Tag Archives | iron condor

The Versatile Stock Option

As the market approaches new all-time highs (S&P 500 Index), it’s natural to want to ride the gravy train. Of course we never know whether the bull market will continue, fade slowly, or disappear. The beautiful thing about trading options is that we can adopt any type of strategy and limit our losses at the same time. No one expects the stock market to open lower by 20% one not-so-fine day, however instead of getting hurt in such a black-swan scenario, even bullish traders should be able to walk away without too much pain.

For that reason, it is important for option traders to recognize what they are trying to accomplish and to own positions for which both potential reward and risk are acceptable. Options are the most versatile investment tools around, and can be used to micromanage any investor’s portfolio. Be sure to manage risk.

    –Aggressive bulls probably own naked long calls, while others own call spreads. Either strategy may be working well — if those traders held on, or re-loaded during the end-of-January market decline. Success also depends on how skilled these traders are in selecting good options to own. Many times the traders buy options that are too far out of the money and never earn a dime.

    –There is not much we can say about aggressive bears. Unless they took a quick profit a few weeks ago, the market has not behaved well for them and the only good news is that bearish strategies come with limited loss. Any bearish trader who was mindful of the importance of risk management should be unhappy, but not financially hurt.

    –Market-neutral traders made or lost money, depending on the strategy chosen. This market may be quite non-volatile from a day-to-day perspective, yet the moves have been devastatingly large for owners of iron condor or ATM butterfly positions. However, straddle buyers and back spreaders probably performed very nicely. Once again, the choice of which specific options to trade played a big role.

Some people in the options world like to repeat the phrase: “You can use options to make money in any market; bull, bear, or neutral.” This is a true statement. However, the most important part of the truth has been omitted. The sentence should also include “as long as you position yourself correctly for the next market move.”

Regardless of your market outlook and the strategy you choose to play, please limit risk to affordable levels. The best way to do that is to be very careful when deciding the size of each position.
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Advice for the new options trader

I ‘borrowed’ (and modified) the following question from the EliteTrader Forum.

I have been studying, paper trading, and real trading – using mixed options strategies with mixed results. I mainly sold call & put spreads and did ok – until I got hammered on one trade. I’ve tried weekly & monthly expiration because I was attracted to these trades and their high probability of profit.

I have a $5k account and pay $1.50/contract flat rate commissions. At the moment, I am being lured into iron condors.

I am not dependent on my account but I want to grow it. I prefer strategies that require low monitoring/maintenance, but I am open to suggestions. What strategies should I try to incorporate and why?

Good news for this trader

This rookie trader is seeking advice, has experimented with several trade ideas, has a good attitude (does not expect instant riches), and incurred a loss from which he has learned a lesson. He appears to be patient and is seeking new ideas to consider.

This person has a nice edge: He has a flat rate commission per contract. That allows him to trade small size (yes, even one-lots) without having to be concerned that the ‘per ticket’ charge will consume too much of any profit. This was an intelligent item to negotiate and I strongly recommend this idea for all traders who trade small size. The savings can be significant – if you can get them.

The not so good part of the story

He is being ‘lured’ into a new strategy, but he should only adopt this play if he feels comfortable using it. In truth, it’s merely a combination of the strategies he has already been using – and in my opinion, anyone who understands the risks associated with selling vertical spreads is ready to consider trading iron condors.

The other problem is the size of the trading account. I understand that brokers allow customers to trade with even less capital, but it is a difficult task. It is simply too easy to lose the entire account when it is small.

Advice

As a young person with a job, he is in position to make a deposit into this account every time he receives a paycheck. That’s an outstanding method for increasing wealth over time. However, with this advantage comes the responsibility of carefully managing risk.

Learning to do this well takes time. The best recommendation I have is to be very careful with trade size because that is the simplest and most efficient method for managing risk for any trader. Smaller is better. Less risk and less profit potential is better – especially when the trader is first getting started. There is plenty of time to increase size as experience and confidence grow.

Patience is necessary because some strategies (such as selling credit spreads) may take some time to perform as hoped. [It’s true that selling a put spread can become very profitable quickly when the stock rises, but in a neutral market, iron condors require patience and good risk management.] Experience does not come quickly.

I also offer this advice for our rookie trader:

  • Rapid time decay may look great on paper, but (as you already learned) it comes with explosive negative gamma, making these trades riskier than they appear
  • Longer-term options come with higher premium and more protection against unwanted market moves. They also lose time value more slowly
    • Trading involves trade-offs. Less risk requires accepting a smaller profit target.
    • Your problem is to find the trade-off that feels ‘just’ right.’ Not a simple task – but it gets easier with experience
  • Choosing a good strategy is important. You want to feel that you understand how to use it effectively
  • However, risk management is more important and will have the greatest effect on your overall performance
  • Which strategies?

