact that the extra long options are no longer 'on top.'  The long option is the April 660 call.

To completely eliminate backspread characteristics, there are alternatives:

a) Buy 5 Apr 650; 670/680 C3 kite spreads.  My preferred choice

c) Buy 5 Apr 650/660 C spreads. Perhaps sell one extra Apr 660 call to offset the cost cost, but only if the risk graph and your comfort zone allow that trade.  I see no good reason to make this trade

c) There is no necessity to make these trades, but if looking at the 'backspread' portion of the position is uncomfortable (too much negative theta), you can take steps to alter the position

That's how kite spreads can turn into positions that resemble back spreads.  And the process continues.  With RUT currently trading near 675, it's likely that anyone holding this position would have repurchased many of the 670 calls as part of a kite that sold more 690/700 spreads.

637

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Adjusting a Near-Term ITM Iron Condor

Mark,

This is my first time here. its great to find someone with good knowledge willing to answer questions. Thanks

I have some March IC's on SPY (trading approximately 114) in trouble. 112-116 top spread. Have adjusted by adding some March19/March31 115 calendars which gives some limited upside protection.

Can the kite spread help protect this situation? Is it too close to expiration? I tried different strikes and months on risk graph. Can you suggest certain strikes and months?

***

Welcome to Options for Rookies.

1) Although adjusting with calendars is attractive, and is recommended by many, I don't like them.

a) The calendar is long vega, and unless you specifically want to add positive vega to your portfolio, I suggest avoiding calendars as protection.  Trading them as stand alone positions is a different situation.

b) Calendars have little value as insurance.  Sure they help when the market moves towards the strike - as has happened here.  But if SPY moves much higher, you not only lose more money on your iron condors, but the calendar spread also loses value.  It's very limited in its ability to help your overall risk/reward structure.

2) Each investor must choose a risk management style that works for him/her.  In my opinion, waiting until the underlying is halfway between your long and short strike prices is waiting too long.  But that's my opinion.  I'm not suggesting you did anything wrong.

3) A kite spread always helps because it adds a net long option - and that single option can play a big role in cutting losses

However, the kite spread is a relatively costly insurance policy and may lose its effectiveness as expiration approaches.  That occurs when the underlying is priced near your maximum loss (116 in this example).  That combination makes kites inappropriate for your situation.  You can buy an April kite.  That will show a decent profit on a continued rally, but you can use some March gamma, not April.

For best effectiveness, the long option in the kite (long one call; short 3 or 4 farther OTM call spreads) should be on top - that means it has a strike price lower than your short call (or higher than your short put).  In this example, I'd want to own the March 110 or 111 call as part of the kite, and it's too late for that.

But, there are always other choices.

4) You need some upside protection for this position.  To me, the best alternatives, in my recommended sequence are

a) Buy a small number of March calls.  110s, 111's or 112s.  You need quantity here, and I recommend more 112s rather than fewer 110s.

b) Cover some 112/116 C spreads

c) Buy 112/114, or perhaps 113/115 call spreads

d) Cover the whole position and call it a day

5) Not every iron condor position can be salvaged.  This a strategy in which losses are inevitable, and your main task is to minimize those losses.

6) Sometimes it's a good idea to buy a small amount of protection early.  That's the appropriate time for a kite spread.

636

Iron Condor Position, Protected by a Kite Spreads II

Last time, we began the discussion of how to work with a 20-lot iron condor position that was protected by three kite spreads.

We owned 3 RUT Apr 650 calls and were short 29 Apr 670/680 call spreads and the discussion now moves towards the need to make an adjustment.

The risk graph doesn't look bad.  There's not much to lose - as things stand today.  But as the days pass, risk increases when RUT is near, and especially above, 670.  See Part I for a more detailed discussion.

Adjustments

When working with kite spreads, there is the temptation to do nothing because the risk graph looks so reasonable.  The passage of time changes the picture drastically, and the prudent kite user adjusts in advance.

I like to use several different adjustment types, and I've decided to combine three of them for  consideration.  These are not specifically recommended, but may give you an idea that you had not previously considered.

1a) Sell your long options.  They are probably costly options and they served their purpose.

1b) Replace those calls.  My most common play is to roll them by one strike.  That means buy 660s and sell 650s.  My idea of the right time to do this is when I can collect between $6 and $6.50 for the spread.  This play is not as good when you still hold this position very near expiration.

1c) In today's example, I went further.  The first adjustment is to sell 3 RUT Apr 650s and buy 6 Apr 670s.  One reason is that I prefer to own the three extra options.  The second is that it's time to begin to exit the 670/680 call spread.  And this is a start.

2) More kite spreads to provide better upside.  Buy 3 Apr 670 calls and sell 9 Apr 690/700 spreads.  These kites cost roughly $500 apiece. 

If spending that $1,500 makes you uncomfortable, you have an alternative.  Choose 1b above, instead of 1c.  Use that $1,800 to $1,900 to pay for the kites.  You may even decide to splurge and buy a fourth kite instead of only three.

3) I avoid increasing position size as a general rule.  But when I now own 6 extra long calls (instead of 3), I believe the risk/reward allows for owning a larger position.

Buy back 10 Apr 670/680 call spreads and sell 20 Apr 690/700 call spreads.  At current prices, this should cost about $80 per spread.

If you choose all three trades, the risk plot looks like this:

Dark blue = today

Light blue = 1 day before expiration

It's important to do your own graphs and consider any adjustments you want to make.

To me, I can live with the position more easily than the unadjusted position.   Please remember, these three trade ideas are not all-or-none.  But they should provide food for thought.   Draw those graphs and analyze alternatives.

633

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Decison Time: When to Exit a Profitable Iron Condor Trade

Mark,

I've got a related question [to this post]. I know, from this blog and your excellent book, that you recommend not waiting to extract the last few pennies from a winning short options position.

Many of us have simple rules to close winning positions, such as when the option premium has lost 75% of its value or when the option premium drops to $0.10. I'm trying to formulate a more formal system for this.

A CSP [cash secured put] example: I originally sold a far out of the money SPX put option for $1.10 with 49 days to expiration. This gives a potential profit of $2.24/day. Currently the option is priced at $0.25 with 27 days to expiration. This gives a remaining potential profit of $0.93/day. The daily profit available has fallen by 58% - is there some figure or formula to indicate when it's time to close the trade?

Steve

***

Steve, I don't believe you will be able to mathematicize this to produce a formula.  My guess is that you will be forced to rely on a 'gut feeling' of how much reward remains and the perceived risk of attempting to earn that reward.

Why?  Residual time decay is very dependent on implied volatility.  That alone can make theta change significantly during any given trading day.

Also, theta accelerates as expiration draws near.  The fact that you own a position with decreased theta tells you that the trade is a winner.  The value of the spread (or single option) that you sold has lost more value than the original daily expectation.

Thus, you already won the major part of the theta wager - time passed and nothing bad happened.

You are also winning the OTM wager.  The underlying has not moved near enough to the strike price to produce an option with a high theta.  In other words, it's far enough OTM that you have a winning trade.

Decision:  Have you won enough, or do you like your chances to increase those winnings?   I know that unlikely events happen and conservatively exit spreads at low prices.  That philosophy may not be appropriate for you, but attempting to remove judgment and substitute a formula does not seem right from my perspective. 

Example:

I cover based on cost and time remaining. The cost of the spread is paramount to me.  Low cost means high risk and little to gain

You look at it differently.  Mesmerized by time decay, and the fact that it accelerates near expiration, is important to you.  And I get it.  You took the risk of holding until 'now' so you want to hold when 'potential reward' accumulates more rapidly.  You (correct for your comfort zone) don't care that the reward is tiny.  You care about time decay.

That's not viable to me, but if it works for you, that's just proof that all traders don't think alike.

Remember this 'problem' occurs when the spread is OTM.  If your shorts were much nearer to being ATM, the time decay would be much higher.  Does that mean you always hold - because decay becomes so attractive?

If the answer is yes, then consider trading front-month iron condors all the time - with their high risk and high potential reward.  That's consistent with searching for a formula to find an exit point based on theta alone.

623

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The Rookie's Guide to Options

Iron Condors and Delta Neutral Trading

Mark,

Was wondering if you would be able to comment on maintaining a 'delta neutral' portfolio. Particularly, when dealing with condors, delta can become unbalanced as price approaches one of the wings... is rolling the OTM spread closer to the money a legitimate strategy?

Andy

***

Condors, 'regular' or the iron variety, are held by traders who believe (or hope) that the underlying asset will trade within a range during the lifetime of the options.  That range is between the strike prices of the options that comprise the position.

Thus, the condor begins with a neutral outlook.

When trading 'delta neutral,' there is no universal definition as to what that means.  Traders with gigantic portfolios have computers dynamically hedging to neutralize as many factors as possible.  That's not for us.

You cannot remain delta zero - you cannot adjust every time the position gains or loses one delta.  Thus, your first decision is how far away from delta neutral are you willing to go before taking action to reduce risk. 

Next, how would you adjust delta?  Some traders prefer to adjust with stock, futures, or deep ITM options.  I understand why many people concentrate on the benefits of this method, but it's not even on my list of possible choices. 

Advantages: Avoids buying options with negative theta.  Premium sellers hate to buy negative theta. The deltas purchased (or sold short) are real, and provide a good hedge when the market continues to move in the same direction.

Disadvantages: Does nothing to solve the continuing problem of negative gamma.  Is subject to a substantial loss when the market changes direction

From my point of view, 'delta neutral' is not good enough when trading iron condors.  Andy, you point out that 'delta can become unbalanced as price approaches one of the wings.'  That's too obvious.  Of course delta is unbalanced when one of you short positions has a delta that moves towards zero delta as the other has a steadily increasing delta.

What you fail to mention is that delta gets out of balance because the position has negative gamma and that negative gamma is accelerating.  Too many traders look to delta as the dominant Greek and ignore the others.  That's why I prefer to adjust by buying options.  To clarify: options have positive gamma.

Perhaps that option purchase is the closing of all, or a part, of the position.  Perhaps it's buying calls or puts.  But please be careful.  It's important to buy options that are closer to the money than the short options in your iron condor.  [Farther OTM options look good, but that's deceiving.  When you know that you will be holding the position for awhile, those FOTM options are going to decay badly.  Unless there is a gigantic market move, they will be worthless when you need them most.]

***

Is rolling the 'good' side of the iron condor a legitimate strategy? 

Yes, of course it's a legitimate strategy.  The problem is that it does not help.  It's merely an illusion.  A very similar situation was discussed recently. 

Your 'legitimate' trade would transform a position with one serious problem into a position with one serious problem plus a second problem that's almost as serious.  Read the linked post and try to relate that situation to moving an OTM spread nearer to the money.

The fact that the position would be nearer to delta neutral is deceiving. It actually increases the probability that you will be in deep trouble soon.  Why?  Same answer:  It's a minor delta fix, but increases negative gamma - this time allowing you to get hurt on a decline as well as a rally.

***

Andy - here is one problem that I frequently encounter  but never previously mentioned.  As a true options rookie, it's natural to ask question one and then question two.  What you must understand is that many answers are connected.  It's important to understand principles and apply them.  The answers are good for more than the single answer to your specific problem. 

Connecting the dots...that's the way to understanding how options work.  

622

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Trading iron condors with negative gamma

I'll be giving a webinar for TradeKing on Tuesday Feb 16, 2010.  Covered Call Writing from a Different Perspective.

***

For space considerations, I've cut some of the wording that's not directly a question.  Here's the entire comment.

Mark:

I came across your blog as I was looking for ideas about hedging iron condors. I have to admit, you have a lot of great info, but I do have a few questions:

1. Obviously, maintaining a delta neutral portfolio is a challenge since the delta changes as the underlying changes, and maintaining a delta neutral profile can result in a lot of trades. Is there any sort of guideline about what is an acceptable delta or what may be considered excessive delta? I realize that if you have many IC positions, you can't view the delta on a per position basis, but rather the portfolio as a whole.

2. Can you provide some 'layman' examples of how negative gamma can impact a position(s)? Is it possible for negative gamma to impact a portfolio of ICs in both a positive and negative trending market?

3. In your posting called "Iron condors: Diversification and VIX options as hedges", I understand why VIX options should not be used...  Have you ever considered, or ever heard of someone, using something like the Proshares Index ETFs options as a hedge?  Specifically, since I almost exclusively trade SPX, I was looking at buying options or debit spreads on UPRO and/or SPXU - which are directly correlated (in theory, at least) to SPX.

Thanks again.

Leo

***
1) Simple answer: No guideline that's universal.  But, you can discover your own as you gain more experience.  Keep a daily diary that contains the portfolio Greeks.  Enter comments about your comfort level, whether you considered adjusting, and whether you did adjust.  Track daily P/L.  It's going to take a bunch of days before anything meaningful can be learned, but merely examining the Greek levels every morning is beneficial.  Over time you will build a record of where your discomfort level lies.  Track any statistics that you believe are important.

With negative gamma, you cannot (as you say) adjust all the time.  You must pick your spots.  There are many methods for trying to keep delta in line.

• Adjust every time SPX moves one (or 1.5 or two) standard deviations from the last time you adjusted

• Adjust when you are 100 (or 500 or 1000) delta from neutral.  Your own comfort zone and portfolio value help you decide

• Adjust when you will lose 1% (or 2% or X%) of your portfolio value if SPX moves an additional X% from its current value.  Note this is percentage of total portfolio, so don't allow the number to be too large.  Your comfort zone will be a guide
  

Delta is not the only Greek to adjust.  When making an adjustment resulting from negative gamma, give serious consideration to picking up some positive gamma when adjusting.

Most iron condor traders disapprove of spending money on option premium, but it's often best to buy some positive gamma to reduce the ongoing problem.  I am not referring to options that are farther OTM than your iron condor.  The gamma must come from options that are closer to the money than your short option (or it's okay to buy in a small number of your shorts). Why? Because your plan is to hold the IC, and when time passes you know those OTM options will lose much of their protective value.

The best way to handle negative gamma is to find a reasonable solution that allows you to sleep at night and not worry about losing too much money.

Any time your delta total seems too large, then it is too large.  I know this is not the specific reply you had hoped to receive, but there is no 'number' or 'percentage of portfolio delta' that suits each trader.

There is no doubt that a single iron condor position is easier to manage, but you and I carry multiple positions and it's best to manage the portfolio as a whole.

WARNING: That last paragraph does not relieve you of the responsibility of seeing that no iron condor ever approaches its maximum loss.  Sometimes you must exit a single iron condor position and find another.

2. Yes. Negative gamma hurts regardless of which direction the market is trending.  When your position has negative gamma, your portfolio accumulates positive delta as the market falls.  It also loses delta as the market rallies.  That's why time decay is good and volatile markets are bad.  That's as near as I can get to describing this is the simplest (layman) terms.  You get longer when you don't want to do so (falling markets) and you get shorter when you don't want to do that (rising markets).

3. Whatever else you do, please do not hedge with leveraged ETFs.  Unless you plan to get out of the hedged position the same day, you will be very disappointed in how they perform.  You do not want to own these vehicles.  Ever. Trading a spread is not as bad, but these are items you do not want to trade.

You can use SPY instead.  Yes, you must trade a few more shares and that may cost commissions, but you must avoid these leveraged devils.

From my perspective hedging with the equivalent of stock is a poor idea.  I know many people adopt such a technique, but to me you are setting yourself up for getting whipsawed (buy high, sell low) when you have negative gamma.  Buying stock or an ETF is equivalent to buying delta and zero gamma.  Yes, it has no negative time decay.  So if that's what you want to do - then that's your decision.  BUT DO NOT buy those despicable leveraged ETFs.

597

Consistently Profitable Option Strategy with Steady Income?

Dear Mark,

In your experience in trading iron condors, is there a simple and "safe strategy" for steady income out there, which if used over and over will result in a outperformace on the index ?

Just curious as getting into this world now (have been in stocks and futures for 15 yrs).

Alok,

***

As an experienced investor I think you know the answer. In my experience the answer is NO.

Iron condors, as a strategy, are easy to understand.
You can increase safety so that some trades are 'safer' than others.

But 'safe'? No. There is always risk of loss.

If the ideal you seek were truly available, every investor in the world would be using that strategy - and the profits would be tiny (because there are people who would be willing to make these trades for 5% per year. And that would drive prices lower and lower).

There are strategies that outperform the index. But these are not 'safe.' They are 'safer.' Covered call writing is such an example. Read about the CBOE BuyWrite Index, BXM).

Covered calls have less risk than owning the index. But nothing is completely safe.

Collars guarantee limited losses - so from that perspective, they are safe. But monthly income is not guaranteed. In bear markets, losses may be small, but there will surely be no income.

Options improve your chances of earning a profit - but there are no guarantees.

592

Size matters. Except when it doesn't.

Mark,

I really enjoy your blog and your book is excellent as well.  Yours is the voice of reason in the forums.  :)

I've been trading front-month RUT iron condors for about 3 years with position size in the 30-50 range.  Typically, I place the order as one iron condor (I don't leg in), and I get filled 10 to 15 cents off mid prices. 

I would like to continue increasing the size of the positions as the account grows, but I am curious how large I can go before size begins to affect things.  If I entered an order for a 100 contract iron condor, would I still get filled 10-15 cents from the mid?  Would it be better to spread these over several strikes and enter orders over several days? 

 I may not be anywhere close to the point I need to worry about this, but I just wanted to get your take on the matter.

 

Thanks,

Dan

***

Thanks for the kind words.

1) If you are trading SPX, GOOG, APPL or any other very actively traded options - and especially if trading the front month - size makes no difference, unless it's far more than you are likely to trade.  With these underlyings,100 lots is no more than a speck of dust.  It would be gobbled up as quickly as your current orders.

Here's a hint:  If you begin to get partial fills on a consistent basis, then you can deduce that your order size is beginning to be too large for the specific options you are trading.

2) Better to split the order over more than one day?  Only if you want to add time diversification to your trading.  If you wait a day or two, a market move would allow you to open a new iron condor with different strike prices.  That may appeal to you as spreading the risk.  Or you may find it inconvenient to have a slightly more complicated position to handle.

3) As far as getting filled a specific number of nickels off the midpoints is concerned, that's not going to remain constant.  Sometimes the market makers will be anxious to grab your offers and at other times they may have to be coaxed by a better price.

Don't forget that what works for one stock or index may not be viable for another.  When we had live market makers in the pits, each crowd had its own personality and trading habits.  With electronic trading, I don't know how much one stock differs from another regarding fills.  Except that high volume makes it easier to trade.

4) My take is that over-confidence is a killer, so be careful.  The simplest method for managing risk when trading options is to pay attention to position size.  If you are trading 30-50, I believe your next level should be 40-60. 

I also think you should begin to remove cash from your account every month, quarter, or year. DO NOT try to continuously compound earnings.  There will be a losing streak. 

588

                     

Is the Other Guy Making More Money than I am? Does it Matter?

Thanks Mark (referring to this Q & A)

The reason I asked was because I too trade mainly condors, but with 2-month time frames. I stagger them so I have 2 condors on at any time, and based on regular margins, I'd say I use about 65% of capital for each position (adjustment capital included). I have portfolio margin so I have enough (and actually much more leverage available) for these positions.

I'm just thinking that in order to compare results with those who trade condors strictly on a one month basis, and assuming using 100% capital every time, I would have to multiply my result by 65% for comparison, or something like that.

Thanks

Peter

***

I understand how you feel.  It's exactly the same as individual investors who loved to open their 401-k reports the moment they saw them in the mail.

Then during the 2008 debacle, many just tossed them aside, unwilling to look.

When you are making nice money, you want to feel extra good about it by knowing you do better than the vast majority of traders.  Competition and all that.

But those are dangerous waters.  Your competition is yourself.  Defeat the demons: trade with as little emotion as possible, enjoy the good times and be prepared to handle the not-so-good times.  Do not get over-confident.  If you do that you win the competition.

If you earn 20% per year, that's so much better than 99% of the population, does it really matter how you compare with the other 1%?  Does it matter when iron condor traders boast of earning 5 to 10% per month - every month.  You know they are not telling the truth, so there's nothing to compare.

