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Trading Iron Condors in 2011

It’s 4½ months into the year and I’ve found this to be one of the easy periods for iron condor traders. Of course, that’s a personal opinion, based on my results. Here’s someone who seems to disagree, yet has made decent money with this strategy.

Christopher Smith at TheOptionClub.com

This year I committed to an experiment that has me trading an iron condor on the SPX every month – regardless of market conditions. The purpose of this exercise is to demonstrate techniques for managing risk and prove that with diligent risk management it is quite possible to limit losses while still creating profitable opportunities.

This year has not been particularly favorable for iron condors, but we have managed to avoid any significant loss and currently we have what amounts to a 20% yield on capital of $5,000 while risking approximately $4,000 or 80% of the capital – holding $1,000 or 20% in reserve.

One of us is living on a different planet. If not, then this comment illustrates that trade selection and risk management techniques vary tremendously among traders. I always knew that traders are different, but cannot see how Chris sees early 2011 as not favorable for iron condors and from my perspective, I could not disagree more.

It’s not a good year for the strategy, but he has already earned 20%?

I think it’s been a very easy year and have earned more during this period than I have ever as a retail investor (over a comparable period of time). I mention this for one reason: I didn’t have to do anything. No skills required. Just trade the iron condors and then exit. Perhaps a minor adjustment or two, but nothing special. I know these returns are not going to continue. And to be honest, I don’t expect to ever see a five month run that is this profitable again. Nor one as easy to manage.

970
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Iron Condor Trading: 3 Ways to Define Neutral

Hi Mark,

I know you're sometimes hesitant to provide too much specific info about how you choose positions, but this type of post is very helpful to certain people. I'll admit that when I started learning about Iron Condors and trying to determine my own comfort zone I did copy your method of taking $3 premium on a 10 point spread (or the equivalent for other spread widths). That allowed me to see how those positions played out and see if my risk appetite matched yours…if not, why not, etc. [MDW: That's exactly how I hoped readers would treat such examples: As examples worth considering]

Questions:

By consistently taking the same premium on ICs, isn't the trader indirectly following the standard deviation method for choosing strikes (assuming inner strikes are equi-distant from the current underlying price)? When IV is high, taking $3 premium will result in a "wider-bodied" condor than taking the same $3 when IV is low. Maybe you have a clearer wording?

However, following along this thought process, if the IC trader wanted to be truly market neutral shouldn't he position his short put slightly farther OTM and position the short call slightly less OTM? When the underlying price drops, IV will almost always go up (bad for a long IC) so the trader would need a bit more "wiggle room" from his puts to compensate. OTOH, when the underlying price rises and IV falls, the trader does not need quite as much "wiggle room" from his calls. So the trader collects a bit more premium on the call side and a bit less on the put side when compared to the equi-distant IC. The risk graph would look like the trader has a directional bias, but after IV is factored in he does not.

Marty,

***

This is an important detail and I thank you for introducing it.  I've written about neutrality before, but it's a topic worthy of clarification. I'll get to it below, but I think there are at least three viable methods for defining a market neutral spread.

1) Because both standard deviation (SD) and option premium depend on implied volatility (IV) – then yes – basing strike selection on premium cannot is similar to choosing strikes based on standard deviations OTM.

I find it to be a simpler process to pick the premium than to think of it in terms of SD.

2) 'Market-neutral' is traditionally considered to be delta neutral.  And using that method, yes, the puts would have to be farther OTM because puts have a higher delta than calls – when the options are equally far OTM.

Volatility skew.  For readers who are not aware why this is true, it's based on volatility skew. To state it simply, the implied volatility of all options on the same underlying, with the same expiration date, do not have the same implied volatility.  In fact, the IV can be very different for various options.  The lower the strike price of an option, the higher is its observed IV.   When observing the IV of a string of options, you can see a steady – but not linear – increase in IV as you move from OTM calls to ATM to OTM puts.