    The list is long. Options are very versatile and provide many alternatives. If you are comfortable with credit spreads, they make an excellent choice because losses are limited, margin requirement is small – allowing you to diversify, and they are easy to understand.

    Then there is something you may not yet recognize: Selling the put spread is equivalent to the very conservative collar strategy. More than that, selling put spreads is the same as buying call spreads (same stock, strike, and expiration date), and selling call spreads is the same as buying put spreads (same stock, strike, and expiration date).

    That means you are already using a much wider variety of strategies than you realize.

    I believe you are on the right track. Don’t get greedy. Increase position size one contract at a time, and don’t do that too frequently. Keep asking questions and don’t accept all replies as ‘correct.’ Use your own judgment.

    Excellent reviews for first live discussion session at Options for Rookies Premium. Become a Gold Member and get invited to future sessions
    941
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    Profit and Loss Targets when Trading Options

    The beginning

    This detailed discussion began here, in the comments section.

    Roberto is asking about profit and stop loss targets for an iron condor and also for a ‘classic’ credit spread.

    Where we are now

    Thanks Mark.

    But I still don’t understand why you prefer to set a stop loss around $300 in a trade (10-point credit spread) where $800 can be the maximum loss.

    In a classical vertical spread, $200 credit and $800 risk, we agreed that the take profit should be around $150 but we disagree about the stop loss. Can you do a statistical example of why, over the long term, using a stop loss in $300 area, its better than a stop loss in $75 area?

    Thanks again

    Roberto

    ***

    Hi Roberto,

    I do not set a $300 stop loss for all trades that have a maximum loss of $800. That’s not how risk management works. There are many factors to consider.

    A huge part of the problem in understanding my original comments stems from the fact that you changed the conditions

    I was talking about an iron condor. You switched to discussing half of the iron condor position (credit spread), believing that the situations are similar. They are very different trades, with very different factors that go into choosing the profit and loss limits.

    Why is that difference so important? In your classic credit spread, one way to profit occurs when the stock moves much higher (Selling the put spread is a bullish position). When that happens, there is a very good possibility of being able to close the position and take your target profit. Thus, selling a credit spread gives you two ways to win: The passage of time and the correct market move. Those two profit possibilities play a large role in the probability of earning a profit

    With the iron condor, there are no profits when the stock moves higher. It just means that the call portion is in trouble rather than the put portion. There are no profits under those circumstances. There is no possibility of taking profits quickly. This position requires the passage of time before the trade can reach its profit target. It is important that you recognize that changes the probability of success by so much, that no matter how you set the risk/reward ratio for a credit spread, it must be set very differently for the iron condor. The iron condor is where this discussion began.

    I hope that’s clear to you. The credit spread wins far more often than the iron condor. If you ask: Why not trade the credit spread instead, the reply is that I don’t know whether to sell a call spread or a put spread.

    Time out for an important issue

    Experienced traders may recognize that there is another big factor that has been ignored: The effect of implied volatility. When trading an iron condor, a big volatility increase can result in being stopped out of the trade quickly. It is true that credit spreads are also short vega, but only half as much as an iron condor. When you establish a relatively small stop loss, you can get forced out of the trade, even when the underlying asset does not make a threatening move – just because IV rose by enough to make the position hit your stop loss target.

    That factor alone – the possibility of being forced to exit by a spike in implied volatility is the major reason why I would never use a small dollar value as a stop loss point. To me it is far too risky to stop yourself out of trades that quickly. I don’t believe you can stay in those trades long enough, often enough, to claim your profit. Thus, I choose a larger stop loss and know that my edge is that I’ll be stopped less frequently than you. Is that enough to make my method better? For me, yes. For you? I cannot know that answer.

    End of time out

    I make trade decisions by doing what I believe gives me the best chance to make money when combining my chosen strategy with my personal risk management decisions.

    You must understand that we do not disagree on anything. I believe that a stop loss at $300 is better for me than a stop loss near $75. You believe that a $75 stop loss will be effective for you. We must each trade according to our comfort zones. Neither one of us is wrong. I allow for a larger loss to reduce the possibility that a change in IV will force an early exit.

    I can understand why you may believe that one of us must be correct and the other person must be making a mistake. However, neither one of us is wrong. Here’s my best explanation of why believe that no one is wrong here.”