To your specifics:  A successful front-month iron condor trader is going to beat you.  That's all there is to it.  Trading front-month iron condors comes with higher risk and higher rewards.  You have already chosen not to compete with them by adopting a more conservative approach.

That aside, if you use 65% of your capital, you don't multiply by 65%.  You divide.  In other words multiply your results by 100/65 to give you 'what you would have earned if you had been 'all in.'

There's a bigger problem that does not concern you because of portfolio margin.  But it's a real problem for those using Reg T margin.  It's that 'all-in' insanity.  When prospering it's natural to want to bet bigger.  Don't do it (OK, do it - but just a small, manageable amount).

You MUST allow some cash for adjustments.  When you have no remaining capital, when an adjustment is needed, your only option would be to close both sides of an IC simultaneously because that's the only way to reduce margin.  Don't place yourself it that situation.

585

Finding a Trade Opportunity

Hi Mark,

I just by chance found your blog and read a few lines... Probably you already wrote that - but I just can not resist at this point to repeat the part of the question above - how do you "find" your trades - or which are your preferred strategies?

Thanks a lot!

Vido

***

My reply indicates how I operate.  Some traders appreciate the simplicity of my methods.  Others shrink in horror at the apparent randomness of my choices.  I must tell you that I do NOT recommend the method described below as a good idea for everyone.  You must (please) think about it and decide whether it's appropriate for you. 

Many people time their trades, with a market bias.  That's 'normal' procedure for traders.  I admit an inability to know where the market is going next, so I just trade when other conditions are met.

The strategies that appeal to me have one thing in common: limited losses and limited gains.  Risk management is far more important to me than seeking giant profits.

You can find potential strategies by reading this blog, Options for Rookies.  If you prefer books, I wrote The Rookie's Guide to Options for people who are looking for answers to questions you raise.  There are also other educational materials offered at no cost online. 

If you understand how a specific strategy works, you should be able to decide if it 'sounds' good enough to try.  And by 'try' I mean a paper-trading account.  Don't use real money until confident that you understand the trading method.

Then experiment with another strategy - until you find one that just feels right.  You will like the risk/reward potential. You will like the probability of earning a profit vs. the probability of losing money.  You will feel comfortable that you know what to do if trouble looms.  In other words, you 'get it.' 

It's important to acknowledge that this is not your lifetime strategy.  As you gain experience, as market conditions change, so will you.  Thus, if you decide to change methods, or modify your strategy of choice, that's more than okay.  It's a smart thing to do.

If you are brand new to options, it will take some time.  If you already traded options, pause, consider several strategies and practice one or two of them until you are sufficiently confident to use real money to trade.

I cannot tell you how to find trades.  If you are into technical analysis, then you can adopt bullish, bearish, or neutral strategies.  I always choose the neutral plays.  But, most traders prefer to express a market bias when investing.

What I do to find my trades works for me.  I don't have any idea if it will work for you, so please do not copy it unless you feel it fits within your comfort zone:

When I am ready to put more money in the market - and the timing is when I have extra cash, not when I predict any special move - I trade an iron condor (market neutral) on the Russell 2000 Index (I prefer using only one entity because it makes my portfolio easier to manage.  You may prefer more diversification).

I choose specific options to trade based on MY comfort zone: 2-3 months prior to expiration; as far as possible out of the money such that I collect about $300 total for the tqo 10-point spreads; and I check the delta of the options traded, preferring to sell options with a delta lower than 15.  That 15 delta suits me.  Many prefer delta in the 8-10 range.

If a suitable trade is not available, I wait.  No urgency to put money at risk.

My specifics probably will not help you - I list them to get you to consider alternatives that meet your needs.  You truly want to find your own zone of comfort.

583

Iron Condors: Establishing an Exit Point or Profit Target

hai mark

i just want to know about iron condor; which is the best to you??
for example,if the margin i use is $1,000 and i trade an iron condor.

1. i collect $250-$300 credit; so it will be 25%-30% profit from margin...
i will close my position when it reach 80% profit... around $200

2.i will have the 40-50% range profit. it should be very tight, and i will close when reach 50% of my profit...around $200

3. i will have 10-15% profit from margin. it should be small return on margin.  i will close when 80% profit...around $80

-with these three strategies, which one is better?

-between number 1 and 2,  in your opinion, which will get to the closing price sooner?

-do you have another idea...

thanx mark...

soemardi

***

Hai Soem,

First, some comments:

You cannot group all iron condors together.  The premium you receive when trading the iron condor depends on the implied volatility of the options.  It depends on the strike prices. 

For example, you are asking about iron condors with strike prices that are 10 points apart ($1,000 margin). A $30 stock would be unsuitable.

Trading 10-point GOOG iron condors is not the same as trading 10-point iron condors on IBM. 

Iron condors are not created equal and it's a good idea to establish a set of  'rules' - but the rules apply to a specific underlying asset, or at least underlying assets that are similar in price and implied volatility.  If you choose stocks that are very different, you should have a different set of rules.

Now - your questions:

'Best' is impossible to determine.  Much depends on your personal comfort zone and which position gives you the most confidence that it will provide the profits you seek.

From my perspective, your biggest problem is that you seem to be ignoring the possibility of losing money. I want to tell you that some trades will lose money.  I guarantee it.  Thus, risk cannot be ignored.  I believe it's important to own a position that you can live with - and to be certain that any losses are not too large for your pocket book or your ability to take that loss.  If you lose too much, it can be devastating and kill all chances for trading successfully.  Please be certain you allow for the chance that positions will lose money.

What will you do if the position is in trouble?  It's important to know when you will close the trade, take the loss, and (maybe) find a new position to trade.  You have rules for taking profits.  You must also have rules for not allowing losses to grow too large.

I know every trader wants to concentrate on profits, but it's the losses that are more important.  Your job is to prevent large losses.

That's why you must make your own decision on how to proceed - it's a decision I cannot make for you.  You must decide how much risk to take for every trade and recognize that you will not always achieve your profit target.

1) Number one is an excellent strategy.  It is essentially the method I use.  80% of the profit potential is a very good goal, especially when you collect a $300 premium.  The major question is: at what point do you give up, if the trade is not working?

It is also not as simple as stating the iron condor will collect a '$300 credit.'  Which expiration month will you choose?  It makes a very big difference because gamma is much higher (and the risk of a quick loss is much greater) with front-month options. A $300 credit with front month options translates into selling options that are much closer to the money than when you trade 2nd or 3rd month options. There is nothing wrong with doing that, but you should choose which iron condor is more suitable for you and your comfort zone.  I cannot help with that choice.

2) Also a good choice.  But this type of trade is better-suited for more experienced traders.  Why?  Because the options you sell are going to be closer to the money (higher premium collected means higher delta) and it's very likely that the position will have to be adjusted at least once. 

You must learn how to adjust positions, but you may prefer to begin trading iron condors when the probability of making an adjustment is low, rather than high.

One problem with seeking a profit target of 50% of the premium collected is that you may find it temping to wait 'just a little longer' before closing the trade, seeking a larger profit.

3) I don't like opening 10-point iron condors for $1 credit in index options or higher priced stocks such as GOOG or even AAPL.  It's my personal preference to avoid this trade.  I want you to know that many iron condor traders do trade these spreads, collecting $1 - or less.  It's a very popular strategy.

These trades are more difficult to close than you realize.   There are few sellers when these spreads get down to ten cents each.

This trade comes with a higher probability of earning a profit, but because the premium is small, any losses (and there will be losses) will be large, when compared with the possible profit.

If you are talking about an individual stock with strike prices 5-points apart, then collecting $1 for an iron condor is more acceptable to me.

Your last question:  #2 will lose half it's value more rapidly than #1 will lose 80% of its value, and you will be able to exit position #2 more quickly.  But only if you survive.  These spreads are not far out of the money when you sell them.

Another idea?  There are as many ideas as there are traders.  Your examples represent good methods for trading iron condors.  Just remember these are not rules cast in stone.  If you decide to take 78% instead of waiting for 80%, there is nothing wrong with that.

576

Iron Condors vs. Credit Spreads

Hi Mark,

I've been buying spreads recently instead of iron condors since I fancy myself to be a market prognosticator.

I want to be certain that you know this, although I suspect you do.  Whether you buy a spread or sell a spread with the same strikes (puts vs. calls), it's the same play with the same risk and reward.

Example:  Buying IBM 120/130 call spread is equivalent to selling IBM 120/130 put spread (same expiration).

Thus, whether you buy the call spread, or sell the put spread, it's the same bullish play.

The difference between your spread (or it's equivalent) and the iron condor is that the latter involves selling both a call spread and a put spread.

That strategy worked for my Jan bull put spread but my Feb bear call spread in RUT is starting to get a little too close for comfort...hopefully I won't have to ask you for exit strategies in a few days. 

Once again, I want to mention a pet peeve of mine.  The term 'bull put spread' is unpalatable to me.  I prefer 'sold the Jan put spread.'

If the Feb call spread that you sold is making you nervous, there's not much to an exit strategy.  You just exit at the proper time.  I assume you are referring to adjustments.  Much depends on how far OTM your call spread is when you decide to act.  There are usually good alternatives.

Anyway, I wanted to ask if my supposition is correct: that the risk is the same for spreads and iron condors with equal deltas. ie: a spread with a 15 delta and an iron condor with a 15 delta will both expire ITM roughly 15% of the time. Somehow I think it's not that simple since it seems the premium collected has been larger for spreads than iron condors of equal deltas.

Right you are.  It's not that simple.

I'll assume you are referring to the same underlying asset, or at least ones with very similar implied volatility.  It depends on what you mean by a 15 delta iron condor. 

If the call spread portion of the IC and the put spread each have a 15 delta, then the IC finishes ITM 30% of the time.

If the sum of the deltas is 15, then yes, one or the other finishes in the money 15% of the time.

The premium for an IC should be double that of a single credit spread, when the call spread and the put spread are each 15 delta.  Double the premium; double the risk.

As an aside, I was wondering what your opinion is on the current market volatility? It seems the only index worth trading currently is RUT, but with earnings coming up this month I presume volatility will only go upwards from here.

I truly don't look at the other indexes, seeking better trading opportunities.  I lack the time, being far too busy writing.

My opinion is that I don't know in which direction IV is more likely to go.  Higher would be my choice if I had to wager, but as recently as Jan 2007, VIX was under 10.  I don't believe earnings season will play much of a role - unless there are many earnings surprises.

If you want to have positions that do better when IV expands, consider single or double diagonal spreads.  They are long vega and both iron condors and credit spreads are short vega.

571

Please don't let this happen to you.

I have been exchanging emails with a rookie option trader, and I must confess it breaks my heart.  I'm not publishing these excerpts from our correspondence to poke fun at him.  On the contrary.  He is making an effort to learn and I'm doing what I can to provide encouragement and good guidance, but his current situation leaves me bewildered and upset.

I am reproducing a variety of excerpts from our exchange with the hope that it will discourage anyone from believing that trading options is a simple game and an easy pathway to getting rick quickly. 

Options are easy to understand.  But trading them requires a substantial understanding of how option prices move up and down; what must happen to earn a profit; the realization that losses occur more frequently than you may have been told by some eager friend; and most importantly, that options are not bought or sold - and then ignored.  You must pay attention to positions and carefully manage risk.

***

I don't know a lot about options but I lost a large amount of money (for me its very huge, but its not for you).

I just read about a strategy (it looks easy and safe) - the iron condor.

My goal is to have monthly income from options and I want to have a simple strategy, with a trading plan that is just easy

My research shows that iron condor has a good probability of winning but many think that if you lose you will lose the entire year's profits.  Is it true? I think I will use iron condors for my monthly income

Your [previous] statement that I will take losses part of the time is a big eye-opener.   Before that, I thought this strategy wins all the time.

I explained that it's not 'easy.'  Nor is there a guaranteed monthly income.  Is it possible for anyone to believe that this, or any, strategy wins all the time?

***

When I mentioned that I never used technical analysis, he was bewildered and asked:

You never use technical analysis?  How do you find your trades?  Or do you just teach and never trade?

I understand that technical analysis is beloved by many and useful for some.  But to believe that one can possibly trade without using it is beyond my comprehension. 

If everyone believed that a stock gave a buy signal, and if everyone wanted to buy the shares, who would sell them?  Just that ought to be enough to convince him that the minority use technical analysis for trade decisions. 

I  know that people trade options with no idea of what they are doing.  Yet when I find evidence that it's true, it bothers me. 

570

Trading Iron Condors: Are you Getting a Fair Price?

Hi Mark,

Can you tell me how to arrive at a fair value for an Iron Condor?

Ivan R

***

Ivan,

This is a topic I have long ignored.  It's a very good question.

In my opinion, it's not worth the effort to determine the theoretical value of each of the four options.  You would have to make a very good estimate of the future volatility of the underlying asset because you need that volatility number for the calculator.

If you don't already know, let me assure you that it's not so easy to make that volatility estimate.  Those who are truly skilled in predicting future volatility have a huge edge over everyone else who trades options.

But, if you want to do the math, you can still get yourself a free option calculator and make the calculations for each of the options that comprise the iron condor.

Another choice is to use the theoretical values offered by your broker.  The only problem with that is you never know how they chose their estimated volatility - or whether it's a reasonable estimate. 

I prefer to look at trading an iron condor this way:

1) When you trade an iron condor, you are a net seller of vega, and that's the component of an option's value that changes as implied volatility changes.

Clarification: When IV increases, the market price of an iron condor increases.  When IV decreases, the market price of an iron condor decreases.

2) If you believe the current implied volatility (IV) is high (and likely to move lower), then you are going to get a good price for the iron condor.  In other words, using the current IV, the market price for the IC will exceed your calculated theoretical value.

I recognize that you may not have a good feeling for whether current IV is high, but if you cannot do that, then you would not be able to determine a theoretical value for the iron condor.  Thus, you are no worse off.

3) If you believe current IV is low, that's not the best time to be trading iron condors - unless you believe IV is going lower.  Note, it's not a terrible time - but you probably don't have any theoretical edge going into the trade.

4) If you truly don't know whether IV is high or low - and most traders don't know, you have two choices:

a) Trade the iron condor anyway.  Over time you will get good prices part of the time and poor prices the rest of the time.  On average you should be okay.

b) Look up the stock's historical volatility over the past 20, 50, or 100 days. If you believe those numbers give you a reasonable estimate of future (from the present time until the options expire) stock volatility, then compare that volatility with current IV.  If current is high, trade.  If it's low, pass.

Here is how to use those numbers from Lawrence McMillan's web site:

The columns hv20, hv50, and hv100 represent the actual stock volatility over the past 20, 50, and 100 days.

curiv is the current implied volatility.

Percentile is the percentage of the time that the current IV has been LOWER.  A high number means that IV is relatively high.

564

The Modified Mouse Ear Strategy

Hi Mark,

I am a daily reader of your blog since last year and you provide a lot of good information here about these income generation strategies. Congratulations.

I did not know exactly how to send you this message, but as the topic is iron condor, I am sending here as a comment.

It is about an adjustment/insurance strategy that I heard in a webinar for Iron condors. The "Mouse Ear" strategy.

For Example on RUT 650/660 Calls 4 Contracts 550/540 Puts 4 Contracts.

To protect you sell 1 660 Call and Buy 1 640 Call

To protect you sell 1 540 Put and Buy 1 560 Put

It is cheaper than the extra calls but is this protection good enough?

My idea is adapted from the "Mouse Ear" using the 2-3 months Iron Condors you use, buying short term options.

On the Above Example : FEB 650/660 Calls 4 Contracts FEB 550/540 Puts 4 Contracts

To protect you sell 1 FEB 660 Call and Buy 1 JAN or DEC 640 Call

To protect you sell 1 FEB 540 Put and Buy 1 JAN or DEC 560 Put

The idea is not to use it as a pre-insurance, but to make this adjustment only when RUT reach the midpoint between my Enter point and my Short Position.

On the Above Example buying the JAN options you can make the adjustment for free or by paying very little.

So the Adjustment will reduce my loss if RUT reach my short option and get stopped out.

I hope you understand the explanation.

Thanks Again,

Fabiano

***

Fabiano,

Thank you for being a loyal reader.  Yes, I understand your question, and commenting here is the best way to ask that question.

The answers are a bit complicated - because there are several alternatives to consider.  Thus, this is a lengthy reply and will require more than one post to complete.

In the analysis below, I've ignored the possibility that you would exit the trade if and when RUT reaches 650.  Obviously any investor can close the position at any time.  The more complete discussion is for anyone who would continue to own the position.

1) As you know, there are many methods you can use to adjust, or reduce the risk of holding, iron condors.

2) The 'mouse ear' is a method used by Dan Sheridan.  It's a good idea.

3) I agree that the cash required to make this trade (the sale of a call, or put, diagonal spread) is small - and many times you collect a cash credit.  The market value of the spread depends on how much time remains in the lifetime of the Jan option, and more importantly, on the implied volatility of the Feb option (because you sell the call with more vega, higher IV means the chances of earning a cash credit increase).

It's not a good idea refer to this as buying something 'for free.'  You do sacrifice something when buying insurance.  It's nice to avoid paying cash, but it's not free.

4) I agree that this is NOT a good candidate for pre-insurance.

5) IS IT ENOUGH?  Does it offer sufficient protection?  And if the protection is adequate, how does the profit and loss picture look?

These are the important questions.  I don't believe there is a simple reply, but let's take a detailed look to see what we can learn.  I'll offer my opinion, but  you must decide if the mouse ear makes the position comfortable for YOU to hold.

*** 6) There is something special about the iron condor you chose.  It's a CTM position, meaning that the options you sold are CTM (close to the money).  The options have deltas of 31 and -24. [Although I have made no specific recommendation, my guess is that most index iron condor traders begin by selling options with a delta between 7 and 15. ]  For many iron condor traders, not only are those deltas too high for an opening trade, but they are well past the original adjustment point.  And some traders would feel so uncomfortable that the position would be closed. 

Thus, this is not a popular iron condor to trade.  But, that does not make it a poor trade.  Some very successful traders prefer CTM iron condors. 

Tomorrow [ADDENDUM:  Monday] we'll continue the discussion using your example.

539

Iron Condors and Trading Style

Dear Mark,

Since completing The Rookie's Guide To Options, I've moved on and have been furiously trying to absorb the information provided in your blogs. I wanted to give a big thanks for keeping all this information available (and organized into sections).

I wanted to tell you about a 'webinar' on iron condors that I listened to over the weekend, offered by an online broker. The 30 minute presentation was ultimately more of an advertisement for the guy's brokerage firm than educational, but I did pick up a couple of points, mostly pertinent to his own views on condors but enlightening nonetheless.

1) He strives for his condors to expire rather than to close them and has even opened them on the morning of expiration day

2) He closes a condor if the delta reaches .45

It seemed obvious his techniques were riskier than what you suggest in your book, but I was a little surprised at how different your approaches really are. First, though I'm not sure if you've ever explicitly said so, I've presumed you choose to open condors at least 2 months in advance and typically close them when you've made a satisfactory gain from theta decay, preferably far from expiration to avoid high gamma and the rapid swings that stocks go through as expiration day nears.

His view on delta came after I asked him how delta and theta affected his condor decisions... I was hoping to get some tips on where to open condor positions based on those values; his .45 delta seemed like a sensible guideline but with regard to theta he laughed, "We don't pay attention to theta, we just want to burn through it as quickly as possible!" I rolled my eyes after that.

Admittedly, my knowledge is just about nil when it comes to using greeks for my positions, but it seemed clear to me that one's acceptable value of delta would change with the amount of theta left on the option.

His next non sequitur statement sort of confirmed that: "If we can make even just a 17% gain on a condor in its first week, we'll take that and close the position"

So, my conclusion after the event is that there's a lot of different methods out there, and those supporting the riskier moves seem to be the more outspoken ones.

I think I'll hang out here and gather more information a while longer before I open any index spreads.