OTM puts almost always have higher IV than OTM calls.  This occurs for one primary reason.  Traders have discovered that OTM puts are truly worth more than predicted by traditional option pricing models (Black Scholes).  Because they are worth a higher price, these OTM put options are bid higher .  Long-time option traders (me) who grew up in the era when skew was not part of the options game, have learned to recognize the importance of volatility skew, or else have long ago been blown out of the game (by selling too many puts).  In the 1970s, after puts were listed for trading) it was typical to value OTM calls as worth more than OTM puts.  The rationale was that markets tend to rise over time.  We now understand that even though that may be true, markets fall much more quickly than they rise, and those little puts can become very valuable in a heartbeat.

Bottom line:  Higher IV translates into a higher probability of moving ITM, and thus, delta is higher.  To trade delta neutral, the trader would have to sell fewer put spreads, or move the put spreads farther OTM.

Delta neutral.  Marty – you can trade delta neutral.  If you do, then – voltility skew forces you to do as you suggest – and that is move the puts farther OTM (or sell calls that are closer to the money).  As stated, most people accept volatility skew as rational and when trading delta neutral they own positions which reflect deltas based on real world implied volatility.

However, if you prefer to trade distance neutral, how can anyone argue with that?  It's a trading bias as any other.  The market has been on the rise for the past year and one half, so if trading distance neutral you fared better than if you were trading delta neutral – at least over that time span.  Obviously, you would have done worse over the prior period in which we had very volatile and declining markets.

It's also reasonable to trade dollar neutral.  That simply means that you collect equal premium for the call and put portions of the iron condor.  For my style (13-week options), that would mean collecting something near $1.50 for each side of the iron condor.

This is not an easy decision to make.  The truth is that I don't have any suggestions as to which is the best method.  I suspect that data is available to back test these various methods, but one would have to go back many years. It's probably a worthwhile experiment, but not for me.  I don't have the time.

I believe this is a comfort zone decision.  I know that right now, some traders with a bullish bias love selling puts because they are comfortably positioned for the steadily rising market.  Trading distance neutral works for them.  On the other hand, the bears may be afraid to sell puts that are too CTM, and prefer to be delta neutral because the puts are father OTM. 

One method for claiming to be market neutral may indeed be better than the others, but I lack the proof.  As much as I hated the idea in my early years, I've come to accept that current IV (barring special situations, such as earning news pending) provides as good of an estimate for future volatility as I can get.  Thus, I base my greeks on current IV, and that means taking the volatility skew into consideration.  I can find no argument against those who prefer to open delta-neutral positions. 

My compromise is to choose a position that its between distance neutral and delta neutral, but I do not dwell on this.  Whichever way you choose to initiate the trade, it should not be too far from 'neutral.'  I admit to fearing the puts and trade with the puts a bit farther OTM than the calls.  But this is truly a 'roll your own' decision.

This is a flexible situation.  I recognize that those who want to milk every last advantage out of options trading may want to keep careful records about neutrality and try to benefit from the data.  If you have the time and patience, it's a good idea.  If you have access to data and believe you can objectively select iron condors to trade – when you know the future, that's the best method for resolving this dilemma: How to be neutral.

850

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Recent Iron Condor Trading Activity

Iron condor traders have faced some interesting decisions as the market continues to rally.  Those who adopted very bullish stances have fared well.  Those who trade market neutral iron condors have faced adjustment decisions.

I understand that my personal trading results differ from yours, however we may have faced similar decisions.  This is how I'm currently situated.

I own RUT iron condor positions with Nov and Dec expirations.  I own a very small January position because I decided to save my free margin for position adjustment, rather than for making new trades.

Each trade was initiated with a minimum premium of $300.

a) I bought all of my Nov put spreads when they became available at $0.15 and $0.20 per spread

b) I've already covered some Dec put spreads at the same prices

c) Not predicting, but fearing a large market selloff, I did not open fresh put spreads when covering those cheapies.  In retrospect, that has cost real cash, but it's not my style to sell new spreads when covering the original trades.

This (idiosyncrasy?) violates the principle of remaining delta neutral.  Thus, I have been trading with short delta as the market has been rising.  To avoid large losses in the rising market, it's necessary to stay ahead of the game and adjust positions.  In some situations, it pays to exit the trade and take the loss as the adjustment.

d) Thus, the bulk of my activity has been concentrated on protecting my call spreads.