    • If you own the position and the loss reaches $100, or $150, you may become very uncomfortable holding onto the position. You may become upset and feel ill. You may lose sleep. A trader cannot allow that to happen. Even if we are investors and not traders, it’s the same situation. It is wrong to hold positions that make us nervous because it means that too much money is at risk. It is also very unhealthy. Losing money is part of the trading game, and if it’s going to upset you – then you are correct to cut losses before you reach that point.
    • It is far better if we can do a statistical evaluation of the trading plan. However, that’s impossible
      • We have no volatility estimate for the stock in question. I assume that you recognize that a very volatile stock will lose that $75 far more often than a non-volatile stock. And it will take a longer time for the profit level to reach $150 because options of volatile stocks hold their premium longer than options of non-volatile stocks. If you get stopped often and if it more time to make the profit, how can that be a profitable plan?
      • When dealing with statistics, time remaining is a crucial factor – and the time remaining before expiration arrives is unknown in our example trade
    • The single fact that we collected $200 credit trading that ‘classic’ credit spread is not enough information to solve this problem.

    Statistics

    Lacking enough information to solve the problem, and ignoring trading costs, we know this much:

    • The $75 stop loss and the $150 profit target
      • You can afford to lose twice as often as you win to break even
      • Thus, the probability of the spread reaching the stop loss point must be less than two in three (win once, lose twice, zero gain)
    • The $300 stop loss and the $150 profit target
      • I must win twice as often as I lose to break even
      • Thus, the probability of the spread reaching the stop loss point must be no more than one in three (win twice, lose once, zero gain)
    • You choose $150 as the profit target and $75 as the stop loss because those numbers have proven to be effective, and you have the profits to prove it. The other choice is that you have no such evidence but believe these numbers will be effective. However, using that 2:1 ratio as a strict guideline is a huge mistake. I guarantee that. If you use a ratio, it must change when trading more volatile stocks. It must change when the strategy changes. It may have been useful when trading stocks, but it’s worthless (in my opinion) when trading options

    Setting stop losses is necessary. Choosing the price at which to set them is a crucial decision, and no simple formula is going to be satisfactory.

    The end

    When trading an iron condor, I often give up on the trade when one of the 10-point spreads reaches a price between $500 and $550. Thus, my stop loss is not based on the number of dollars lost. Is that heresy? If I collect $300 for the position, then my stop loss is about $250 (plus the cost to cover the profitable side of the trade). If I collect only $250 in premium, then my stop loss is about $300 (plus the cost to cover the winning side).

    I exit the trade when I believe risk has reached the point at which I am not willing to lose any more on that trade. It has nothing to do with my profit target. That is the reason I do not use a risk/reward ratio, and I hope this explanation makes sense. You don’t have to agree with my conclusions, but you should understand the reasoning behind them.

    I never said that it is ‘better’ to set the stop loss at $300. I said that is where I am comfortable setting it.

    We each have different comfort levels and must trade accordingly. When I trade an iron condor (or credit spread) I am not willing to set exit points as low as you set them. That does not make either of us ‘wrong.’

    897
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    Legging into an iron condor: A Good Idea?

    Mark,

    Can you please provide some in depth info on what would the preferable steps to leg into an IC – by spread – would be?

    Example. if I open the put side today and next week index moves higher I sell the call side, that's great. But what if next week index moves lower? Roll-down the puts? Take losses and wait for another opportunity? Sell the calls at current prices?

    My second question is: from your experience, would an IC constructed around 1 standard deviation OTM be really ~68% probability of keeping all the premium (given we do not make adjustments, in plain theory)? Thanks.

    Dmitry

    ***

    In depth discussions are not always possible.  That's the stuff of which lessons and book chapters are made.  However, I'll offer the major points in enough detail, that it should satisfy your needs.

    As it turns out, you do not need a lot of information about legging into iron condor trades. 

     

    Legging into iron condors

    1) Here are the major points – everything else on this topic is far less meaningful.

    I do not like the idea of legging into iron condor trades by selling puts first.  It simply doesn't work as well as it should – when considering the risk involved. I know that's not good news for the trader who usually has a bullish bias, but there are good reasons.

    When the market rallies, IV tends to shrink.  When IV shrinks, the value of the call spread that you are planning to sell also shrinks.  By that I mean it increases in value by less than you anticipate.  Often much less because it is an OTM spread.  I'm assuming that the iron condor trader is not looking to sell options that are CTM (close to the money).

    It takes a significant upward move for that OTM call spread to increase in value by enough to compensate the trader for taking the leg. If you do sell the put spread first, and the market cooperates, it's often better to buy back that put spread, take the profit, and forget about getting a little better price on the call spread.