By the way, if you have any readers who are getting frustrated at not getting the options approval level they want with their online brokers, I figured something out. In addition to having the prerequisite liquid assets and net worth, you need to check off 'aggressive growth' and 'speculation' as your investing style, instead of simply 'growth' which is what I had been choosing. It's hard not arguing with the people at the other end of the line that spreads are supposed to be protective, not speculative.

***

Hi Andy,

1) I'm reorganizing those categories.  There will be fewer categories and hopefully that will make it easier to find previous posts

2) Overall comment.  I have no problem with much of what he does.  A lot of it is 'style.'  But when he is 'willing' to 'settle' for 17% in one week, there are only a few conclusions I can draw:

a) He has no idea how to calculate percentage return.  or

b) He is a trillionaire - and clearly the wealthiest person in the world.  Seventeen percent in a month, turns $1 into $6.50 in a single year; or

c) He lies

I vote for choice a).

3) It's not 'wrong' to trade very short-term iron condors.  It's just too risky for me.  This is a personal comfort-zone decision.

But he does run a brokerage and wants clients to generate commissions by trading more frequently.  I admit that I am surprised that he appears to pay little attention to risk. After all, it's in his best interests to promote strategies that are profitable and not too risky.

4) Closing at a 45 delta is as reasonable as other alternatives.  He apparently does not attempt any adjustments, which is also a trading style decision.  I have no quarrel with this action - for the right investor.  It's not to my personal liking.

Other traders would choose a different delta, but it is a reasonable way to limit losses.

Keep in mind that I don't really 'suggest' when to close or adjust.  I try to indicate what I believe is a workable trading style, with reasonable risk.  But those terms are relative and it's right for you, or any reader, to select his/her own parameters when managing risk.  If you are comfortable, making money, and don't feel the 'need' to take more risk, then you are doing just fine.

5) I did explicitly say that my (typically) 3-month iron condor suits me and my risk profile.  I recommend that readers consider that as one alternative.  I don't believe my style is suitable for all, and encourage you to carefully think about (or practice trading) different types of iron condors (different expiration, delta of options sold, etc) to find your own comfort zone.  This process is not completed overnight.

I do not like being negative gamma on short-term options.  Someone else may prefer the higher risk and higher reward.  That's not 'wrong' - it's just wrong for me.

6) I believe it pays to be aware of theta and vega, and especially gamma - but the truth is that if he has a system of opening new trades and exiting those trades when he perceives risk is high, how can anyone say that is 'bad' or too risky?  Obviously it makes you and me uncomfortable, and we choose to manage risk differently.

7) When looking at delta near 50, you know the option is trading nearly ATM.  Theta is attractive; gamma is dangerous.  Play 'em or fold 'em.  That's the decision.

It's a compromise:  Less time means a smaller probability that the move will occur.  That encourages you to hold and collect that time decay.  But, if the move does occur, gamma is worse and the option can move to 100 delta very quickly - maximizing losses.  This is, as already mentioned, a personal trading style/comfort zone/risk-reward decision. 

That 45 delta is always going to mean 'nearly at the money.'  The truth is that he exits when he feels the underlying has a chance to quickly  move into the money.  I cannot argue with that, although I prefer to exit sooner.

It may feel unscientific or too lax of a method for you, but I don't find exiting at 45 delta (or 40 or 50 or ?) to be unreasonable.

8) The longer you 'hang around here' the more information you will gather.  My goal is to have readers use that information to form opinions, think for themselves, and not depend on me, or anyone else, to suggest specific trading styles.  And don't forget that being flexible is important - i.e., trading style can change as you gain experience and as market conditions change.

9) Good suggestion for 'permissions' but it's also easy to change brokers.  Some allow any trader to trade any position.  That can be dangerous for rookies, but that freedom is available.

10) I don't know if they don't recognize that spreads represent reduced risk, or if it's easier for them not to challenge old guidelines.  But it is a constant reminder that ignorance plays too large of a role in determining how our world operates.

538

Front-Month Iron Condors: Why do Services Recommend them?

If you are taking advantage of Black Friday pricing at Amazon.com, please consider linking to Amazon through this link. You will not notice any difference in your shopping experience. Thank you.

***

Question from DC:

I notice that many of the services and information aimed at option trader wannabes do promote front month credit spread selling - why is that then?

Is it because the simpler they can make their systems seem, the easier it is to sell?

***

Hi DC,

The profit potential - on an annualized basis - is MUCH higher with near-term options.  It's very attractive to attempt to earn 5% in two or three weeks.

Most services talk about the great profits they earn and how you can do the same by paying for their advice.

The problem is that those high returns come with added risk.

If the market moves against the position big time, then the front month options are dangerous for two reasons:

They are less far out of the money to begin.  If you move too far OTM, the premium becomes tiny.

That means they move into the money more frequently than options that are farther away.  Once ITM, the delta of the short options approaches 100 quickly (due to negative gamma) - much more quickly than the delta of longer-term options
Losses mount much more quickly when the delta is high.  that means the spread approaches its maximum value more quickly

Bottom line: front month is more attractive to most traders because you earn your profits quickly, the returns look huge (and they are huge), but risk is much higher and those services seldom, if ever, talk about that aspect.

Short-term is NOT wrong.  But you must be willing to take higher risk for better rewards.  Personally, I prefer less risk, less reward.  But you may prefer the 'more exciting' near-term game.  You would not be wrong to do that - but do be careful about how many contracts you trade at one time.  The terminology for that is: don't trade too much size.

***

Poll: Proper font size.  Is the font size in today's post too small?

533

Front Month Iron Condors

Mark,

I am not a very experienced trader and currently trade SPY iron condors. Every week, I read TA reports from Larry McMillan and S&P, so I think I have a rough idea about the possible directions (support and resistance) of the market until next expiration day (I allow enough margin for safety on these ideas).

Based on that, I try to establish one new position, for the front month, roughly once a week (but not in the last 6-10 days before expiration). However, I find that trying to establish a "safe" IC position, reasonably OTM, many times, I can not get a "good" premium for both the call and the put leg.

Therefore, my question is whether it is a better idea NOT to establish both legs of the IC on the same day, but one leg today and the other a few days later, depending on the move of SPY. If SPY moves in one direction only (rather unusual) then I will accept that my portfolio will only have some "good" call (or put) credit spreads and no iron condors for this month, which is not a big problem.

What do you think?

Thank you,

Dimitris

***

This is a good topic for discussion.

1) TA is not easy to master and many people believe it is bogus.  As long as you do not depend on support/resistance as gospel, it is one method for choosing strike prices.

2) My feeling is that front-month credit spreads (including iron condors) are far too risky for me, and - despite the fact that this is the method of choice for most iron condor traders - I do not recommend it for inexperienced traders.

The reward looks tempting; time is short; theta is pretty, but gamma is ugly. These are very difficult positions to defend or adjust.  I'd prefer to see you trade options with a longer lifetime.

It's obvious that I dislike 4-week iron condors, hate 3-week ICs and loathe 2-weekers. 

3) Now that I've expressed my thoughts, I'll reply to your questions.

a) If (and it's really up to you) you are comfortable with owning only one half of an iron condor position, then it is viable to open just one leg of the iron condor, hoping to open the other shortly.

b) But this plan often disappoints. Especially when waiting a 'few days.'  Unless you are selling spreads that are fairly close to being at the money (I know you don't because you would never refer to those as being 'safe'), the call spreads do not widen as expected (on a rally) due to IV declines.

If you happen to sell the call spread first (do not believe I am suggesting that you get short all the time), then you should have a good opportunity to sell the put spread - on a decline, if IV increases.

c) Note: This idea of trading one leg at a time is always a reasonable choice, regardless of time remaining.

d) I prefer selling only the call spread, or only the put spread, to selling the other half of the iron condor at a terrible price.  Although you win most of the time, selling front-month spreads for small credits is a long-term losing strategy. You seem to agree.

e) Although you mention it nowhere, I assume you never cover your shorts and plan to see them expire worthless. That adds to risk.

526

 

Butterfly and Condor Spreads

I received a question recently about butterfly spreads.  I never write about them, despite the fact that many individual investors like to trade such spreads.

Definition:  An option strategy combining a bull and bear spread such that these two spreads share a common strike price.  Frequently referred to as a 'fly.'

Example:  The options in a butterfly are either all calls or all puts.

Buy AAPL Nov 100/110/120 call butterfly:

Buy 1 APPL Nov 100 call

Sell 2 AAPL Nov 110 calls

Buy 1 AAPL Nov 120 call

Note: 

Long the 100/110 call spread; Short the 110/120 call spread

Buy AMZN Dec 105/110/115 put butterfly:

Buy 1 AMZN Dec 115 put

Sell 2 AMZN Dec 110 puts

Buy 1 AMZN Dec 105 put

Similarity to Condor spread:

The butterfly is a condor.  The only difference is that there is a separation between the strike prices of the bull and bear spreads in the condor, and there is no separation (the spreads share one strike price) in the butterfly.

Condor Example:

Buy 10 SPY Jan 85 calls

Sell 10 SPY Jan 90 calls

Sell 10 SPY Jan 100 calls

Buy 10 Spy Jan 105 calls

In this condor, there is a 10-point separation.

Thus, the butterfly is similar to the condor.  They are both members of the family of spreads called 'winged spreads.'

Iron Condor

The condor is equivalent to the iron condor.  Why?

In the iron condor, instead of buying the bull call spread, the equivalent put spread is sold.  Thus, the iron condor is:

Buy 10 SPY Jan 85 puts

Sell 10 SPY Jan 90 puts

Sell 10 SPY Jan 100 calls

Buy 10 Spy Jan 105 calls

Because selling the Jan 85/90 put spread is equivalent to buying the Jan 85/90 call spread, these two positions are equivalent.

Going one step further, the butterfly is equivalent to an iron condor in which there is zero separation between the strike prices of the bull and bear spread.

Bottom line:  This is just another way of stating that iron condor traders can purchase a condor or butterfly and have a position that behaves similarly.  The chosen strike prices represent the real differences in how the spreads perform in the real world.

498

Q & A. Iron Condor and Butterfly Spreads

This was originally posted as a comment.  I made minor changes for clarity.

Hi Mark,

I've enjoyed the lightning round and the quizzes. I am reading about IC and DD and have condensed what I believe you have been teaching about adjustments and I want to see if these are your thoughts and basic tenets.

1. Any position that is uncomfortable has too much risk

Not necessarily.  It could have too little reward.  Or no longer suit your trading style - I assume it suited when position was initiated.

2. When looking at adjustments examine whether or not the new position is one that you want to be in.

3. Sometimes closing is the best option.

4. IC benefits when Vega drops after the initial purchase and DD benefit when Vega increases.

Vega is a property of the option and it's value changes as the price of the underlying asset changes,  The term you meant to use in place of 'vega' is 'implied volatility.'

5. Typically 13 weeks before expiry is a good purchase time and attempting to be out 2 weeks prior.

No.  This is what makes me comfortable (most of the time).  I never recommended that anyone else adopt this idea.  I talk about it so that others can consider this as one alternative.

My question today revolves around Iron Condors that you want to hold, but one of your inside (sold) legs is being threatened (moving too near its strike).

You mention buying an ATM Put or Call [I recommend buying OTM options - but they should be closer to being in the money than your short option]  as applicable to minimize risk.

How do you figure how many to buy?  For example if you have a 1-lot (meaning all 4 legs X1) or a 10-lot, 10 point RUT IC, is there an equation or some other information in the Greeks that would assist in providing how many you would buy as protection?

The Greeks, coupled with the P/L graphs provided by your broker should be all the information required.

How many to buy?  I do not use rules.  You could arbitrarily decide to cut delta by X %.  Or decrease negative gamma by X  %.  If you are adjusting late (short is almost ATM), then X is a higher number than if you begin adjusting in stages. 

I think cutting delta and gamma by 20% is enough - when the adjustment is made early (early is a flexible term and depends on how YOU look at the position).  If you don't adjust until the short option is already ATM, that's 'late' in my opinion and 20% is not going to be good enough.

One other aspect of 'how many' depends on which strike you choose.  If short 10 of the 800 calls and decide to buy calls, I might buy one 770, but would want at least 2 of the 790s - again assuming this is a stage I (early; not in trouble yet) adjustment.

You can also buy insurance when it's not needed (I do that frequently).  I buy put protection on rallies and call protection on dips.  Then I am not pressured (as much) when the market moves against my position.  Because there is little urgency, if I were holding a 10-lot IC, buying 1-lot would be good enough.  Then I'd buy another, if available, at a better price later.

How much to spend on these adjustments is usually a consideration.  I don't dwell on the credit collected from the original iron condor.  I buy portfolio protection when the price is right and see some portfolio risk.  Again, no rules.  No guidance I can offer - other than to post my trades and discuss as time passes.  But right now, I don't want to do that.

Also, I read on another web site about IC's that are traded for a  $1.00 premium.   But even at a 90% win rate, if you don't adjust or exit, or consider your max potential loss, one month could wipe out the year's profits.  Why would they settle for such a low premium -or is this personal preference?

You know that everyone looks at investing/trading from an individual perspective.  The $1.00 IC trader may be very happy with a 90+% win rate.  We don't know if he/she ever adjusts, or whether he closes his eyes and hopes for the best.  My point is: just because he collects only $1.00, it does not mean he is careless with risk management. But it's very likely that he doesn't cover early and holds to expiration in an attempt to collect each penny.  Not the risk I take, but that does not make it 'wrong' or a poor investment style.

Lastly, what are your thoughts on using a butterfly to extend your break-even in the event one of your legs is threatened? For example you have a 550/560 Put spread and see movement towards the short 560 strike.  You could take that out with a 540/550/560 butterfly and push that leg out-just wondering if this is an adjustment that you consider?

Butterflys also seem to have a high reward to risk, do you ever use these as a part of a short month IC, for instance looking at November? Like to hear your thoughts.

I do occasionally buy a butterfly to move my short options from one strike to another.  But not often.  It really does depend on two major factors: 

a) How much does the fly cost and are you willing to pay that much for a TINY (TINY TINY) bit of protection.  Remember that 10 points is essentially nothing in a $600 index.  To me, the butterfly is often just too expensive.  I'd pay $0.25, but not $1.00.  You may be willing to pay more.

b) Does this adjustment move you from uncomfortable to comfortable?  I don't think that's possible.  It's just 10 points.  If you were to buy a condor (see tomorrow's post) instead of a butterfly, you could move the short strike more than 10 points - and that could easily be worthwhile - at the right price.

You obviously just discovered butterfly spreads.  I get that you want to learn more about them.  But, as with any new toy, you cannot expect to jump right in and use it with maximum efficiency.

By coincidence, I already prepared the blog post for tomorrow and it's about butterflies and condors.

I do not trade butterflys as part of a front month plan.  What I used to do, when I needed FOTM protection, is bid 15 or 20 cents for a FOTM  butterfly - but only if I needed protection.  Example, with RUT near 570, if my downside looked bad, I would bid 15 cents for the 450/460/470 Jan or Dec fly.  Probably would not get filled.

Yes, good risk/reward.  But VERY low probability of collecting anything resembling the maximum reward.

Thanks,

Don

497

Lightning Round. Q & A.

Hi Mark,

You responded to one of my emails a few days ago - and just wanted to say that I set up a side by side Collar and Put Spread in a spreadsheet and now I COMPLETELY understand why you said what you said below [The positions are equivalent].

The two positions basically have the same profit/loss profile, and yes, the temptation is there to put on more spreads because they're more "affordable". But with each additional spread, the risk mounts.

You have succeeded in teaching this Rookie an important lesson. It's also become clear through this what leverage really means. Wow!

The pieces are falling into place.

Thanks!

Rob

***

Rob,

Good news.  Thanks for sharing. 

When you see the P/L graphs side by side that makes it easier to understand that the positions are equivalent.  I tend to avoid using such graphs because I assume the 'proof' that the positions are equivalent should be enough. 

When managing risk, the primary consideration is position size.  Get that right and you will not have any extra trouble if the position moves against you and an adjustment becomes necessary.  When you trade too many contracts for your risk tolerance or pocketbook, you begin with a position that can quickly move out of your comfort zone.

Any of these call or put spreads is equivalent to one collar (long or short).  Thus, the admonition:  don't trade too many spreads just because it appears that the cash at risk is small.

***

I looked at the blog, but haven't seen this covered.  The question is:

Do you ever sell your condor spreads separately?  For example, let's say you believe that there is more likelihood of a downside move than upside.  So you sell the call spread first, then wait a bit to sell the put spread.  Or vice-versa.

Brian

***

Good question Brian. 

It seems natural to do just as you suggest and 'leg' into iron condors by trading either the call or put spread first.  I've done this enough times to tell you that it does not work as efficiently as you would anticipate.

a) Selling the put spread first.  When you anticipate a rally, it's okay to sell the put spread portion of the iron condor.  The plan is to sell the call spread on a rally, and thus collect a higher premium for the call spread.

If you sell option spreads that are out of the money by a significant amount, then you will discover that the call spreads don't get any wider unless the up move is big.  And if it's that big, you may no longer want to sell the call spread.

The reason that the spread doesn't widen is twofold:  First the spread has a small delta and it takes a decent move to make the spread worth more.  Second, and more importantly, the spread has positive vega.  Thus, when the market rallies, most of the time implied volatility (IV) decreases.  That IV decrease causes the value of the call spread to decrease - at the same time that the long delta increases the value of the spread.  These counter forces tend to keep call spreads from becoming more valuable on rallies, unless the strike prices are near enough to the stock price to have a significant delta.  When that happens, the delta overwhelms vega and the spread widens.

The only good news to this scenario is that the put spread has been narrowing - due to delta and IV working together. That means you may prefer to take a profit on the put spread rather than sell the call spread.

b) Selling the call spread first.  If you have a bearish bias, this plan actually works.  If you sell a call spread and the market declines, two good things happen for you.  First, the put spread widens by a small amount due to delta.  Second, the spread widens even further as IV increases.

Thus, taking the bear leg is a much more successful plan than taking the bull leg.  Warning:  Do not allow this factor to convince you to take bearish legs.

Another interesting situation that I discovered when I used to leg into these trades is:  When the market falls, the put spread widens.  But the call spread narrows by so little that you gain little with your successful leg.  In other words, the fact that IV increased is enough to widen the market price of the whole iron condor and the benefit of taking the successful leg is small.  Depending on your point of view, it may turn out that there is too little reward for taking a successful leg, to bother.

***

Tomorrow's webinar: 

Tuesday October 27, 2009 at 6:00 PM (Eastern Time). 

Title: Collars; Combining Covered Calls and Married Puts

Register for webinar by clicking here.  All events are free and open to everyone.

The webinar platform is by webex.  To participate, you must download the platform to your computer.  You can do that as you register.  No telephone lines will be used for the event.

492

The Greeks Speak

The final part of Don's questions,

"Today at noon, I ran a trade using the RUT December options Trading the 560/550 Put and the 650/660 call spreads according to TOS (thinkorswim) that trade could be executed with a net inflow of nearly 5.00 I know that you feel comfortable with 3.00 credits.  Is this trade something that you would consider?"

Yes, I would consider it.  There is nothing magical about a $3 credit.  But this position is not that far OTM, and the probability is high that this iron condor is going to run into trouble.  I prefer to have better odds of success going in, and would not do this spread because: a) My comfort zone manager tells me that I'd rather be short options that are farther OTM and b) I have room to satisfy that need because I'm willing to take less than the $5 premium.  I can more farther OTM, accept a smaller premium, and still be happy with the trade. 

"Lastly I know that you would never hold to expiration but is negative gamma the main reason that you do not trade into the last week,?  Or is the cost of doing business, by closing the open trades, ensures the profit, removes risk and allows you to look into your next trade?"

'Never' is the goal.  I sometimes find myself holding longer than I prefer.

It's the negative gamma.  Too risky for me. 

Commissions are not a factor.  I trade what I want to trade.  It's wrong to fail to make trade because costs are too high.  It's much easier to go with a less costly broker.

Closing positions and removing risk is something I like to do.