Here are two sample (the volume mentioned below represents the lowest common denominator, not the actual trade volume) trades:

i.  Kite spreads. Here is one example

Buy one Nov 710 call; sell three 740/750 call spreads

This provides a much better upside, if the market surges.  It adds current + delta and gamma.  That's all good.  However, if the whole position is held into expiration week, the negative gamma becomes worse near RUT 740. 

This type of kite allows for the sale of four 740/750 spreads, but I'm selling only three to reduce risk

This trade was made when RUT was near 690

ii. Buy one Dec 730/740 call spread;  Sell two Dec 760/770 call spreads.  Traded when RUT was near 710

This type of trade is not appropriate for all.  It works under two conditions.  The first condition is that your account is not already exposed to major risk.  By that I mean that current risk – before and after the above trade is made – is within your comfort zone.

It is a poor risk management technique to convince yourself that although the 730 strike appears to be vulnerable – that 'surely the 760's are safe.'   When the market moves as it has been moving, you never know how far the move may extend.  There is no sense making predictions. 

Because I have extra room (by choosing not to open January positions), I'm using some of that extra margin (and risk) availability to make this trade.

Iron condor traders may choose among many types of trades to reduce risk,  Tomorrow I'll discuss some possibilities.

820


 

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Trading Without an Opinion: Is it Possible? Is it Foolish?

Mark,

I'm bewildered by your reply. I've been reading your
blog for a while, so I think I understand your admonition to consider
one's comfort level when trading. Nevertheless, I find it hard to
believe that you don't have some sort of underlying assumption if not
about market direction, at least about it's relative range when you make
a trade.

I understand adjusting before the underlying gets to a level
that reaches your discomfort point. But short of exiting the position,
when you roll up/down or out, it would seem that you've made an implicit
bet on market direction. That is, you expect the underlying to reverse
before it touches the further out strike.

Maybe you don't look at it
that way. I could imagine that you only look at the risk/reward of the
new position without forecasting market direction. But it would seem to
me that the risk/reward of the new position depends on the probabilities
of the underlying's movement, which still implies some sort of bias.


Even if you don't consider the probabilities, the premium you collect
reflects the market's view of the probabilities, so you're implicitly
betting against the market since you're selling premium.


This isn't a criticism of your method. But as I think more and more
about your suggestions I find it hard to to conceptualize how you get
comfortable with your positions without having some view on market
conditions.

Any insights would be most appreciated.

Burt

***

Hey Burt,

I see your point of view.  Sometimes people use different words to express the same view.  When I tell you that I have no market bias or no expectation for how the underlying stock is going to behave, I mean that from an intellectual point of view.  I have no belief (on which I am willing to wager) that the markets are moving higher or lower or are range-bound.

However, every time I open a position, my account balance is affected by the market action.  By trading iron condors, the bet I choose to make is that the stock price will remain within a range specified by the strike prices of my iron condor. 

I do not believe you are correct when stating that I am betting 'against' the market.  The market has established the odds (when holding the iron condor through expiration).  But those odds apply to both sides.  Why do you think I am against the market?  Why aren't I on the same side as the market?  Oddsmakers go out of their way to make the bet equally attractive from both sides so they can earn the vig (vigorish).

A significant portion of my overall strategy includes: If that price range does not hold, then I wager I can manipulate the trade to hold losses to an acceptable level.  That translates to this: I can make more when things go well than I lose when things go badly.  Every trader makes the same wager: they can earn more when profitable than they lose when unprofitable.

To me that is not a bias.  I am depending on my risk management abilities to keep me out of trouble – despite the fact that they are not 100% reliable.  I choose iron condors because I have no reason to choose bullish or bearish plays.

I adopt a strategy that owns positions that are near neutral in delta and gamma, but which have positive theta and negative vega.  If I am comfortable trading those positions, why should you be bewildered?  I'm always surprised when people believe they can profitably wager on market direction.


My explanation

I believe it's a good idea to open a limited-risk position whenever I 'like my chances.'  If I lack an edge in predictive ability, I must depend on my ability to avoid disasters. 

I must also compromise between safety (how long to wait before exiting a winning trade) and taking advantage when the markets trade within my range.  I decide how long to hold and how much profit to seek.  If I lose when markets are volatile, I must compensate when they are calm.  Risk management precludes holding through expiration (for me) and thus, there is a time to cover.