    It's different with calls. If you correctly (i.e., you are correctly short-term bearish) sell the call spread first, then you have the opposite effect.  If the market declines, the put spread widens faster than expected and you have an iron condor trade at a good price.

    Thus, unless bearish, I suggest not legging into iron condor trades.

    Managing the single leg

    2) If you don't get an opportunity to sell the second leg of the iron condor, I suggest forgetting about it and managing risk for the one credit spread that you did sell. 

    Let me point out something that seems 'obvious,' but may not be obvious to everyone.  More than that, a significant number of traders may have never considered this simple idea: Once you own the full iron condor position, my experience tells me that it is far more efficient to forget that it is an iron condor and manage risk as if it were two separate trades:  one call spread and one put spread.

    Thus, I recommend trading the situation described above as a put spread.  The fact that you did not collect any option premium by selling the call spread no longer matters. 

    [If you had sold the call spread, and the market declines, the only important consideration is knowing when to buy back that call spread by paying a small price .  Waiting for it to expire worthless is far too risky.  Sure, it expires most of the time, but on those occasions when you get the big bounce (and that's what you (Dmitry) are in the market to find, isn't it?) there is no point in taking a good-sized loss on the call spread when it could have been covered by paying $0.20 – or another low price that suits you.

    That's why I suggest managing the put spread as you would normally manage such a spread.  I understand that you are primarily a stock trader and have not traded a bunch of these, but there is no single best way to manage the risk.  My advice is DO NOT allow the fact that the call spread was not sold influence your decisions.

    Yes, you can roll it down; yes you may be uncomfortable with the trade and exit at a loss.  Yes you may sell a call spread now – but that is my least favorite adjustment method and I strongly recommend that you not do that.  I base that on your bullish personality, and for you, losing money in a rising market would make you very unhappy.  Much more so than losing in a falling market.  These pshychological factors may not be a legitimate of scientific trading, however I truly believe that a successful trader does not place him/herself in a situation that can result is a very unhappy outcome.  My strong guess is that if you were to lose a given sum, you would be far unahppier losing on the upsdie than the downside.

    Standard Deviation

    No.  The chances of keeping the entire premium are nowhere near that 68%.

    If you sell an option that is one standard deviation (SD) OTM, then yes, it will be out of the money approximately 68% of the time when expiration arrives.  But don't ignore the fact that it may be ITM far earlier than expiration (and then finish OTM), and you would probably elect to adjust or exit, rather than clsoe your eyes and wait for expiration.

    More importantly, you are selling a call and a put.  The probability that the put finishes OTM is that 68%.  The probability that the calls finishes OTM is also 68%.  However, you have both positions and the probability of finishing ITM is 32% for either option.  these probabilities are additive. 

    Conclusion:  The probability that either the put or call will finish ITM is ~64% and the chance that the iron condor will expire worthless is only 34%.  That is nothing near the 68% that you mentioned.

    It gets worse.  If you decide to determine (see yesterday's blog post) the probability that the underlying stock or index will move to touch either the put or call strike price during the lifetime of the options, you will discover that the probability of touching is much higher than the probability of finishing ITM.  Assuming you would make an adjustment, the probability of keeping the entire sum is now far less than 34%

    Iron condors are riskier than they may appear at first. That's why risk management is so important.

    883


     

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    Meet Our Readers

    My Journey to becoming an Option Trader

    Over a three year period I went from a mutual fund only investor to a stock only investor, to a debit spread option trader and now primarily a credit spread option trader. During this period of time from January 2008 until December 2010 I read various books and subscribed to different services. 

    I made my first investment based upon recommendation from the American Association Of Individual Investors (AAII).  I purchased over 30 stocks during January 2008 and it was during this month the market started making some large moves both up and down.  I also began a subscription to MorningStar and Investor Business Daily and began watching Cramer and Fast Money TV shows.  After about six months I began realizing I did not have enough time to monitor financial news on this many stocks since I still had a day job.  I scaled back to approximately 15 stocks but I still lacked a real strategy and a discipline approach to investing, I was continuing to search for a better way to invest and make money.  The death kneel  for me as a stock investor came in October 2009 when I was invited to attend a presentation made by our companies primary lender( at the time I was our company's CFO) by our lender's CEO and CFO. Each of them had just returned from attending discussion in Washington about a program everyone was interested in hearing more about called TARP.   This bank's presentation offered confidence in their position related to loan losses, bad debt reserves, exposure to housing etc.  I was even able to ask questions one on one with the CFO and CEO and then I felt confident about the bank's future.  I went out and bought some stock and two weeks later this bank was forced to sell to a larger firm since it was not going to be a recipient of TARP funds due to its large amount of home equity loans.  From that event I concluded if I cannot determine a company's financial prospects from a personal presentation from the CEO and as well being able to look in them the  eye to ask questions then what chance do I have of knowing what stocks to buy to make money.