***

In addition to the above I ran the following and traded in my paper money account:

Received 4.50 credit for the RUT Dec 560/550/650/660 IC trade with the following Greeks:
-Delta 12.70 Gamma -.85 Theta 31.01 Vega -164.52

I also traded the following SPY bought 100/sh at 106.5 sold the Nov 107 call (2.98)and bought the June 105 Put (8.25) my Greeks are:
Delta 6.65 Gamma -3.16 Theta 1.60 Vega 20.12

I am interested in how you would use these Greeks to assess risk now and in the coming months. Note: the Greeks are sums of the individual positions.

Using real words like...geez I have too much Gamma when that's added to my Delta I'm gonna lose-LOL or something like that! Maybe geez my vega risk is really high I could lose 'X' if this happens...

What are these Greeks saying to you and your experience that I do not yet see?

Don

***

Don, you do not make it easy for me.

1) You said the IC could be traded for $5, but you accepted a $4.50 credit when trading.  That doesn't sound good to me.  But is it not relevant to the question.

2)Regarding the iron condor, the Greeks tell me the same thing they tell you.  You are collecting some time decay - and I know you understand that. You are short vega, but all your iron condor positions are short vega. 

By choosing December options you are short more vega than someone who sells short term options.  The good news is that you are gamma neutral. 

Don, I always thought I used 'real' words, but I'll see if I can accommodate by re-wording what I said above:  [For all readers, I apologize for the English and hope my European and South American readers can follow]

Geez Don, That nasty guy - that gamma - youze know, da enemy - he's not too ugly right now.  I wouldn't trust him as far as I could t'row him,  and he can get real ugly real fast - but right now he's ok.  We got a truce.  He's our temp buddy.

Now da one we gots to watch out fer - he's dat vega guy.  He's ready to make a move - but dunno which way.  We could make a fast buck if someone kicks him in the shins and he falls over.  But if he makes a getaway and speeds up - we could be in trouble.

Outside of dat, I got nuttin' to say.

3) The buy-write, or covered call.

I see you adopted the collar strategy outlined in the recent academic paper.  I'd be interested to see how this works for you.  I don't like it.  I find the longer-term put to be too costly.  I do understand you hope to write calls about six times and collect far more in call premium than you paid in put premium.

These Greeks speak a different dialect and I'm not understanding what they are saying.  They mention being long vega and there's some risk in that.  The Greeks also talk about how that negative gamma can get worse in a hurry, if SPY moves higher. 

Here's the risk in this position: A rising market will kill the premium you paid and will make it difficult to make any money.  If that put premium disappears, you will  not be able to recover it.  The calls will move well into the money and you will be assigned an exercise notice - leaving you with naked long puts.

To protect those puts, you would have to take some action with your call spread.  It's as if you are forced to roll the position on a rally - even when you prefer not to do so.  That is the risk of buying puts with a high premium.  Of course, a lower market will provide extra profits.  But to me, that's a play on vega and is not a true collar.

Don - collars are very flexible and there is nothing wrong with the collar you chose.  From my personal point of view, I like the collar as protection for assets, and not as a market play.  That being said, it is a perfectly reasonable idea to turn it into a market play.

486

Q&A. Iron Condors, Double Diagonals and Impled Volatility

More questions from Don:

With IV [implied volatility] and the pricing of IC [iron condors] and DD [double diagonals], you mentioned that trading IC works better when IV is high and that DD are better when IV is low...but those are relative...yes the IV affects the price, but it affects ALL four components relative to each other so that their relative profitability towards each other is the same?

Same with DD's but it may be different because of the calender component. Doesn't IV affect the front month more than the back month?

***

For my comfort zone I prefer to trade iron condors when IV is elevated.  When I believe (obviously I cannot be certain) IV is at the lower end of its range, I prefer to trade double diagonal spreads.

This concept is explained in The Rookie's Guide to Options.

For those unfamiliar with the strategies, the iron condor is constructed by selling a call spread and a put spread in the same underlying asset and for the same expiration.

The double diagonal is similar to the iron condor, except the options you buy still have the same strike price, but they expire one month later.

1) The major reason that my strategy selection depends on IV is based on the nature of these positions.  When you own the double diagonal, you effectively own the iron condor plus two calendar spreads.

When IV increases, the value of a calendar spread increases.  That's another way of saying that DD spreads have positive vega.  Positions with positive vega do well when IV increases.

Thus, I buy these positive vega positions when IV is low and  the chances are good that IV will be higher (than it is now) when the front-month options are about to expire.  If IV has increased, I will get a good price when I exit the position and sell my longer-term options.  If IV has declined, I will be forced to exit my position at less favorable prices.

Iron condors have negative vega and do well when IV decreases.  If that IV decrease is significant, it's often possible to exit the trade with a quick, but good-sized profit.  Because these spreads do well in a falling IV environment, I prefer to own them when I believe IV is high and likely to fall.

It's not complicated.

If any iron condor trader wants to own a portfolio that has very limited volatility risk, it's a simple matter to add some double diagonals to the position mix - enough to turn the portfolio vega neutral.

2) Your point about the option prices moving in tandem is not accurate.  When you are selling OTM call and put spreads, those spreads widen as IV increases because the options which you sell have more vega than options you purchase.  That's why the spread has negative vega and it's the reason that higher IV means you can get a higher premium when you sell these put and call spreads.

3) It is true that a rising IV environment usually imparts a larger percentage increase in the IV of the front-month options.  But you do not trade percentages; you trade dollars.  Longer-term options have more vega than their front-month counterparts.  Thus, even though the IV increases by a smaller percentage, it increases by more dollars.  In other words, the premium increases more for the long-term option than the short-term option.  That's why calendar spreads widen (become more profitable) as IV increases.

***

I have difficulty reconciling "buying a spread" netting me money and "selling a spread" costing me money so I have just used trading a spread for ease of use.

***

When you buy an iron condor you sell the call spread and the put spread.  That means you are buying the iron condor and collecting a credit.

There is no official nomenclature for the options world, and to me, that's a shame.  Many people feel as you do and use the term 'sell' an iron condor when I would say 'buy' the iron condor.

There is a rationale for this, but it's lengthy.  In summary, when you buy a condor spread, you profit when the stock remains between the strikes.  The 'iron' variety of the condor should profit under the same circumstances.  Thus, logic tells me that if I'm buying the condor, hoping the stock remains within a price range, then I'm also buying the iron condor when I also want the stock to be range-bound.

One further point.  Suppose you want to trade a diagonal spread - for example the XYZ Dec 100/Nov 95 call spread.  Your goal is to own the Dec call and sell the Nov call, and you tell the broker to buy the spread and pay a 10 cent debit.

When your broker comes back and reports that you 'bought' the spread at your price, a 10 cent debit, and that you own the NOVEMBER call and sold the DECEMBER call, you will be very disappointed.

What do you do if his explanation is this:  You said 'buy' the spread, so I bought the higher priced option (NOV) and sold the lower priced option (DEC).  How can you complain?  Doesn't that fit your description of buying the spread?  You bought whichever option was higher priced and therefore paid a debit.

That's why 'pay a debit' is insufficient to distinguish between buy and sell orders.  At least in my opinion.

there's still more from Don...

482

Using a Probability Calculator when Trading Options

Mark,

Please correct me if I am wrong but you never mention the use of a probability calculator (e.g., Monte Carlo Probability Calculator) as a way to get help in choosing the strike prices and hence, a position with a good risk/reward profile for a spread or IC.

Is it useless or is delta good enough for checking the probability or is there some other reason?

Thank You

Dimitris

***

You are right.  I have never discussed using a probability calculator, and it's time to correct that oversight.

Those calculators are far from useless.

In addition to the calculator mentioned above, Peter Hoadley offers another.  Unless you buy his software package, use of the free online version is limited.

***

What does a probability calculator do?

Needless to say it calculates the probability for the occurrence of specific events. 

This discussion is about the probability calculator and the useful information it can provide.  Thus, I'm going to be talking about expiration and the chances that an option will finish (expiration closing price) ITM or OTM.  If you are like me, and prefer not to own positions through expiration, you can change the number of trading days to agree with how long you intend to own the position.

Another important point: in this discussion ITM simply means in the money.  Clearly it makes a difference whether the option is 10 cents or 10 dollars ITM.  Thus, just because the option is ITM at expiration, it does not mean that you have a loss.  It depends how far ITM. This idea is not part of today's post.

Probability of option expiring worthless

As a premium seller, it's important to know the chances that the option you sold will be in the money when expiration arrives.  You must decide whether the potential reward justifies the risk - and the probabilities can be considered when making that decision.

Option buyers also benefit by having a good idea of how often their option will finish in the money.  As with premium sellers, when the option is held through expiration day, all time premium is lost and the profitability of the trade is determined by how far ITM the option moves.

What you already know

Option traders already know the chances an option will finish ITM, because the option delta gives a good approximation of that probability.

But that's not enough information to evaluate the risk of owning a specific position.  More information would be useful - unless you are someone who opens the trade, closes his/her eyes and opens them on expiration Friday.  That's too risky for me, but some iron condor traders do just that.  If that describes your modus operandi, then the probability of expiring worthless is all you have to consider when looking at probabilities.

For everyone else, there is more to consider.  These probability calculators provide very useful information, including the probability that one or both options will be in the money - at some time - before the options expire.

Probability of underlying reaching a specific price

You can calculate the probability that the underlying stock or index will move far enough before expiration arrives, so that it touches a specific price.  For most traders, the strike price is the number used.  But there are alternatives.  For example, a trader who depends on technical analysis may want to determine the probability of hitting a resistance or support price.

Let's look at an example:

RUT is 514.92

RVX is 29.34, and we'll use that as the volatility

As of this morning, Monday 10/12/2009, November expiration is 6 weeks or 39 days (30 trading days) in the future.  The Hoadley calculator uses calendar days and the Monte Carlo calculator uses trading days.  Assume we trade the following iron condor, collecting a premium of $1.60: NOTE: This is an example, not a recommendation, so please don't ask why I chose this IC. [It's based on the premium available, and yes, I know it's far from delta neutral]

252 trading days in one year

Sell RUT Nov 530/540 put spread

Sell RUT Nov 670/680 call spread

Delta of 540 put:  11.6;  delta of 670 call: 16.8     Total delta 28.4

a) Using the Monte Carlo Probability Calculator (MCPC), 10,000 trials is maximum allowed

 

Results: 10,000 is not that many trials.  If you run this several times, you will get different results each time.

1) Delta says 28.4% chance that one option will close ITM and MCPC says 29.48

2) The calls will move ITM one third of the time; the puts move ITM one time in six.  There is a greater than 50% chance that one of the options will move ITM.  If you are someone who manages risk carefully, that suggests you will be making an adjustment most of the time.  And that's even more true if you adjust in stages and don't wait until one of the options has moved into the money

If the idea of knowing you will be forced to make an adjustment so often bothers you, then you have little choice but to sell call and put spreads that are farther OTM.  Or, you can trade a stock or index that is less volatile.  Either way, that means smaller premiums.

3) The probability that each of the short options will be in the money is near zero.  But, if you find yourself making an adjustment on one half of the position, I believe it pays to exit the winning side of the iron condor when it reaches a satisfactory low price.

b) Using the Hoadley calculator

1) Probability that one will end ITM: 27.0%.  This is lower than the other calculator or delta predicted

2) This calculator shows a higher probability of either option moving into the money:  36 vs. 33% for the calls and 18.4 vs. 17.4% for the puts

3) Low probability of both being ITM at one time or another, but again, the probability is a bit higher using this calculator

Probability calculators provide information "that can be of significant value when used in a conscientiously applied program of option trading and regular risk management."

Does anyone recognize the origin of most of the words in the final paragraph? It's not fair to use any search engine.

479

Options Trading and the Importance of Adjusting Positions

I've been receiving comments and questions on the idea of adjusting positions - usually iron condors - that have become too risky to hold 'as is.'

Adjusting positions includes knowing when to exit the trade and lock in the profit, but all questions (to date) refer to adjusting when the position is in trouble.  This comment from Cliff is worth discussing.  Feel free to provide any relevant input from your own trading experiences.

When adjusting, there are many alternatives.  This post discusses   one of those ideas.

***

Mark: 

Today’s blog is very timely for me, as I am still “licking my wounds” from the thrashing my IC positions took in August and September due to the big (and unaccountable?) market upswing. I’m looking at position adjustment from another angle and would like your thoughts.

My concept is fairly simple: As you teach,* on a portfolio basis I am concerned with the Greeks more than the actual positions.

*I hope I don't teach this

Assuming I have a satisfactory (to me) position in terms of gamma, theta and vega, but my delta has been trashed by market movement, I “adjust” delta - and only delta - by buying ITM call(s) or put(s), as circumstances dictate, with a delta of 100 or about 100.

The adjustment requires a greater cash outlay than putting on additional ICs or verticals, but far less cash/margin than buying/shorting the underlying, and changes delta in extremely useful 100 point chunks per option.

If the market continues to move “against” the IC positions, the long option(s) will increase in value at about $1 for $1 rate. If the market were to reverse, which would serve to improve the IC positions, the long option is simply resold for whatever loss it has incurred – a loss that will almost certainly be less than would be incurred by the damaged IC positions.

Please let me know your thoughts on this practice. Thanks much, as always.

***

Cliff, I don't like it.

1) This simple truth cannot be altered: It is difficult to trade positions with negative gamma, and we must pay attention to risk.

To compensate for owning such positions, you are paid a premium, in cash. Our job is to manage risk - and that includes delta and especially gamma - effectively.

2) I don't accept the original premise: The actual position is crucial and must be managed with care.  The Greeks measure risk and provide the information necessary to allow you to make intelligent adjustments.  The Greeks provide vital information, but when traders are short call spreads and/or put spreads, and especially when they plan to hold this position for a period of time, I don't believe they can just watch the Greeks and ignore the position.

Because you plan to hold a position for weeks or months, all deltas are not really equal.  For example, if you buy a bunch of OTM options, you have plenty of delta and gamma.  And that gamma may come into play and provide a big payday.  But, as time passes when you maintain the same position - and you know it will because holding is the plan- then those OTM options soon lose a lot of their delta and gamma.  They become almost useless as protection against an iron condor position - unless the underlying asset makes a very large move.

The point is: when adjusting it's important to buy options that will help your position and reduce risk.  It's clear that buying options with 100 delta provides good protection.  But...

3) Buying options with a 100 delta doesn't do it for me and my comfort zone. Please understand - it may be just fine for you and I am NOT suggesting you do anything different, but your recent experience suggests that you needed to own some options with positive gamma. 

Before going further, let me say something important to all readers of this blog.  I provide opinion in these posts - and these opinions represent what I believe is excellent advice based on my (almost) 33 years as a professional options trader.  But, these are opinions, not facts.  If your comfort zone or intuition tells you to disagree, that's fine.  Think about my recommendations and then decide on your own whether they apply to you.

When buying 100-delta options, you gain no gamma - and it's the negative gamma that makes it 'too easy' to incur large losses.  Your call purchase is helpful in reducing additional losses, and does move dollar for dollar with the stock.  But, because of negative gamma, you continue to get shorter as the stock rallies and you may need to buy more calls as the stock continues to move higher.

In my opinion, reducing the need to buy more options is a very important part of keeping the position under control.  Consider the iron condor: we do not sell naked strangles.  Instead we buy farther OTM options as protection. Just as those options increase in delta - when we need those deltas  - so does buying additional puts and calls.  That's why I like the idea of buying pre-insurance.  You gain extra calls and puts at decent prices.

If the market reverses direction, you sell those recently purchased options at a loss.

Question: When do you sell them?  Do you wait (to sell) until the stock is significantly lower and you no longer need the delta?

4) There was a time when I hated  buying options for my retirement account, when those options had much time premium . Investors who adjust with stock, or 100 delta options, must feel the same way. I now believe that is an inefficient approach. When adjusting positions, there is more than delta to consider.

As a premium seller, I cannot anticipate earning all the premium that is sold. Thus, I buy insurance as needed, in an effort to keep losses manageable. Obviously, you don't (currently) care about gamma, because it is at a satisfactory level. Re-think this idea about gamma.  You may change your mind.

Your results indicate that whatever you are doing isn't working. This was a very bad period for iron condor traders, and unidirectional markets always will be. Sometimes losses cannot be avoided.  But we must strive to eliminate large losses.  I don't need to know the details, but it seems to me that you held your iron condors, adjusting delta periodically, and refused to exit the position.  Although I recommend adjusting in stages, there is a point at which the position should not be maintained.  There must be a reasonable expectation (other than 'I cannot believe the market has advanced so far') that the position will be profitable going forward.  If it's just hope, that's not good enough.

We trade options to get an edge.  That edge is the ability to modify risk, as needed. That's something a stock trader cannot do without selling some of the position.  Thus, hoping, praying, begging, crying - none of these are helpful.  To maintain that edge, have a position that has a chance to work for you.  Take losses when necessary, sit on the sidelines when too bruised to continue, but when you do own positions, they should be positions from which you anticipate a profit.

Your decision is: do you want to protect against more of these unidirectional markets (as a bonus you get black swan protection), or continue to adjust with 100 delta options?

This is not a case of right and wrong. Your adjustment does reduce risk - and that's the main idea. But, do you hold onto bad iron condors (the strike price has been breached)?   If so, then that's the problem.

i do not believe you can prosper using that approach - unless the rally is large enough that both your long and short strikes move FAR ITM and you are simply naked long those extra options you bought.  It's not easy to continue to own and adjust a losing position, hoping the move will suddenly explode in your favor.

I prefer to own portfolio insurance [I prefer buying OTM options BUT ONLY when they are LESS OTM than my current shorts] - at the beginning, or as needed.  Because that insurance includes options with positive gamma, it can offset a decent part of those losses.

But at some point a position is not worth adjusting.  If you feel you are playing defense all the time, it's not a good position to own.

Summary

1) Don't fail to adjust

2) Many types of adjustment trades are viable.

3) If and when it's needed, you'll be pleased to own positive gamma.

4) It's not necessary to buy insurance/protection early.  It's okay to buy it later.

477

Q & A. Adjustment Discussion

Continuing an earlier discussion:

"When I put on the adjustment I am not really thinking of it as a stand alone position that I want to own.

I think the question is do I want to lock in a loss (when probabilities are still on my side) on the initial spreads and then put on another position? Or do I want to own the new combined position, that is the one where I sell an equal amount of iron condors for equal money, where the delta of the original position is now offset by half or so.

I think in a way the loss and new position is not that different in terms of aggregate risk from what I am proposing. But, I admit I might be wrong here."

***

1) Most adjustments are made with the primary purpose of reducing the risk of holding an existing position.  However, that is insufficient.  It makes no sense to reduce risk and then have a position that you hate.  Thus, when adjusting a position think of it it terms of:

Can this position be salvaged?

What are the chances of doing some good, instead of just spinning wheels?  In other words, do you anticipate the adjusted position will make money going forward?

Is there a better position to own?  Should you exit this trade and open a new position?  The problem with the new position is that it may require a longer time period to earn the profit.  I don't let that bother me, but I know some people want to make a profit every month, despite the fact that this is an unrealistic expectation.

2) If you ever open a separate position, i.e,, not as an adjustment but as general portfolio protection (for an example, click here), that profits from a market move in one direction or the other - then that is a standalone position that may offset losses from a current position.  In other words, it's just semantics.  I buy pre-insurance as a standalone trade - and occasionally close that trade, earning a profit.   At other times that standalone trade is needed to offset a loss from a previously existing iron condor.

3) Just a comment: There is more to a trade than just the probabilities.  When you own an iron condor that is not behaving well, the probability of success may still be more than 50% (and thus, the 'probabilities are still on your side') , but that does not always translate into a position in which the risk/reward ratio is satisfactory.  

4) There are different mindsets that a trader can use, and we each have an opinion as to which best represents reality and a reasonable method. 

I ignore whether a trade has made or lost money.  I look at the position as it is TODAY and decide whether I want to continue to own it at the current price (the original trade price is meaningless) with its current risk/reward potential.  Then I decide whether I prefer to exit this trade and own another.  I also have the choice of modifying (adjusting) the position.  It does not make any difference whether the current trade has lost money. 'Locking in a loss' is a blind spot for many investors who cannot see that money has already been lost.   Because I prefer to own a less risky portfolio that has an increased chance to be profitable, I'll give up an a bad trade and move on.  This thinking may be inconsistent with the boundaries of your comfort zone.