You are correct.  The premium collected determines the maximum reward.  Risk is more difficult to determine.  I will not allow the trade to move to the worst case scenario, but I also don't know – in advance – at what price I'll exit.  Thus, 'risk' is only estimated.  Options traders estimate future volatility all the time.  I estimate future risk.

If I like the estimated risk/reward for no well-defined reason, does that suggest the trade is 'wrong' or a bad idea?  Not to me. 

Those who use technical analysis, and never trade without a very strong opinion, would disagree.  In fact I had one novice who was incredulous that I traded without using technical analysis.  When I asked how much money he was making by having an opinion, I did not get a satisfactory answer.

I was trained in the 'always be neutral' school, and although I don't strictly adhere to it's teachings, I learned that 'neutral is good' and 'opinions are bad.' 

Question – without trying to get into a philosophical discussion: Is this any different from religion?  As children we are taught to believe that certain things are true.  Most hold those beliefs while others turn away from religion.

There's no 'proof' that the beliefs are true, but people live their lives by those 'truths.' To be a true believer, means that everyone who doesn't think as you do is wrong.  Is that reasonable?  It is how we live.

So I ask: Why is my approach so bewildering?  I don't believe I can accomplish anything with technical analysis.  I don't have a good method for predicting the markets, and believe the vast majority cannot consistently do so.  I choose to trade as a non-believer, i.e., neither the bulls nor bears have an edge. 

I see nothing wrong with remaining faithful to the neutrality idea which tells me that having a market bias is wrong.  I have enough proof that it's wrong for me.

1) I've frequently traded with directional bias in my career, with a dismal track record.

One example: I clearly remember Aug 1982 when I was certain the market had not bottomed.  I was short, stayed short, watched my money disappear (I had made a mint in 1981) and stubbornly refused to change my opinion. When I ran out of money, I conceded defeat.

I've had similar results when opinionated.  I have an opinion right now.  I do not understand why the DJIA is not 5,000 instead of 10,000.  But it is 10,000 and I cannot afford to wager that there will be a huge decline.

If I am a skillful risk manager and don't hold onto positions that are too risky, I do well.  When I get stubborn, I either get lucky and survive, or get clobbered.

I don't want to depend on luck to avoid getting clobbered.  Thus, I learned to control my emotions and opinions when trading.

Is that a good idea for anyone else?  I believe it is, but I'm not adamant.  Each trader goes his own way  I must trade this way.  I proved to myself that I cannot afford the luxury of placing market bets based on my opinion. 

My job is to help people understand options and how to use them.  To that end, I share my philosophy and strongly held views.  But I do not tell people that my way is the truth.  I encourage independent thought.

2) You said: "But it would seem to me that the risk/reward of the new position depends on the probabilities of the underlying's movement, which still implies some sort of bias"

Yes.  It depends on the probability of where the underlying is going.  But I don't know where it is goingThis is where we disagree.

I do not distort that probability with
my opinion.  You believe that if you have a
market opinion, then there is an increased probability that your opinion
will come true.  I know from past experience that my opinion is
not likley to come true. That's why I always ask about a trader's proven
track record when he/she want to bet on market direction.

I suppose I do trade with a bias (if you want to call it that) of sorts.  The volatility skew allows me to sell puts that are farther OTM than calls.  This suits me because I believe a collapse has a higher probability than a melt-up.  It's not a big deal and does not play a huge role in my choice of options to trade.

Rolling

I no longer roll a position unless I want the new position in my portfolio.  The new trade must offer a sufficient reward for accepting risk of being 'wrong.' Wrong in this context does not mean that my expectation does not come to pass.  I have no expectation other than I believe I can make money with the trade.  'Wrong' means that the trade loses money.

I consider trading as a study in probabilities.  I estimate the probability of success (difficult to measure because I don't know exactly how long I will hold the trade) – estimate a reward for that success – and decide if I am willing to accept the risk associated with the trade.  That risk is also difficult to estimate, but if I set a max loss per trade, then I have a very reasonable estimate.

Most traders have strong opinions.  That's great when they have a track record to support that opinion.  I have a track record that screams: don't bet on me.

710

Lessons of a Lifetime: My 33 Years as an Option Trader (Kindle) and e-book versions available.


Lessons_Cover_final

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