My goal as a trader is to own a portfolio with the best chance of making money from today forward.  I am less concerned with recovering assets that are no longer mine.

My goal as a risk manager is to be certain that the decisions of my trading persona are acceptable and within both of our comfort zones.

The point: Do you want to adjust the position or would you prefer find something better?

5) The adjustment you suggest - opening a new iron condor that is not neutral - in an attempt to partially neutralize the Greeks for the entire position, is reasonable, but it does violate one of my priorities: When adjusting a position, do not increase position size or risk.

If the new position, with twice as many iron condors as you originally owned, is acceptable to you, then there is no problem.  There is no reason why this adjustment is better or worse than any other: if used in moderation.  But it does increase size and thus, risk.  Keep in mind that the Greeks are improved, but if you were short a call or put spread that is threatening to move ITM, nothing has changed.  That threat has not been eliminated. 

The new and improved position may require another adjustment.  You must be careful not to repeatedly increase position size.  That's just looking for trouble.

6) Are you wrong?  You are neither right nor wrong.  It depends on what you believe.  I feel that your suggested adjustment results in increased risk.  Adding iron condors to a portfolio, increases both profit potential profit and risk.  Of course with Greeks that are closer to neutral it appears that immediate risk has been reduced. 

It depends on how your comfort zone feels about  immediate delta risk vs. risk of a major market move.  I'm more worried about the latter.

476

Q & A. Why adjusting iron condors is profitable

Mark,

I appreciate your professional opinion as I recognize your expert advice in the field of IRON CONDOR trading.

Is it better to buy high probability IRON CONDORS at .10 deltas on call and puts for like a 20 cent credit and then just load up on contracts to make the higher monthly income, or...

is it better to buy lower probability IRON CONDORS for around 75 cent credits and then adjust at the break-even points as needed to roll up or down.

Dan Sheridan and xxx xxx both say that adjustments are the key to making profits every month on IRON CONDORS. I hate to just close out a CONDOR, if they are correct and adjustments and roll ups and downs really do work in trending markets. 

I would like your opinion please.

Thanks in advance!

Joules

***

I must tell you that I have great respect for Dan Sheridan.  He knows what he is doing.  I deleted the other name because I don't know of him and he sells videos and makes big promises.  I cannot support that.

My basic philosophy when trading options:  The strategy you choose is important, but long-term success depends on your ability to manage risk.

Regarding iron condors, I believe that risk management - the ability to adjust existing positions coupled with knowing when to close trades that have gone awry - makes all the difference in whether you succeed as an iron condor trader.

I don't want to go so far as to make this bold statement: Make adjustments because they will be profitable.

But, I do believe: After you adjust a position, your risk/reward profile is improved and that suggests you will make money going forward - sometimes based on what's left of the original iron condor, and sometimes based on the trade made as an adjustment. 

When making that adjustment, you are making a trade based on your best judgment at the time the trade must be made.  That new addition to the old position will not always earn a profit.  But, over the longer term, you will own less risky positions after the adjustment, and you will own good positions after the adjustment.

Why are they good positions?  It's a bad idea to take an iron condor (or one half of it) that is too risky to hold and make a trade that gives you a new, somewhat less risky, but still poor position.  If you cannot transform the position into one that you want to own, then you are better off closing the position, taking the loss, and moving forward with a new position that you do want to own. 

Holding bad positions and hoping for a good outcome is not a winning strategy.

The bottom line is that when you make a trade to adjust the position, it's going to improve what you currently own.  That's why it tends to be a money maker going forward.  No guarantee.  But you had no guarantee when you initiated the iron condor in the first place.

Regarding trending markets: Adjustments control risk and iron condors do not do well when the market moves too far in one direction.  So I guess the results are going to depend on just how far the market trends and just how quickly you make adjustments to iron condors.  Some traders wait for a long time - perhaps until the short strike moves into the money.  Others move more quickly, based on the delta of the short option.  No one is 'right.'  It's truly a question of where your comfort zone lies and how you want to move positions back into that zone. Take a look at the idea of adjusting iron condors in stages:

After all that, it's time to return to your question.

FOTM vs OTM call and put spreads

When trading options there is almost never a 'best' or 'better' situation.  Each alternative has merits and a great part of knowing which is better for you depends on understanding the boundaries of your personal comfort zone.

However, this is one of those situations in which I have a strong preference and I'll share that with you.

a) FOTM, low premium spreads.  I dislike these very much. When you sell a spread and collect a small premium, it makes it very difficult to consider closing the trade early.  I trade my 90-day, 10-point, iron condors on RUT, an index priced near $600, for approximately a $3 credit.  Then I close the winning side when it is possible to pay 20 to 25 cents.  I then close the other side when appropriate - either to reduce risk or lock in the profit.  Covering early has a residual benefit that many miss: Being out of the market with the profit already locked in makes it impossible to lose money - until you open your new trade.  It seems trite, but this is a wonderful method for reducing risk - less time exposed to an unlucky event.

When you sell a call spread for 10 cents and a put spread for 10 cents, that doesn't leave much room to repurchase.  Especially when commissions must be paid.

The other reason I dislike these positions is illustrated by your idea to 'load up' on them.  If you disagree with everything else I say in this post, please, please accept this to be true:  You do NOT want to load up just because the premium is small.  Increasing 'size' to generate more income is a deadly strategy.  I'm not telling you there is a chance you will regret doing that one day, I'm telling you that you WILL regret it.

If you choose to play with these very low-priced iron condors, please accept the reduced profits and do not sell too many in an attempt to generate more profits.  Sure you can sell 20% more than your normal quota, but doubling- or tripling-up is a common, but ill-advised strategy.  I know that after a few months of seeing the options expire worthless, you will be tempted.  Be careful.

When you write about 75-cent iron condors, you neglected to mention how far apart the strikes are, the price of the underlying and the volatility.  All of these are important.  If you are trading 10-point spreads in GOOG for 75 cents, I don't like it.  If you are trading 2.5 point spreads in a $15 dollar, non-financial stock, that's much better.

Choosing the premium is an art.  Here's what I do.  I know the premium I want to collect.  Then I go as far OTM as I can to enable me to collect that premium.  When IV is high, I sell options that are farther OTM.  When implied volatility is less, I must choose options that are less far OTM.  If that 75 cent level suits you, I'd suggest doing those, rather than the 20 cent iron condor.

As far as 'adjusting at the break-even' points, that makes no sense to me.  I hope Dan didn't suggest that.  First, when talking about options, the break-even point is measured on the assumption that the options are held all the way through expiration.  To me, that makes no sense.  Next, I'm not holding that long.  Third, why should the premium you collected (that determines the b-e point) play any role in deciding when to adjust?

My belief - and it's very strong - is that the premium collected when opening the trade is 100% unimportant when it comes to managing risk.  You should manage risk to prevent large losses and minimize all losses - not to try to eke out a profit from a bad position.  Profits are needed - but once you own the position, risk management determines your long-term fate as an option trader.  Adjust when uncomfortable.  Better yet, adjust in stages and make your first adjustment before you reach that discomfort level.  In my opinion, you should never calculate the break-even prices or think about them in any way.

Remember:  October promotion.  Buy my book @ 30% off and you will be entered into a drawing for one of three prizes.

NOTE: Some readers bought the book and did not send the e-mail that enters you into the draw for prizes.  If there is a problem, please comment to let me know.

474

Examining Adjustment Alternatives

When it's time to adjust a position, most of the time, it's easiest to exit the trade and find another.  At other times there are multiple - and all satisfactory - choices.  Let's consider one example.

The market has been marching higher in recent times, so iron condor traders may be facing a difficult time with their call positions.  In today's example, I'm looking at a portfolio that has two trades:

Position one:  An iron condor that is in trouble.  In fact, many traders would have closed this position long ago.  But a good number would still be holding because the short call is still out of the money.

Index is currently priced at 850, after a nice rally

Bought 10 (not recently): Oct 720/730P; 860/870C  iron condors

Collected $325

Position two:  A pre-adjustment, bullish spread with a naked long call, bought earlier

Bought 2 Oct 850 calls;  sold 8 Oct 880/890 call spreads. 

Paid $1,000 total debit for this trade.

Net credit: $2,250 (10 x 325 - 1,000)

Where do things stand:

a) The October put spread was covered by paying $0.20.  Cost $200

b) The 860/870 call spread is in dangerous territory and your action may depend on how much time remains before expiration; your market outlook (if you have one); your comfort zone; the size of your portfolio (is this a large or small position for you?), etc.  There is no 'one-size fits all' solution.

c) The 850; 880/890 (1 x 4 x 4) spread looks great.  This position never loses more than the original cash debit (if all options expire worthless), and has unlimited upside profit potential - above 890.

With your long call being ITM by 10 points and the OTM still away, this is a profitable position (at least right now).

What now?

You have two basic choices.  Manage these positions separately, or combine them and use the total Greeks to help manage risk.

There's no set of rules for anyone, but I prefer to combine the trades and make a single position.

Viable ideas

1) Cover the 10-lot of call spreads that remain from the iron condor.  To pay for those spreads, sell your two long 850 calls.

The advantage of this trade is that: Your 'naked' call spread position has been moved from 860/870 to 880/890 and the number of short spreads is now only 8, rather than 10.

You used your 2-lot of long calls to good advantage.  You sold them to pay for the losing side of the iron condor trade.  There should still be some cash left over, after these closing transactions.

If you want to refine this position further, you can close the 8-lot 880/890 call spread to exit the trade; sell an 8-lot put spread against the calls to create a new iron condor; hold the call spread, knowing that you may be forced to close it at a higher price later.

2) This is an example of rolling down the position.

a) Cover the 10-lot of 860/870 spreads and roll down by selling 10-lots of the 880/890 spread.  Your position is now short 18 of these call spreads.

b) Roll down the 850 calls

If it's more important to you to bring in some cash to offset the roll, then sell the 850/870 call spread 2 times.

If it's more important to have a less risky position, then sell your 2-lot of 850s and buy 3,4, or 5 of the 870 calls.

Rolling both positions down is likely to cost cash out of pocket, making it more difficult to end up with a profit by the time expiration arrives, but I prefer to ignore that.  If your position makes you uncomfortable and you must make a change (or exit), then that takes priority over taking extra risk in an attempt to salvage a profit.

c) It's always reasonable to reduce the position and you can do that here by cutting each position in half.

468

Q & A. Insurance, Risk, and Uncomplicated Positions

Hello Mark and thanks for your excellent blog! I have been considering your thoughts on trading 2nd and 3rd month Iron Condors and did a successful test last month, closing out the position 1 month early. I have been trading front month RUT iron condors for an average credit of 1.00, however I tend to leg into my trades. For example, I will first sell the call spread as the market is rising for around 0.50 (based on some technical analysis) and then wait for an opportunity to sell the put spread for again around 0.50, or vice versa. On some months I do not open up both sides of the iron condor because I don't like the risk of one particular side and can't get enough of a credit that would give me sufficient "breathing room" in the trade.

I had a question about your method of buying insurance. You tend to look for higher credits in your condors and then buy extra insurance. Would this not be similar to just opening up a wider iron condor for a smaller credit? It would seem to make things less complicated and have less commissions as well. I tend to think of these extra puts/call as complicating the overall portfolio, especially in relation to your recent posts on when you would then exit these positions (i.e. would you exit your long puts at the same time you adjust your put spread early?) I find the idea of opening up longer dated iron condors intriguing but the concept of purchasing extra insurance seems to really complicate the portfolio for me.

Tom

***

Tom,

NOTE: Overall 'risk' is a combination of how much you can lose and the probability of losing it. Thus, 'reduced risk' can occasionally be a confusing term.  In today's context, I'm referring to 'dollars that can be lost' rather than the 'chances of losing those dollars.'

1) Any trading ideas I offer are meant to be something for readers to consider. I would never tell you that you must (or even 'should') adopt them.

What I am trying to do with this blog is to explain how options work and how the average investor can use them. Obviously some readers are far more experienced than others and already have ideas of their own. That's good. If those readers think about what I have to say, they may accept those ideas, or discard them. That's an educational process because it gets those readers to consider alternatives and make a choice.

For the rookie, such as yourself, I'm offering ideas that you may want to consider. But, if you are making your first few trades, we can agree that you should take it slowly and not do anything that feels complicated.

2) If it makes you uncomfortable, or if you don't fully understand, please don't use such ideas. Not until you understand them well enough to decide if they seem right for you and your trading style, philosophy, and bankroll.

3) There is nothing wrong with legging into trades, if you believe you have the market timing skills to do that profitably. Just remember when you sell inexpensive spreads, it takes a decent-sized move for the spread to widen by ten cents. That makes it tough to get your price, even after the market moves your way.

4) Regarding selling wider spreads: NO. That INCREASES risk (larger possible loss) with little extra to gain. That is not a good idea, and is NOT anything similar to owning insurance. The whole idea behind any type of insurance is to reduce the amount than may be lost.

Wider iron condors have a larger credit, not a smaller credit. Thus I ask: Did you mean: open a wider iron condor that is FARTHER out of the money?

If that is what you mean, that reduces 'risk' from the perspective of: 'it reduces the probability of losing money on the trade.'

When I refer to 'reducing risk' I don't mean it that way. I use that phrase to mean: 'less money can be lost' on the trade.

5) Yes. If I am adjusting a losing put spread, I would sell out all, or part of my extra puts. I would buy new insurance puts that are appropriate for any new put spread that I sold.

But, if I buy in a put spread early because it became very cheap, I'd still be tempted to hang onto my insurance. It truly depends on how much I can get when selling those extras. If it's very few dollars, I do not sell. Black swan events do happen. I may not want to bet on them, but if I already own a cheap option, there is no point in giving it away.

6) Commissions are not to be ignored.  But in today's world you can find a broker who charges less than $1.00 per option contract, with no additional 'per ticket' cost.  If you find commissions are hindering your ability to trade (and I get it, because I used to feel that way before the deep discounters arrived on the scene), you have the option to change brokers.  It's very difficult to avoid a trade just because the commissions are excessive.  If you feel that way occasionally, you must think about a new broker.  You don't have to change, but it is worth considering.

I hope this was helpful. Trading in an uncomplicated fashion is NECESSARY in order for you to remain within your comfort zone.

435

Options Trading: Selecting the Expiration Date II

Part I set the background.  Now it's time to consider which factors are important to the trader, and this time I'll answer the question: When establishing a positive theta, negative gamma spread (a position that falls under the category of 'selling premium') is there a good method for choosing the best time frame - number of days before the options expire?

The short answer is 'no.'  Once again, this commentary is based on my point of view.  There are many reasonable ways to make this decision that I don' see how anyone can claim to know how to choose the best method.  Your goal is to trade positions that fit within your comfort zone and which are profitable.

Let's limit this discussion to choosing among one-, two-, or three-month spreads. If you discover that none of these choices works for you, an obvious compromise is to write options on a date, other than expiration day.  There's nothing wrong with preferring 6-7 or 10-11 weeks.  There is a great deal of flexibility when trading options.

I don't believe there is a 'best' time to write options because there are advantages and disadvantages for different time periods.  My suggestion is to find a trading methodology that allows you to: not fret over risk, sleep at night, and especially, like the position.  Too many traders, adopting the opinions of others, and open positions without really understanding why those trades were chosen.  That may be profitable for a while, but it's not going to help you learn to think for yourself.

Because premium sellers want to earn profits as time passes, and because long-term options (LEAPS) have much slower time decay, I'm only going to consider trading options that expire in four months, or less.

To be consistent when counting the number of days remaining before options expire, I'll discuss opening new positions on an expiration Friday.  If you prefer to wait until the following Monday, then subtract 3 days from the stated time remaining.

Selling the front month.  Expiration: 28 or 35 days.

Most premium sellers prefer collecting the time decay as quickly as possible.  And that leads them to sell front-month options and option spreads.  Some prefer one-week options.  There is also a significant number of traders who prefer to get started a bit earlier and chose 42 to 49 days.

There is no arguing with the fact that near-term options decay more rapidly than others.  And that's very attractive to the premium seller.

The argument can be made that when there is less time remaining, there's a reduced chance for something to go awry.  But to offset that factor, you collect less premium when selling the options, compared with the premium available when selling longer-term options. 

Because time decay is not linear and accelerates as expiration approaches, a 56 day option has far less than twice the time premium of a 28-day option.  That means the near-term option has more rapid time decay.  When the trade works to perfection and the options expire worthless, the maximum possible profit (annualized) occurs when trading these near-term options.  To rephrase, the total premium collected over one year, is greater when selling 28 (or 35) day positions twelve times than when selling  56 (or 63) day positions six times.  And that's good - when nothing bad happens.

The problem is that these short-term options have higher gamma.  In simple terms, that means if the market moves significantly against you, the losses are larger when you are short front-month options.

To see for yourselves that this is true, look at an ITM spread.  Today, RUT is near 560.  If you compare the values of the 540/550 spread, you will see that this spread is priced higher for AUG than SEP, which in turn, is higher than Oct.  Thus, when the market goes the wrong way, you can lose more money more quickly.

The reason the near-term, ITM spread is priced higher is because there is LESS TIME for the spread to move OTM. Thus, it's more likely to be worth $10 when expiration arrives.

Sure, you can adjust the position and prevent holding positions that are so deep ITM, but the point is to show that near-term options come with special risk - to compensate for the special rewards that come with rapid time decay.

Selling two-month options and spreads

Selling spreads 8 or 9 weeks before they expire represents a good compromise - if the negative features of writing front-month options concerns you.  Time decay is less rapid, but the options have less negative gamma.

You remain in jeopardy of seeing a large move in the price of the underlying asset, but there is the offsetting compensation of collecting a higher cash premium for the trade.  More cash is beneficial in two ways.  First, the potential profit is higher (obviously).  But, more cash also means that the maximum loss is reduced.  Thus, you have more potential reward and less potential risk.  Remember that the reward is less on an annualized basis - when all goes well - than when using front-month options.  But in the real world, all does not go well (at least not month after month after month), and less risk and more reward is attractive to the less aggressive trader.

Selling three (or four) month options and spreads.

The opportunity to sell four-month options is not always available, but when you trade broad based indexes such as SPX, NDX, or RUT, that opportunity is available a few times each year.

Choosing 13 week spreads provides more of the same.  Less immediate risk (because gamma is reduced); less immediate reward (because theta is reduced), more time for something bad to happen (but higher premium and a better risk/reward ratio).

There is no way to say that these options are 'better' to write than shorter-term options, but it depends on your style of trading.  I recommend these options for the more conservative investor because 13-week options can be repurchased after 9 or 10 weeks have passed.  You do not earn the maximum, and you would forgo the most rapid time decay, but you would also gain the advantage of not owning the position when it becomes most risky - as expiration nears and gamma increases.

Prime consideration:  For me, the number one factor that tells me whether to write three (or four) month options is the level of implied volatility, as measured by VIX, the CBOE volatility index. Selling naked options or selling call and/or put spreads result in negative vega.  I don't enjoy being short vega under two conditions:  a) I anticipate that vega will move higher soon, or b) VIX is at a relatively low level and I don't want to be selling volatility (vega) at that level.  Obviously we don't know in which direction IV will be moving next, but if you don't want to take vega risk, then avoid selling spreads with this much time remaining.

Bottom Line If you are a premium seller, there are decisions to be made each time you open a new position.  And those decisions are based on risk - and that means the Greeks (which are used to measure risk) should be considered. Theta, gamma, and vega are all in play when selling option premium, and assuming you establish a position with a delta that suits your market bias (bearish, bullish, or neutral), then you must decide how badly you want that rapid time decay, or how conservative you want to play by accepting positions with less risk.

I prefer 13-week iron condor trades.  But, with IV at reasonable - but not high - levels, I've been buying 8-9 week iron condors lately.  I'm sure that will change some day. 

If you find a strategy that is comfortable to trade and is making money for you, congratulations.  That's the goal.

407

Q & A. Timing the Market

Updated two hours later

Mark,

On timing- here's a simple style I've had good luck with: When you "see" a trade, initially execute and things don't start happening as hoped for (immediately) then it's time for a very simple (usually very cheap at that point) adjustment: Get out!

I'd be really interested to get your opinion on this admittedly frequent trader's paradigm (I'm still an option rookie) but from where I sit it looks like many "adjustments" are a stubborn refusal to be wrong. And ironically, v-e-r-y smart guys are particularly prone to this ill fated thinking.

In my supreme option rookie ignorance I must say- timing smells a lot like predicting direction: Try it when ya have to and be prepared to change your mind almost instantly.

Dave

***

There is nothing illustrating any ignorance in this comment.  You have hit on something important.

1) I did not mean to use the word 'timing' in the traditional sense.  This post, and the one that follows is concerned with deciding - on an ongoing basis - how long before options expiration is an ideal time to open a position in which we sell option premium.  In other words: is it 'better' to sell that premium one, two, three, or more, months before the options expire?

This discussion includes iron condors, selling put and call spreads, naked options, covered call writing.  These are premium selling strategies.

2) In this context, there is no 'start happening immediately' because what we want to happen is 'nothing.'  We want time to pass without the stock moving against us.

3) Your idea is a good one.  But it's for a very different type of strategy.  It's a directional play - and that applies when you BUY (not sell) option premium.  You are buying, and paying for, positive gamma and that comes with negative time decay (theta).  So, if you don't get the move you want, then your timing is off, and it's often best to exit - and decide if and when it's time to play again.

4) As a general rule, I don't like predicting specific direction by buying options.  It's not that it's such a terrible way to make money, but it involves being able to pick market direction correctly, and it also involves being able to time the market move.  I cannot do that.  I don't believe many people can.  Thus, in my opinion, buying options is a losing game - for the vast majority.

But if you have a proven track record of knowing when to buy and sell, then buying options can work for you.  It's just not for me and I shy away from talking about option-buying strategies.

5) Yes, 'timing' is an important part of 'predicting direction.'

6) I don't look at adjustments as 'refusal to be wrong.'  I see it as:  I already was wrong, and what should I do now?  Sometimes I exit and take the loss.  But when I see an adjustment that reduces risk and still leaves me with a position that has acceptable risk/reward parameters, AND (this is the part most people miss, and do indeed refuse to be wrong) is a position I want to have in my portfolio - then I make the adjustment.  I do not do it, nor do I recommend anyone do it, just to avoid taking a loss - which is what you refer to as 'refusal to be wrong.'

Being wrong is part of the game, and pretending that part does not exist is foolish.

***

UPDATE: I received the continuation from Dave, so added it to this post.

"there is no 'start happening immediately' because what we want to happen is 'nothing.' We want time to pass without the stock moving against us"

ummm, when I put on my RUT ICs about 2 weeks ago and nothing (didn't!) happen immediately I became pretty wrong (immediately)...

I understand at that point I could have "made an adjustment" to salvage my odds of a lesser profit than I originally had in mind when I put on the trade *BUT* I also need to weigh that expense against the cost of the get-me-out-now button, AND consider that the trade moved against me and my thesis (and right out of my comfort zone).

-I spent last week with a real smart guy- math phd etc and self proclaimed experienced option trader... He's taking a "little break" from the market now because about a year ago he lost a good portion of his wealth- hmmm, I think he mentioned a couple hundred grand a week or so at the zenith, "adjusting" his way out of (?) trouble.

At the risk of kicking him when he was down I couldn't help politely mentioning my Golden Rule: never, never- ever let a trade run over 10% against you and he just chuckled a somewhat condescending; "that's an impossible rule". I've noticed really smart guys tend to have trouble with really simple rules :-) Sorry for the diatribe... I love your blog.

***

Dave,

Thanks.  Tell more people to come visit me here!!

It's not a diatribe.  It's conversation.

You hit the nail on the head.   If the trade moved right out of your comfort zone, your decision is 'HOW' to move back into the zone.  Exit, adjust...doesn't matter.  As long as your zone does not remain violated.

And here's a bit more of how I think, which may not apply to you.  The original plan for how much you intended to make is 100% irrelevant.  You own the position at the new price after RUT has moved against you.

The easiest, and often the best, solution is to exit the trade and perhaps find a new trade.  But - and I do not think this is being stubborn - if you can satisfy the conditions of

a) reducing risk to move back into your zone  AND

b) If the adjusted position is one you would open right now - in other words, is one you want to own - then adjusting is fine.

But too many people - intelligent or otherwise - refuse to accept a loss and make adjustments they do not want to own.  They make these trades in an attempt to 'get even' on the trade. 

That is contradictory to my philosophy.  I do not care about getting even (honestly).  If I lose 10 grand - I want to make 10 grand.  That's normal.  But - I DO NOT CARE from whence that profit comes.  It can be the old position adjusted, or it can be one (or more) new trades.  I have no need to try to salvage the old trade.  My goal is to profit today and tomorrow.  To do that, I MUST own a portfolio of good positions, not positions adjusted with 'hope' as the driving force behind the trade.

As a side comment:  Options are not like stocks.  If you buy stock and it drops 10% - or some other number, exiting makes lots of sense.  But an option trade is different.  A change in implied volatility can easily produce a 10% loss.  To me that's not a reason to exit.  It's a warning not to double the size of my trade, but if the Greeks (which are used to measure risk) are acceptable, I'm not exiting.  I don't want to suggest you do the same, but recognize that options are traded differently.

My guess is that your friend rolled down and out, in a plunging market.  He moved the position to lower and lower strikes, with longer times to expiration.  And he probably also multiplied the number of contracts so that he could 'roll' the position for even money or a cash credit.

That's a common strategy.  And perhaps it ok to add a few extra contracts ONE TIME.  But increasing size and continuing to sell vega in a market in which IV is rapidly rising is a very desperate, and risky strategy.  Very.

If the market had stopped going down in time for him to survive, and if IV had stopped rising, he would have survived.  But, apparently that did not happen in time for his gambling methods to become profitable.  Yes, even math PhDs who know that gambling is bad - make losing decisions.  I agree he was unlucky - and that the outcome was far against the odds.  But there must be a limit as to how much can be lost in a single trade (or entire portfolio), and he violated that limit.

Doubling the bet again and again in an attempt to get even is something that wins most of the time.  But when you lose, it can take all your money.  How can that be a reasonable gamble?  It cannot.

And don't forget this John Maynard Keyes gem:  "The markets can remain irrational longer than you can remain solvent."

Thanks for this discussion.

405

Options Trading: Selecting the Expiration Date

Paying attention to the results from the survey taken earlier this week (thanks to all who voted), and supplying additional detail for TR who raised the question, today's post contains a more detailed description of a topic that should be beneficial to all but the most experienced option traders.

As always, I present an opinion based on my perspective.  I'm not telling you that this is THE right answer and that any other choice is wrong.  My goal is to get you thinking about the possibilities and hoping you can form an opinion as to whether my suggestions apply to you, your comfort zone and your investing objectives.  If you can form your own conclusions after considering more than one alternative, then it's likely you will have made a good decision for your own trading.

Question: When selling option premium, is there an optimum time to initiate the position, based on time remaining before the options expire?

Some very smart people believe that there is such an ideal time and they recommend their beliefs to their followers.  They may be correct.  I must confess that I have not done any rigorous (or other) mathematical study to determine whether a specific time period works out better over the long run.  My guess is that a detailed statistical study would suggest that there is a window for which the combination of: probability of earning a profit and average return on investment can be optimized.  But, I suspect that that 'window' varies depending on how volatile the market has been.  Lacking such studies, I'll share what I believe to be true for premium-selling strategies. 

To clarify: 

a) If you are considering buying calls or puts to profit from a market move, none of this applies to you.

b) Buying a call spread or buying a put spread does count as a premium-selling strategy.  Why? Because the equivalent strategy (selling a put spread or selling a call spread) is a premium selling play.

I. Strategy choice

When selling option premium, the investor's usual outlook for the market is neutral.  Sometimes rallies (naked put selling) are better than declines, and sometimes vice versa (selling call spreads).  But, in general, these strategies do well when the market does not undergo a large move.

2. Size

The single best way to manage risk is to avoid trading too many spreads.  Consider what can go wrong, give some thought to what your plan of attack will be to manage risk (you don't have to have iron-clad rules, but you do want to be prepared). 

3.  Probability of achieving maximum result

Most premium sellers love to sell the position and watch it expire worthless.  I'm not saying that's a bad idea, but I prefer to buy back my short position whenever it reaches a low price.  Because 'low' is a relative term, there's not a lot to talk about on this topic.  My belief is that when there is very little left to be earned, it's appropriate to take the money and eliminate the possibility of turning that profit into a loss.

The farther OTM the options you sell, the greater the probability they will not move into the money during the time you hold the position.  But there's a trade-off.  The less likely it is that you will encounter a problem with the trade, the less cash you will collect when opening the position.  It's up to you to find a comfort zone that is willing to accept the risk and reward for each specific trade.

Because this post's main thrust is (supposed to be) on when to open these positions, it's important to mention the obvious:  the longer you own any specific position, the greater the chances that it will move far enough to result in a loss.  That's the reason for closing the big winners early, but it's also a consideration when opening the position in the first place.

4. Timing the trade 

to be continued...

This is an appropriate time to take another survey.  In an effort to provide at least as much detail as I have in the past - as requested - this post is lengthy - and I have not begun to reply to the topic question.  This is all background material, and this post (when completed) could  be used as a significant portion of a book chapter.  Thus, there's one question to ask:

Click Here to take survey

404

---

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?

***

Mark

I have some questions for you on managing risk and complementing IC positions with double diagonals. In your 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 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

***

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 profitability.  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.

Yes, it feels right to postpone buying Aug insurance options because theta will make them less costly when you buy them later.   And 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 earn 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.  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 those spreads.  Yes, prudence is intelligent at all times.

380

Neutralizing Risk When Trading Options

Sophisticated option traders loathe risk.  The larger the positions they trade, the more important it is to manage a portfolio with as little risk as possible.  Thus, market makers (and the trading firms that employ them) use sophisticated trading algorithms that automatically raise bids for options that reduce current risk while simultaneously raising the asking price for options that would make matters worse.  By bidding higher than anyone else, the probability of buying needed options increases.

None of us trades like that.  Nor is it feasible to have a Greek-neutral portfolio.  We choose to be as neutral as necessary to remain within  our individual comfort zones.  The most common way for individual investors to be neutral is owning positions that begin life delta neutral.

I've devoted many blog pages to methods that can be used to adjust positions to reduce risk, including ideas such as closing (to end the misery) or rolling out of the current position, and the idea of adjusting in stages, instead of making an all-in-one adjustment.

Because the positions under discussion were almost always iron condors, these risk-reducing ideas focused on the major risk factors that are of concern when an iron condor has moved against you, and those are delta and gamma.  When delta risk is too high (the position is too long or too short - and another move in the wrong direction is costly.  When gamma is negative, that loss accelerates as the move continues.  Ignoring these risk factors is hazardous to your financial health.

The other commonly monitored Greeks (there are always more risk factors than can be considered if the trader wants to get more and more sophisticated) include theta and vega (sensitivity of an option's value to changes in time and implied volatility, respectively). 

Next time I'll take a look at theta and vega and consider some choices that are available when you decide to reduce (or increase) your exposure to these risk factors.

to be continued...

377

Iron Condors vs. Condors

CBF raises a good point:

What is the benefit of selling** iron condors (bull put spread/bear call spread) over buying condors (bear spread/bull spread - puts or calls, but not both)? The profit/loss graphs of the IC and the condor are identical. Clearly, with the IC the cash remains in your account and is increased by the premium collected rather than paying for the condor and collecting a profit (hopefully) later on, but the interest earned on the funds is, at least presently, negligible. Also, it appears that there might be a slightly greater premium for an IC over a condor, but I don't have enough of a statistical sample to draw that conclusion.

So, why are iron condors so popular while non-iron condors are rarely mentioned?

CBF

***

If a 10-point condor can be bought for a $7 debit, then the iron condor can be bought for a net credit of $3 (a little less when interest rates are high enough for the cost of carry to be affected).

1) It's true that iron condors receive a great deal of attention.  One big reason for that: it's the strategy of choice for hypesters who want people, who know nothing about options, to pay them to manage a portfolio of iron condors.  Money management is a profitable business, as the managers keep 20% of all profits with no risk of loss.  Of course one must be licensed to manage other people's money and I have no idea whether that rule is obeyed.

Others offer to sell trade recommendations to newbies for far more cash than the information is worth.   Ads that promise to 'generate a steady monthly income.' and trade with a success rate of between 80 and 95% attract suckers customers.  It all sounds so attractive and the messages come with a hard sell that apparently works. I have no idea how many people pay high fees to have someone recommend iron condor trades, but there are plenty of them.  Some of these people run a legitimate business.  They are careful in choosing their trades and manage risk with skill.  But it's difficult to know whom you are hiring when you go that route.

There are (or at least were) a bunch of hedge funds that charged hefty management fees to trade an iron condor portfolio.

Then there are brokers (thinkorswim comes to mind) who encourage the use of iron condors.  Don't get me wrong, there's nothing wrong with that.  I also encourage their use, as long as it's accompanied with careful risk management.

2) The reason these strategies have the same risk graph is that the positions are equivalent.  Assuming options are priced efficiently, as they are almost all the time, there is no 'real' advantage to trade an iron condor rather than a condor.

But, there is a psychological advantage, and my guess is that's the reason iron condors are far more popular.  It's just 'fun' to sell premium and watch the price of those options fade away.

3) **The condor and iron condor are equivalent.  If one buys the condor - as in your example, then (to me and a number of brokerage houses) the equivalent position is also a 'buy.'  Thus, buying an IC is equivalent to buying a condor, and, I use the verb 'to buy' when opening an iron condor position.  Others believe that collecting cash means, by definition, that you are selling the IC.  There is no commissioner of nomenclature, so this disagreement goes on.

You refer to the 'bull call spread.'  Yes that is the spread being sold.  I believe using the term bull and bear are not only unnecessary, but adds confusion.  The call spread, by definition, is buying the lower strike (more valuable) option.  Thus, you either buy or sell the call spread.  Why get the issue confused by having to think about the difference between buying a bull call spread and buying a bear call spread?  There is no need to define it as bullish or bearish - it's just a call spread.

Likewise, buying the put spread refers to buying the more costly put option.  When buying an iron condor, you sell both the call spread and the put spread.  Once again, this is not universally accepted.

4) Options tend to be priced efficiently and that means there should never be an advantage to buying either position.  But sometimes one of the options is mispriced (probably because an individual investor is trying to buy or sell a few contracts), and there could be an edge in the pricing of a condor compared with an iron condor.

371

Trading Double Diagonal Spreads; Part II

Part I

Double diagonal (DD) spreads provide profit opportunities that are not available to iron condor (IC) traders.  But, from the point of view that it's possible to lose more money per spread with a DD than with an IC, they can be riskier investment choices.  One immediate disadvantage is they they have higher margin requirements.  While reasonable brokers have identical margin requirements for an iron condor as they do for either of the spreads that makes up that IC (no additional margin to sell a put spread when already short a call spread). That's not true with diagonal spreads.  A double diagonal has twice the requirement as a single diagonal.  That makes no sense to me, but I have no influence over brokers and their rules.

The margin requirement for a diagonal is the difference between the strike prices, less the credit collected (if any), per diagonal. 

Trading RUT iron condors, I choose strike prices that are 10-points apart.  These simply feel comfortable to manage than when the strikes are near each other - but that's a personal comfort zone decision, and not a recommendation.

When trading diagonal or DD spreads, I use strikes that are farther apart.  I confess that this is not based on a sound, mathematical rationale.  It's based on the fact that I prefer to own a diagonal spread that provides a cash credit, or a small debit.  Because of the pricing of RUT options, most of the time I own a diagonal spread in which the strike price of my month 2 long is 30 points away from the strike price of my month1 short.   Occasionally I buy the position when the strikes are only 20 points apart and find these 20-pointers to be easier to manage.

If RUT marches strongly through the short strike, the maximum loss can approach $3,000 per spread (less any time premium remaining in the long option).

I look at it this way (referring to just the call spread, although this point applies equally well for the put spread):  If I have a position similar to: 

 Short 10 GOOG Sep 470 calls

Long 10 GOOG Oct 480 calls

the position is not going to do well on a quick upside move through 470.  Thus, there's upside risk.  If I pay a big debit to open this position - say $500 - then there is also downside risk.  If GOOG drops too far, especially if a few weeks have passed, both options may quickly move towards zero and most of that debit can be lost.  Thus, I trade these spreads to avoid the chance of losing in both directions. [Yes, if it's a double diagonal, the downside move threatens the put spread, but at least it will not also hurt the call spread.]

 

DD Opportunities Absent from IC

To offset that extra risk, there are profit opportunities not possible with iron condor positions.

1. If the stock moves toward one of the strike prices - and especially if some time has passed, instead of facing a loss as the iron condor trader would be facing, there's a good chance that the diagonal spread could be closed profitably.  Whether that comes to pass is going to depend on how much time remains before the front-month option expires, and the current implied volatility of the calls you own.

2. If closing doesn't appeal, and you prefer to hold this position, selling the calendar spread when it is nicely priced (the stock trading near the strike price increases the value of a calendar spread) allows you to take cash out of the trade.  In the GOOG example, you sell your GOOG Oct 480 calls and replace them with Sep 480 calls.  That's selling changes the position from a DD to a combination spread.  It's half an iron condor on the call side and remains a diagonal on the put side.

If the position soon becomes risky to hold, you can use some of that newly- collected cash to pay for an adjustment.  Alternatively, you may elect to exit.

3. If enough time passes and if the underlying moves far enough away from one of the strike prices, you may be given the opportunity to repurchase one of the options you sold at a very low price.  Looking at that GOOG spread again, if the GOOG SEP 470 calls are available, you may decide to cover them by paying $0.20.

When you do that you have two good choices.  The first is to sell the Oct 480 calls, closing half the DD and probably earning a decent profit.  The second choice is to sell the Oct 470 call spread, converting the call portion into half of an October iron condor.

Deciding which is better is going to depend on the price you can collect for the Oct 470 call and how attractive it looks to own that specific GOOG Oct call spread.  Do not make this trade unless you want to own the position.  There's nothing wrong with exiting the trade.

The possibility  described above was discussed in the comments to Part I.

4) If IV explodes higher and if your underlying has not moved so far that your position is endangered, you can collect on that IV surge by selling two calendar spreads and converting the DD (which you want to own when IV is low) into an iron condor (which you prefer when IV is high - because it's too costly to buy the vega-rich DD spreads).  Of course, if it's attractive to do so, you may choose to exit the DD instead, and pocket the profit.

The new IC may run into trouble in the volatile market, but selling the two calendar spreads allowed you you own this position at a very favorable price.

Double diagonal spreads are more flexible than iron condors, but they are rich in vega and you want to own them only when you believe IV will be increasing - or at least not decreasing.  If IV feels too low to be trading iron condors, you may decide to compromise and own both iron condors and DD spreads.  Or you can open the combo spreads: Half an iron condor on the call side and a DD on the put side [or vice versa, but a downward move which hurts the put side of the IC may not be hurt as badly when you own the extra vega that comes with the diagonal].

367

Comparing Iron Condor, Ratio Spread and Broken-Wing Butterfly

Erin asked:

Hi Mark,

I was wondering if you had an opinion on ratio spreads and BWBs? Would something like a 1:2 put ratio + 1:2 call ratio have any advantage over an IC, particularly with regards to adjustments?

Look forward to hearing your thoughts.

I'm guessing that BWB refers to a broken-wing butterfly (if not, I'm stumped).

The positions:

IC:                        + 10 GOOG Jul 380 put
                               - 10 GOOG Jul 390 put

                           -10 GOOG Jul 440 call
                    +10 GOOG Jul 450 call


Ratio:            -20 GOOG Jul 380 put     (IC is long this option)
                     +10 GOOG Jul 390 put    (IC is short this option)

                     +10 GOOG Jul 440 call
                    - 20 GOOG Jul 450 call


BWB               +10 GOOG Jul 440 call
                      -20 GOOG Jul 450 call
                      +10 GOOG Jul 470 call

These positions are very different.  For example when comparing the iron condor with the ratio spreads, they are long and short the opposite options.

For our discussion, let's assume by 'time to make an adjustment' you are suggesting that the market has moved higher the short call is threatening to move into the money.  It doesn't matter how far OTM that call currently is, because different investors have different points at which they adjust.

Let's also assume that the short option is 10 points farther OTM than the long option.

The last assumption is that the adjustment of choice is to exit the position.

***

Iron Condor

With an IC, you are short a call spread that can become worth $1,000 (worst case); and you sold it for far less.  Our responsibility as risk manager, is to prevent that (or any similar loss) from happening.

The danger occurs as GOOG approaches 440.  If holding or closing the trade is the only consideration, I recommend establishing a maximum acceptable loss, and if and when that point is reached, exit.  That may when the call spread reaches $4, or $5, or whichever price your comfort zone allows. [Remember that if you bought the IC and collected $3 originally, then paying $5 is not the disaster it would be if you collected only $1.]  Your decision is when to pull the trigger.

Ratio Spread

With a ratio spread, you face a far different situation.  This time you own the 440s and are short twice as many 450s. 

There's the good news:  You own a spread that is ITM and is heading towards the point where it will reach maximum value of $1,000 (if it remains there at expiration).  So that's a better situation than you faced with the iron condor. 

But, you are short two calls instead of only one, and the second is a naked short. Some brokers do not allow customers to carry naked short call positions.  But, if you are allowed to do so, it's considered to be a risky trade and I no longer allow myself to own such positions, but that's not the point of this discussion.

Once GOOG moves past 450, then the naked short option quickly eliminates any profit you had from the 440/450 call spread [Mentally breaking this trade into two parts: the call spread and the naked short].  In fact, if there is much time remaining before the options expire, the position quickly turns into a  loser, with the loss mounting as the stock rises. 

When there's very little time remaining, the position still has terrible negative gamma, but the limited time prevents the extra 450 call from exploding.  If time runs out (the market closes on expiration Friday), and if GOOG is under 460 (your break-even point if you paid zero cash to establish the position), things are not too bad.  Obviously, a lower price is better.

The major factor in deciding whether to hold or exit is going to be time.  With expiration rapidly approaching, you may still want to exit because you probably have a profit (although it's only risk that should matter, but I know that most traders only want to know if they have a profit or loss, and risk be damned.  This is not good thinking, but it is the way the world turns).

Thus, it's possible to have a good profit as the stock moves towards 450, and that profit possibility makes this trade look 'better' than the iron condor - which has virtually no chance of being profitable as GOOG moves towards 440 - a full 10 points lower!

The ratio has a higher profit range, but there is that 'unlimited loss' possibility that makes it more dangerous to own.  In response to your question Erin, I'd rather have the adjustment decision with this position than with the iron condor.

This is just another personal comfort zone decision.  The optimist  understands that the stock is currently at its sweet spot, but danger looms.  The intelligent pessimist sees the danger, and may fold in the name of safety.

These are interesting positions to own, but I have removed them from my arsenal of strategies - just because I do not want to face a margin call (which can happen as the stock rises) or a nightmarish stock market opening gap.

Broken-Wing Butterfly

With a BWB, you are short a 20-point spread, and the maximum loss is $1,000 less the premium collected to open the trade.

This is essentially the same as the ratio spread, but this time you are not naked short any options.  You own the 470 call and there is neither a potential margin call nor an unlimited loss in your future.

I'd treat this spread the same as the ratio spread because it is the ratio spread.

Erin,

I hope that helps.  The iron condor is really the odd man out.  The other spreads are similar to each other and the IC trades very differently. 

IMHO, the ratio (better yet the BWB) is easier to adjust because time is THE consideration.  [ADDENDUM: But the risk of owning such a position is so great, that I never recommend this position to anyone.]

Iron condors are risky at all times (if the short strike is approached) - but the risk is limited.

363

Unintentional Butterfly Spreads

Butterflies are a very popular option trading strategy among  individual investors.  I seldom trade butterflies, but because of my style, I often find that I own flys (a convenient abbreviation).  The question arises: How can I take advantage of owning those unintentional butterflys, or should I pretend they are not part of my account?

A butterfly is a spread with three legs.  All three are calls, or all three are puts, and each expires at the same time.  A call butterfly combines the purchase of a bull spread with the sale of a bear spread of equal width [If the bull spread is 5-points wide, then so is the bear spread], with the proviso that the option sold in each spread is identical.

The ratio for a butterfly is: long one; short two; long one.

Here's a butterfly spread that I held last week:

Long  12 RUT Jun 540 calls
Short 24 RUT Jun 550 calls
Long  12 RUT Jun 560 calls

Note this position is

Long  12 RUT Jun 540/550 call spreads
Short 12 RUT Jun 550/560 call spreads

There are other types of butterfly spreads, including iron butterflies and broken-wing butterflies.  Perhaps that's a good topic for another post.

Unintentional?  How can I own an unintentional position?

I trade iron condors most of the time.  Last week I was still holding onto some June positions, against my better judgment. [But this time I got lucky and earned a good profit.  More often than not, I find holding these risky positions results in further losses.]

I had two June call spreads remaining, having recently covered the put spread portion of the iron condors at low prices.  I was short the Jun 530/540 call spread and the Jun 550/560 call spread.  Here is a list of my positions (but not using the correct quantities):

Short 20 RUT Jun 530 calls
Long  26 RUT Jun 540 calls  (I owned six extra calls)
Short 25 RUT Jun 550 calls
Long  25 RUT Jun 560 calls

Embedded in those two call spreads are two butterflys. 

I was long 12 RUT Jun 540/550/560 call butterflys (12x24x12)

I was also short 12 RUT Jun 530/540/550 butterflys.

I refer to these positions as unintentional butterflies because I did not originate the positions as flies, but as individual call spreads.  Nevertheless, those butterflies were in my portfolio.

If RUT were to rally to 550, the butterfly spread would be a winner.  But that's not the way to evaluate risk because the 530/540 spread would lose the maximum possible amount, and my six extra calls would only help (up to 550) on a continued rally.

Above 550, I'd be facing immediate danger from the 550/560 spread.  Six extra longs don't go very far when protecting a short position of 25 spreads.

NOTE:  Looking at values when expiration arrives, at 550, the six extra calls would be worth $1,000 apiece.  Because I was short 25 Jun 550 calls (and still long six 540s), for each point above 550, I'd lose $1,900 - up to a maximum of $19,000.  After 560 the losses stop and my six extra calls would produce $600 per point.  But this is a very risky position when RUT is trading that high.  the position was bad enough at 530, but I did not want to face that trouble if we rallied far above 550.

Thus, I sold my call butterfly spreads.  My rationale was that it reduced risk if we rapidly rose above 550 (yes, I understand if that happened I could sell the fly at a better price as the index approached 550), and would provide extra profits if RUT ended its rally and headed lower.  The point of this story is that I had a butterfly embedded in my position and made a trade it when I thought the price was good enough ($1.30). 

The position looked strange after the trade, but was still easy to manage.  As it turned out this time, the market receded and the June positions were readily closed.

Position after butterfly sale:

Short 20 RUT Jun 530 calls
Long  14 RUT Jun 540 calls
Short   1 RUT Jun 550 call
Long  13 RUT Jun 560 calls

When you own flies, the best result occurs when expiration arrives and the underlying asset is very near the middle strike.  Then the bull spread (you bought) is worth near its maximum value and the put spread (you sold) is worthless (or worth very little).

Thus, holding has benefits.  The spread can continue to increase in value.

But, holding is risky because if the market moves and the three options are out of the money (or in the money) at expiration, then the fly is worthless.  Thus, it's best to sell a fly at some point.  But choosing that point is a difficult proposition.  I'm sure some fly traders have their individual guidelines, but I was pleased to collect that $1.30 with a week and a half remaining before the options expired - and especially when all the options were OTM at the time I sold the fly.

If you have more than one iron condor position for any given expiration month, take a look the possibility (don't jump in without a good understanding of how to handle the residual position) of trading those embedded flys for additional profit opportunities.

361

A Back Spreader's Nightmare

Definition:  Back spreads are positions in which more options are bought than sold.  The options expire in the same month and the investor has unlimited upside and/or downside profit potential. 

But there's always an expiration range on the underlying asset (the sour spot??) that makes owning such positions painful.  That price range is near the strike price of the options you own.  If those expire worthless (or almost worthless) while the options you sold are nicely ITM, the result is a good sized loss.

***

I was disciplined this month.  I adjusted when necessary, I have plenty of protection if the market continues to rally.  My downside is good.  In fact, my risk graphs are all smiles.

 Sample 'smile graph'

But that does not tell the whole story.  With RUT currently trading @ 531, I'm short the RUT Jun 530/540 call spread.  Under normal circumstances, and following my risk management style, I would have already exited that spread. 

But this time I have a great deal of extra protection.  I own extra Jun 540 calls.  I also own extra July calls.  Although those longs were bought to protect other call spreads that I sold, these extra options represent a significant upside opportunity.  This is one time that owning pre-insurance has paid off.  Let me restate that:  It's currently doing it's job nicely, but there's risk that the position can collapse.

The problem is that there are only two weeks remaining before the June options expire and it's crunch time.  I must decide whether to hold onto the Jun 540 calls - with their wonderful positive gamma and their not-so-wonderful negative theta.  Or I can replace them in my portfolio with July calls. 

If I sell the extra Jun 540s, holding the Jun 530/540 becomes iffy.  The good news is that I will lose most of that large negative theta.  The bad news is that I'll lose the near-term gamma that produces big profits (to more than offset losses) if the index moves much higher (quickly). 

If I buy July or August calls when I sell the Jun 540s, I'll gain a bunch of vega.  That would not ordinarily be a problem because iron condor traders are usually short vega.  But I've been trading flat vega as the market has risen, and this doesn't feel like the right time to get long too much vega.  There are, of course, steps I can take to sell vega (buy iron condors), but I don't want to add much more to my portfolio prior to June expiration.  Owning too much vega can be a problem.

If this Jun spread were my only position, I would not hold it.  However, it's just one part of a larger portfolio, and much of the risk is covered.  But it makes me very nervous and it's always tempting to sell those near-term, soon-to-be ATM calls, and replace them with a larger quantity of further OTM calls.  That's adding a diagonal back spread to the portfolio. 

Is this going to turn out to be a back spreader's nightmare - or a dream come true?

P.S.  If the market declines, this problem disappears.  I'm not holding my breath.

348

Building a Vega Neutral Portfolio

Hi Mark,

I am happy to see my questions and your answers.

Please explain, in a practical way, with examples how to move to a vega neutral status when you are short vega, such as when you own an iron condor.

Thanks a lot.

Antonio.

***

This is a very simple process.  You have positions with negative vega.  All you have to do is open positions with positive vega. 

There are three types of trades I recommend for adding positive vega to a portfolio:

Buy strangles for insurance

Buy calendar spreads

Buy double diagonals

Let's assume that an investor owns 20 RUT August 370/380/580/590 iron condors.  Here's how the Greeks looked at mid-day yesterday (5/28/2009):

The call spread vega is -7.70 x 20 =  -154.0

The put spread vega is  -4.71 x 20 = -94.2

As expected, your iron condor position is short vega (248).

***

Buy strangles

Without going into a discussion of how to choose which strangles to buy, let's assume you want to own some July puts and calls to guard against a huge move in RUT.

Assume you choose to buy RUT Jul 560 calls (vega = 38) and RUT Jul 390 puts (vega 30).  If you buy four of each, you pick up 68 x 4, or 272 vega.  If you feel that's too much, you may prefer three of each.  Or you may choose different strike prices.  The point is that when you pick the strangle you want to own, you can buy an appropriate quantity to turn your position vega neutral.

If your broker doesn't allow you to see the Greeks for each option, then this is going to be more complicated, but you can use an option calculator to determine the vega for each option.


Buy Calendar Spreads (Note if you choose to buy a calendar spread that corresponds with the strike price of the options you own as part of your iron condor, then you may (if you sell the option you already own) convert the position into a double diagonal.  DO NOT do that with your entire position, or else you will be long vega.  The idea under discussion is to have a vega neutral portfolio.)

Assume you decide to add some protection to your portfolio by owning calendar spreads with strike prices that correspond to areas of risk.  The calendar becomes profitable when the strike price is ATM, and the resulting calendar spread profit can be used to offset a portion of the iron condor loss.

In this case, you may decide to buy the following:

RUT Aug/Jul 390 Put spread

RUT Aug/Jul 570 call spread

Calculate the vega for each spread and then purchase an appropriate number to give you a net gain of however many vega you want to add.  Obviously 248 gets you vega neutral now, but there is no need to be that near zero vega.


Buy Double Diagonal Spreads (or single diagonal spreads can accomplish your goal).

If owning double diagonals appeals to you, choose appropriate spreads, calculate the vega for each, and purchase an appropriate quantity.  It's not a difficult process.  I'm not going to provide any examples for fear some readers would take that random selection and decide it's a recommended trade.

NOTE:  This method works for any of the Greeks.  If you are uncomfortable with any portfolio risk - delta, gamma, theta, or vega - there are appropriate steps you can take to reduce that risk.  Obviously the simplest is to exit some positions.  But there are appropriate strategies you can adopt to add or subtract any of these risk factors from your portfolio.  Today, at a reader's request, we considered some alternatives for adding vega.

341

Q and A. Iron Condor Set-up

I received this question from a twitter friend:

"Do you tend to establish Iron Condor positions based on deltas of short options, distance between shorts, minimum credit amounts, other?"

I'm assuming that choice of underlying has already been made because that's a very important consideration. 

Each of these topics is worthy of a separate discussion. 

Delta of short options  

I decided not to use delta as the basis for choosing which specific options to sell.  Instead I decided to focus primarily on something different - the cash credit. 

I want to emphasize that choosing strikes by delta is a sound idea.  It also makes it easier to manage risk, especially for those who prefer to make adjustments in stages, rather than adopt an adjustment method that is basically: hold 'em or fold 'em -

a philosophy that tells you to hold the position until it reaches the limits of your comfort zone, then exit the trade.  I adopted that style in the early days of my iron condor trading.  I now prefer to make several small adjustments, as needed.

When choosing iron condor options to sell based on delta, adjusting may become simplified: if you sell calls and puts with a 10 delta (8 to 12), you can make a stage I adjustment when delta reaches 20 (or any other  number that suits), and then another depending on how uncomfortable you become when holding the position, choose to adjust again every time your short option moves another 5 or 10 delta.  But at some point, there are no more stages, and it becomes time to fold 'em.

Distance between shorts

Some sophisticated iron condor traders believe this is important, but it's something else I chose to ignore.  I prefer to have my short options as far apart as possible, as long as I can achieve my minimum credit requirements.  I want to emphasize that I am not dismissing the importance of concentrating of the distance between the shorts, but I prefer to keep my trading as simple as possible for two reasons. First, it works for me.  Second, this is the easiest path for teaching rookies about trading options.  Once the basics are understood, anyone who wants to take the time can study some of the finer points. 

Expiration month

This is one of my prime considerations.  When implied volatility (IV) is high, I prefer to buy iron condors that expire in 13 weeks.  I open three-month positions on Monday - after the third Friday (expiration).  When IV is low, I trade the two-month options.  Unlike the majority of iron condor traders, I avoid trading front-month positions because they have too much negative gamma to suit my comfort zone. Yes, they have the most rapid time decay - and that's the major deciding factor for most.

Minimum credit

This is the main driving force for me when choosing specific iron condors to trade.  If I were to put my trading rules into writing, my rule would be: Collect $100 per remaining month per iron condor.  That means when I open a 13-week position, I want a credit of $300.  Sure, I'll take $280 if those strike prices are more appealing.  And when IV is especially high, I may collect $350 instead of moving farther OTM.

But, my general style is to collect $300 and I choose strike prices that provide that sum - going as far OTM as possible.  Obviously there are going to be choices.  You can choose spreads that pay about $1.50 each, spreads that have equal delta, or spreads that are equally far OTM.

I prefer to begin my life as an iron condor owner with spreads that are equally far out of the money.  But, if you have a market bias, this is the time to put that bias into play.

One of the reasons that being exactly delta neutral is not essential is because you can counter those unequal delta by:

   

Choosing strikes that provide more neutrality

   

Selling more put spreads, or more call spreads to even the delta

   

Ignoring the fact that you are leaning slightly long or short

   

Buying pre-insurance (if you believe in this method) to provide         protection where its needed

There are other factors that can be considered, but as you gain experience, you will discover that it becomes easier to select iron condors that work for you - and that means holding positions that feel right.

337

Post Expiration: Option Trading Ideas

Today I'll share some of my thoughts as I look at my current portfolio (mostly June with a some July RUT spreads).  Another expiration has passed and it's time to consider new positions.

August RUT options will begin trading today, but I think I'll pass.  Right now I'm not anxious to sell call or put spreads when IV is so much lower than it has been in recent times.  These spreads are short vega, and if I'm going to take a 90-day position and sell vega that expires in August, I need better prices that I anticipate will be available. 

I have no idea if IV will move higher over the near term, but it feels safer to add to my July positions, if I decide to do anything new.

***

I now own a very well-insured portfolio.  I am in no danger of incurring any significant losses, but because of that insurance, my potential gains are limited.  My gut feeling is that I own this insurance at the wrong time, but I'm not going to sell it out now.  I'm looking for a bit of extra safety these days.  If I find that new July iron condors are attractively priced, I can add several to the portfolio because I already own insurance.  I'm not interested in adding to my short-term (Jun) positions.

***

There's one decision to be made in the coming weeks.  Because I own so much protection, am I still willing to cover those OTM call and put spreads when they reach my 'one penny per trading day remaining' threshold?  There's no need to cover for risk management, but it's still an inexpensive method for giving myself a chance to have a big win if that unexpected market event occurs.  I plan to compromise.  I want to repurchase those spreads, but I'll hold out for a better price.

Good trading to everyone and may this be a winning expiration for all!

332

Q and A. Overlapping Iron Condor Positions

Hi Mark

I have been using an approach of "time diversification" with RUT iron condors (IC). Roughly every week I have been buying 1 lot of a RUT IC with short strikes at a delta of about 10. It is very early but so far I am happy with this approach. I closed my 2 June positions with profits of $1.20 and $1.30 which I am happy with.

I am also fairly happy with my July positions from the perspective that my risk curve (IB risk analyzer) is very balanced and in line with my ambivalent view on market direction. I do however have little area of concern that I want to ask you about, which is related to something you somewhat predicted before I started this "time diversification" strategy.

So here's my situation with the July RUT IC's...1) I first bought a 1 lot of 360/370/590/600. 2) Next 1 bought a 2 lot of 380/390/590/600. 3) next I bought 1 lot of 400/410/590/600. 4) Finally I bought a 1 lot of 370/380/580/590

What this leaves me with is:

1 360/390 PUT SPREAD
1 380/390 PUT SPREAD
1 400/410 PUT spread

3 590/600 call spreads
1 580/600 call spread

My question to you is am I putting myself at significant risk with the 360/390 PUT spread. It seems 3 PUT spread purchases have cascaded to create a 30 point spread. My risk management game plan was to close the position when the short strike is breached. My concern is that buying a 360/390 could be costly when RUT is at 390.

What are your thoughts? Any suggestions? Am I over thinking this?

Rgds

TR

***

Hello TR,

One reason you are happy with this is that the markets have been kind to recently opened iron condor positions. If you missed buying iron condors before the big rally, as you did here, then you are doing quite well. Nice timing.

You are not over thinking this situation.

I do have a suggestion: You see a potential problem, so look for a different risk management plan. You have plenty of time to think about alternatives, but I would not do the 'all or none' approach of sitting tight until the strike is breached. Not if it makes you nervous.

If you are forced to adjust your 360/390 spread, then you will have already closed the 400/410 spread and the 380/390 will be in trouble at the same time as the 3-lot spread.

To me that's no big deal. I am assuming that 5-lots is not too many for you and that had you opened a single position at one time, you would have at least as many spreads. Thus from the perspective of 'size,' I don't see too much risk.

But if your adjustment approach is single-minded, that could be a problem. Sometimes you must be flexible.

a) If you close 'the spread' when breached, ask yourself: What is the definition of 'the spread.'

Originally it was a 10-point spread, now it's become a 30-point spread. Do you feel forced to cover the 30-point spread because that's what you have, or do you still want to close a 10- or 20-point spread? We previously discussed the advantages of closing the wider spread in a single transaction, rather than doing it 10-points at a time. Nevertheless, you are not forced to do it that way.

So, to answer your question, yes, it will be costly to buy in the 30-point spread. Perhaps the compromise is to buy the 370/390P spread, leaving the 360/370 behind.

b) Another alternative is to tell yourself that you don't like this position, and look for the opportunity to exit earlier, by paying a bit more to exit than you ordinarily pay. If you want to pay 20 cents per 10-point spread, then paying 25 or 30 cents this time would be worth it to you. When you sense extra risk, that's a time to pay a bit extra to get out of the trade. Especially when it gets you out sooner and leaves you with a nice profit.

c) There are more alternatives.

Adjust sooner because you are more worried than normal. Consider adjusting in stages.

Consider paying a cash debit for a spread that cannot lose money on the downside, but which may earn a profit. And if it loses money, then that's good also because it means that your 360/390 spread is ot threatened. This involves buying a single put and selling 3x as many put spreads in which the put you sell has a strike that is 20 or 30 points lower [corrected] than the single put you buy.

Example: But one Jul 450 put and sell three Jul 420/430 put spreads. For a lower cost, buy 1 Jul 420P and sell three Jul 380/390 spreads. Examine risk graphs and choose the spread that suits.

I can't give you my 'best' suggestion because I don't know what that is. So much of it depends on your style of trading. And one more point. It's great to trade small - but trading one-lots makes adjusting difficult.

331

Options Trading: Insuring the Iron Condor

Here's one way to look at my recent trading activity.

I admit it.  I've had a difficult time with iron condor positions during the recent unidirectional moves of the stock market.  Yet, I also understand how owning enough insurance would have solved those problems.  I've taken care of that situation going forward (more on this below).

To make matters even worse, during the decline to the March lows, I covered almost every one of my short call spreads at very low prices (nothing more than 35 cents), leaving me with a portfolio that consisted of only short put spreads - right at the bottom.  Imagine the profit potential if the market headed higher!  Well, I imagined it, but did not believe it was possible.  Because I had covered all my call spreads, I sold new call spreads to convert my portfolio back into an iron condor portfolio.  At least I sold fewer spreads, but still, it was too many. The proverbial riches to rags story.

My current portfolio is so safe from market movement that it hardly resembles an iron condor portfolio.  It's also essentially vega, gamma, and delta (ok, I'm short a couple hundred RUT delta) neutral.  That's not much fun.

The reason I'm mentioning this is that so many investors buy at market tops and sell at market bottoms that I'm wondering whether I've fallen into a similar trap.  I now own enough extra options to eliminate market risk (for now) at today's relatively low implied volatility - ok, ok - it's low compared with recent history, but still very high on a historical basis - that I'm concerned that I may have 'bought the top.'  By that I mean: I bought strangles just when the future may show that no protection was necessary and that this is going to be one of those periods in which unhedged iron condors were extremely profitable.

But, I'm still going to stay with my safer portfolio.  I want very limited losses - and that's what I have.  My weak spot is RUT between 530 and 540 as expiration approaches because I'm long extra Jun 540s.  But for the moment, I'm going to enjoy the peace of mind that I bought.

327

Trading Iron Condors. More Risk Reducing Investment Ideas

Yesterday I blogged about why it's important for a trader to be flexible and be ready to change strategies (at least temporarily) when the market is not being kind to your current methods.

I also covered some ideas for protecting portfolios that contain negative gamma.  Negative gamma causes positions to become more bullish as the market slides, and more bearish as it rises.  Obviously that's not the path to profits when the markets are making significant moves. 

Today let's look at a different idea for buying insurance to protect against large losses.  This can be used as a standalone bullish strategy, or as as adjustment to an existing position.  When one of your short spread positions is becoming uncomfortable to hold, it time to make a Stage I adjustment.

RUT, the Russell 2000 Index, is currently trading near 502 (2 hours before the close on 5/6/2009).  Let's say you have an iron condor position in which you are short the Jun 530/540 call spread.  The 530 call is more than 5% out of the money, but it has a 37 delta, and that's outside the comfort zone of many iron condor traders.  whether you have already made an adjustment to your original position or not, this idea is applicable.

If you own a similar position and decide to buy protection against an upside loss, one obvious choice is to begin to buy back a portion of that spread to reduce exposure.

Here's an alternative:

Buy one Jun 530 call and sell three Jun 560/570 spreads.  This trade gains 25 delta for each 1 x 3 unit.  At current prices it costs about $1,100 in cash.  That's a costly adjustment, but it's roughly the same cost as buying three Jun 530/540 spreads; and I'd rather spend a few extra dollars to make this trade.

Are you worried about buying one call and selling three spreads?  Don't be.  The fact that you gain one call option each time you make this trade enhances your upside.  If RUT moves over 570, the three spreads will be worth $3,000 at expiration.  But the 530 call will be at least 40 points ITM, and thus worth at least $4,000.  This trade cannot add to your upside woes, and makes sense for some traders. If this trade is attractive, you can use it as a separate position.

This type of trade is flexible and you can sell a different call spread or use a different ratio.  But be careful:  If you want to reduce cost and thus, sell too many spreads, then upside profits are no longer unlimited (at least over a reasonable price range).

Buying a call you are short, instead of buying a short spread, provides interesting upside possibilities for a portfolio that faces upside risk. 

The equivalent trades can be made with puts.

323

Flexibility is Essential When Choosing Trading Strategies

As I've discussed previously, when you trade options, managing your positions is far more important to your overall profitability than choosing the 'best' strategy.  More money is lost by mismanaging risk than is made by adopting one specific strategy over another.

At the moment I admit to being undecided about how to proceed with my trading.  I still own some RUT June positions (they began life as iron condors, but most of the put spreads have been covered @ $0.25 and $0.30).  One thing I know for certain is that the unidirectional markets of recent times have made the iron condors I chose unprofitable. 

My methods are not designed to profit from markets such as those we encountered recently (huge down followed by a huge up).  Owning pre-insurance would have solved all my problems.  But I strayed, buying some, but not enough insurance. 

Discipline is still the name of the game for traders and investors.  And over-confidence remains a killer.  I had been doing well and became too confident.  Thus, I backed off when buying insurance.  Somehow I didn't believe I needed a 'full load' of insurance over the last two months.

A recent comment by GMG made me glad to see that those methods worked for someone else.

"Using pre-insurance was a key reason that I expect to end up with a (meager) profit. The April rally would have stopped me out long ago without those extra calls I bought."

Recognizing that pre-insurance (the purchase of extra options) works wonders when the market makes a sustained move in one direction, and noting our profitable (if hypothetical) diagonal back spread (latest update and original post), makes me want to own extra options.  The steadily decreasing volatility makes that strategy less expensive to adopt, but one not-to-be-ignored risk is that IV will continue to decrease, and these spreads are rich in vega.

Another of my favorite ideas for providing insurance for iron condor positions is to open an insured half-iron condor.  In other words, sell a put spread and own extra puts, or sell a call spread and own extra calls.  For anyone who believes the market may re-test the bottom, this is a decent proposition.  If the markets reverses big-time, those extra puts will work nicely.  If the rally continues, there's nothing to lose from the put spread - and a call spread may become wildly profitable.

In this scenario, all roads lead to backspread positions.  For a dedicated premium seller, it's not that easy to make the temporary change.  But one of my premises is that market conditions change and a successful trader must be flexible.

322

Iron Condors: Reduce Volatility Risk

For the individual investor who is trading options without taking the time to learn many of the finer points of options theory, the major risk for the owner of an iron condor position is that the underlying stock or index will be too volatile, or even worse, be uni-directionally volatile (several big moves, all up or all down) resulting in one of the options sold moving (or threatening to move) into the money.

The iron condor is a position in which one call spread and one put spread are sold: same underlying, same expiration date.  Profits are earned when time passes and you can buy both spreads for less than you collected when you sold them.


What can be done to reduce risk?

1) To reduce or eliminate the loss that results when the stock moves too far, you can buy extra puts and calls (strangles).  I've already covered this idea more than once.  Naked long options go a long way towards offsetting losses (and sometimes can turn the entire position profitable) - when you own the right strike prices.

2) Certain risk characteristics of options are described by Greek letters, and are collectively known as 'the greeks.'  Trading and keeping things simple is acceptable, but it's not a good idea to trade options by ignoring your exposure to risk.  Four of these risk factors are worth your time to understand: delta, gamma, theta, vega.

The numbered statements below assume a 'normal' iron condor.  That means that the underlying has not moved so far that prudence would have convinced you to exit the trade.

3) Iron condor positions always have positive theta.  That means the theoretical value of the position increases every day.  Theta is your friend.

4) Gamma is negative.  Because gamma measures the rate at which delta changes, that negative gamma is your enemy.  It makes you longer in a falling market and shorter in a rising market.

5) Delta is a measure of how 'long' or 'short' the position is.  When delta is -30, you can expect to lose $30 for the first point that the underlying moves higher.  Because of negative gamma, the next, and each subsequent one point move, results is slightly larger losses.  Similarly, you earn that $30 when the underlying makes a favorable move (down is favorable when you have negative delta).  But each subsequent one point move earns less and less (negative gamma reduces positive deltas quickly), until delta turns positive.  Then you begin to lose money as the underlying declines.

Thus, it's important to pay attention to delta and not allow it to reach an uncomfortable level.  I cannot define that level for you.  At some point, I recommend that you consider making a Stage I adjustment.  And then a Stage II adjustment, if necessary.  If the market continues to move against you, at some point (Stage III or IV), it's time to concede defeat on this spread and take the loss.  Why?  To be certain you incur no large losses.  If you avoid big hits, you will make money with iron condors.

6) Vega is always negative for an iron condor position, and that means volatility risk.  When implied volatility increases, the iron condor trades at higher prices, resulting in a loss. 

But this is one risk you don't have to take.  There are methods for making these positions vega neutral, or at least, less vega negative.

One such idea is to buy calendar spreads.  These spreads have positive vega.  You have a couple of reasonable choices:

a) Instead of opening iron condor positions, open some double diagonal spreads (combination of iron condor + calendar) and some iron condors.  Choose an appropriate number of each to make the combination vega neutral.

b) Choose a different calendar spread, but choose strike prices that are in an area where the iron condors will be losing money.  Calendar profits can offset some of those losses (that happens when the calendar strike price becomes an ATM option).

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Iron Condors are Both: Directional & Volatility Play

Continuing on a theme covered by Jared at CondorOptions:

"One of the primary problems with option selling strategies... consistent profits can easily be wiped out by those [occasional] large periodic jumps in realized volatility.  The most obvious way to begin addressing that problem is to opt for risk-defined option spreads like condors and butterflies in lieu of straddles and other naked positions."

As an owner (sell call spread and sell put spread) of iron condors, it's easy to consider this position as a bet on market direction - specifically the lack of a significant move in either direction.

But an iron condor is a position that's short vega, and that means as the market's implied volatility (IV) increases, the iron condor trader tends to lose money.  Not only because of a market move that jeopardizes one leg of the position, but also because when IV increases, the value of the IC increases.  And that results in a loss.

Traditionally, you may have considered the sale of a straddle or strangle as  the most obvious method for 'selling volatility'  because such positions are short vega.  Not only that, but they present the possibility of unlimited losses - something avoided by investors who pay attention to risk management.  Option traders who want to get long or short vega are used to thinking in terms of those straddles/strangles.

As Jared mentions, trading iron condors is one method for going short volatility without being forced to take the risk of unlimited losses.  Nevertheless, significant losses are still possible, despite the fact that they are limited.

As mentioned above, most iron condor traders think in terms of market movement and believe they own positions that are predicated on the belief that the market will not trade outside of a specified range before the time comes to close out the position.  But iron condors represent more than that. They are also negative vega plays.  And the part that I don't like is that is essentially a double or nothing bet.  When IV remains low, the markets tend to be non-directional and the iron condor trader wins twice.  The price of the position declines as time passes, but it declines faster as IV declines.

The obvious corollary is that when the market tends to make big moves (especially when that move is lower), the IC trader loses twice: once to the big move and the second time to an increase in implied volatility.

When you trade iron condors please be aware that it's also a volatility play.  If you don't want to own negative vega, there are positions you can own that have positive vega.  If you own some vega-rich positions, it offsets some, or all, of the negative vega risk associated with iron condors.  One such position is the calendar spread.

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Treating a 20-Point Iron Condor as Two 10-Point Iron Condors

This discussion picks up after a previous exchange in which TR was short a 620/640 call spread (as part of an iron condor).

Mark

I hear what you are saying and I suspect you are right but I think this is probably one case in which my "science" oriented brain struggles with the "art" side of options investing.

My thought process in my suggested approach I was bouncing off you is that I was treating the 620/640 bear call spread as two distinct bear call spreads: 1) 620/630 and 2) 630/640 . This is what I would have if my two IC's bought weeks apart were actually bought in separate trading accounts.

So my thought process was "just because I have two IC positions and the proximity of the call side of the two positions created a 20 point call spread, I should still act as if they were two separate 10 point spreads, not one 20 point spread". Or another way of saying this "just because I have 2 IC's in one trading account, why should I act differently than if the two IC's were in 2 separate trading accounts?"

I believe the most important part of my suggested adjustment is that I reduce the spread from 20 points to 10, not that I moved the short strike by 10 points or 1.5%.

I would appreciate your thoughts on this and let me know what I am missing.

TR

You are not missing anything strategic - but you are ignoring the real-world expenses associated with adjusting these positions and how to make the best trade (most likely to boost the value of your account) possible under the circumstances.  I'm encouraging you to think in terms of minimizing losses, cutting expenses, and having a position that fits within your comfort zone.

It's intelligent to recognize that the 20-point spread is the equivalent of two 10-point spreads. 

If you are going to strictly abide by your rule:  'Don't adjust until the strike is breached,' then your plan is viable. 

But I believe you are missing a subtle point associated with the 'art' side of trading.  I understand how you feel, as I was also educated as a scientist (chemistry), but I'm suggesting you consider the following and then decide:

With an index priced near 600, I believe it's a losing tactic to close only the 620/630 spread - when there's a good chance that you will be closing the 630/640 spread later that same day - or the next.

Every time you trade, you incur slippage (the cost associated with your inability to get the best price when executing an order.  You must pay closer to the ask price when buying, or sell closer to the bid price when selling) due to the bid/ask spreads.  Ignoring the cost of commissions, you are selling the 630 call in adjustment number one and are likely to be buying it soon thereafter in adjustment number two.  That's just throwing away money.  The ONLY time this method provides a better result is when the market turns right then and there, and does not go up another 10 points.  How likely is that?

I believe it's far more reasonable to close both the 620/630 and the 630/640 spreads at the same time.  Slippage is not the only reason.  You also gain when the index does move higher because you cover the 630/640 spread earlier, and thus, at a lower price.  Once again, the ONLY time this decision loses is when the market move stalls and quickly reverses.

I urge you to consider that an option that is one and one half percent out of the money is hardly out of the money at all - at least in today's higher volatility environment.  Yes, far less volatile than last fall, but much more volatile than average. 

TR and his adjustment point

I'm not telling you how to establish your adjustment point, nor am I suggesting that you adjust in stages, but I don't see the harm in closing the very risky 630/640 spread prematurely - especially when you know you are being paid a bonus to close it - and that bonus is avoiding the slippage and reducing current risk.

That's my perspective.  I'm asking you to consider it, and I am NOT telling you that you are wrong.  But I do feel your play is against the odds of saving money.  By that I mean you will end up adjusting a 2nd time far more often than the market will turn - and that in the longer run, you save far more than you would lose (if the 2nd adjustment proved to be unnecessary).

One more note:  The cost of slippage makes the difference here.  I'm not telling you that you should close a 630/640 spread when index hits 620 (although I've already done a stage I adjustment by that time).  It's the fact that you no longer officially have a position in the 630 line that makes the difference in this scenario - because you would be forced to trade that call option twice, when making two adjustments. 

This is a 'think outside the box' situation.

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Q and A. Using the Greeks to Adjust an Iron Condor

Hi Mark,

Would appreciate an article about adjusting an iron condor related to the greeks (delta) or about Sheridan´s methods?.

THKS

Slait

***

Hi Slait,

As you know there are many possible methods you can use to adjust an iron condor position.  The ultimate purpose of any method is to reduce, or eliminate, risk.  By exiting the whole position, risk is eliminated, and that's the most extreme, and effective, adjustment possible.  But when we are ready to adjust a position, it's too soon to think about exiting, and we look for risk-reducing trades that give us a good chance to earn a profit going forward.

Regarding Dan Sheridan, his methods can be found elsewhere (Click on 'Dan Sheridan archives' in left column, after you sign in).  But one of his ideas is to open a position 4 - 5 weeks prior to expiration and to exit, after holding just over two weeks.  I approve of this general approach:  Make a decent profit, then eliminate all residual risk by not having a position as expiration approaches.  

I use a longer time span (enter 13 weeks prior to expiration, and exit 8 to 9 weeks later), but the idea is the same:  collect a profit (if the market co-operates) then eliminate risk by closing the trade.  The reason for the early exit is to avoid holding when negative gamma increases and becomes more of a threat.  And yes, I do understand that it's difficult to pull the trigger and exit a trade - as time decay is accelerating.  Thus, I want traders to understand that this is my decision for my comfort zone, I'm not recommending that anyone else trade that way.

Adjusting with Greeks

It's always a good idea to know the risk factors associated with your iron condor (or any) position, and the Greeks provide a quick and easy method for tracking that risk.  Every morning I enter the portfolio delta, gamma, theta, and vega into my daily diary.  Doing that prevents me from closing my eyes to those numbers.  There's nothing like writing something on paper (or in a computerized document) to help you be aware of your situation.

Let's assume you open a 10-lot iron condor position, expiring in 45 days, and that you sell options with a delta of 12 (that's just a random choice for the purposes of discussion).  You buy the wings, choosing options that are 10 points further out of the money.  Note: these options are chosen on 'distance' symmetry,' not delta symmetry.  Thus, the original iron condor may not be delta neutral.

[If you prefer delta neutral, then choose different options to sell.  This is not too important for this discussion, and although I prefer to leave no questions unanswered, this is not the place for more details on this point.]

As time passes and the underlying stock or index moves higher or lower, the Greeks change.  At some point, the position reaches an uncomfortable level and it becomes advisable to make a stage I adjustment.  You cannot use a set formula to determine when that point is reached.  Instead, each investor has his/her own comfort zone that helps choose that point for you.  I wish I could make a recommendation on how to choose that point, but cannot do so with any assurance that it represents anything but a random number. 

It's up to you to find the right time for making an adjustment.  For example, if you own a position with 200 negative delta and 10 negative gamma, you can assume (IV holding constant) that a 5-point move in the underlying index will cost more than $1,100 as your negative delta moves from 200 to more than 250.  Can you tolerate that loss?  Are you willing to take that chance.  If the reply is yes, you have not yet reached Stage I.  If that potential loss is too high for you, then do something.  Perhaps cover 50 to 100 delta plus at least 2 gamma.  You can do that by buying some naked long options or by reducing the size of your spread. [This paragraph updated 2 hours after original posting.]

The one piece of advice I offer is this:  Don't let yourself get hurt.  If you have a reasonable fear that the position can lose more than you are willing to lose on a single position, then do something to reduce that risk. 

[Full disclosure: I believe this advice to be wise, intelligent, and reasonable.  But I do not follow it 100% of the time, and take more risk than I should.  I'm much more disciplined that I was earlier in my career, but I truly wish I could blindly follow my own heart-felt advice.]

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