    As 2008 came to end my investment portfolio was dwindling and economy along with stock market seemed more uncertain than ever, now what do I do?  I believed I still needed to invest in stocks but was uncomfortable with the risk, staying in cash seemed like a doomed strategy by never regaining what I had lost.  As 2009 started I began to purchase stocks using Vertical Spread Options.  I found I was comfortable with the risk and related reward.  Individual stock prices were so depressed during the first quarter it was almost as if any stock was as good a pick as another, fundamentals of stock investing seemed to me to have been thrown to the wind.  Fortunately as the summer of 2009 rolled around the market and my portfolio was doing much better but I was still searching for a better way.  I has stopped all my subscriptions to AAII, IBD and MorningStar but did join Vector Vest.  That summer I also lost my job two weeks before my daughter got married and after 35 years of working decided to see if there was another way ahead for me.  I thought perhaps about day trading but the idea of getting in and out of positions in a day or even a few days seemed like a roll of the dice. I began to focus on using the VV system and tested many of their strategies using their "what if" software.  After just a few months I thought there were just too many possible strategies to select from and many of the stock were small firms I had never heard of so I stopped my VV subscription.

    As 2009 ended it was a very good year for my portfolio and the vertical option strategy had worked well yet I still was searching for a better way.  I came across a service called Terry's Tips which primarily sold calendar spread with the idea that by rolling the premium over month to month so one would collect additional income.  Still being unemployed I liked the idea of collecting a monthly premium for income.  In January 2010 I purchased a variety of SPY calendar spread both call and puts, some out a few months and others out even further to year end.  Second quarter of 2010 with the  market once again gyrating I found it very difficult to manage these long and short, puts and call positions , how do I decide which to buy/sell roll or close?  It was at this time I came across the Iron Condor strategy were premium is collected upfront.  It seemed to me like a trade based upon making an over or under bet in a football game just as long as it stays in that range then you make money.  I began trading SPY only iron condors and went back a few months to see what range SPY went from options expiration to the next month expiration and began using this method to select where to sell the short strikes for calls and puts.  I also began to understand how to better use Greek symbols in trading options.  During 2010 I continued trading SPY calendar spreads but only on calls, it seemed as I was rarely successful on calendar spreads puts.  I also continued trading verticals on selected stocks (only about 8 to 10 stocks of large companies with liquid options) 

    As 2010 ended my primary trading focus was on SPY iron condors.

    I know I still have much to learn in making adjustments to condors and better using Greeks to manage changes yet at this time I am very comfortable with where I am at as a trader.  I actually look forward to Monday  and what will happen next in the market and what I may learn.  Of course being able to be with my family, play golf and run marathons whenever I want is also a pleasure.

    The Option Rookies Blog archive has been very helpful to me in refining and expanding my knowledge of options trading.

    Regards,

    Frank   

    881

    If you want to share your story, send an e-mail to blog (at) mdwoptions (dor) com


     

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    Doesn’t making money mean it was a good trade?

    Some days it's difficult to find a blog topic.  When that happens I spend some time reading other blogs, looking for ideas.  One, by the Stock Bandit, Jeff White, drew my immediate attention.  I've been saying the same thing for a long time, and it's always reassuring to see someone else with the same opinion.

    In a post titled: Succeed by Not Failing, Jeff offers his opinion on a topic that many consider to be controversial:

    "Too many traders think a winning trade is a good trade, and a losing trade is a bad trade鈥 failure.  I disagree."

    The result of a trade is either a profit or a loss, but not a success or a failure.  Good trades can end up being losses, and poor trades can sometimes result in a profit. 

    John gives an example and provides three common ways that traders fail.  It's worth reading.

    ***

    If this is a topic that has not bothered you, consider the situation of someone learning to trade.  He/she dutifully opens a paper-trading account, chooses a strategy, but is not confident when choosing which options to trade. 

    • The covered call writer may be torn between selling ITM, ATM, or OTM options.  Then there's the problem of which expiration month to choose
    • The  butterfly trader may not know how far from the center strike to place the wings
    • The iron condor trader is told to find a comfort zone and begin from there

    Comfort zone.  That sounds good.  We can tell when a position makes us nervous or whether we are entering into a trade with more confidence than usual.  But how do we do that?  It's based on experience.  We know what works and what doesn't work for us.  It's far better to have written trade records than to rely on what may be a faulty (biased) memory, but we have a feel for what to trade.

    What is our beginner to do?  When initiating an iron condor position, the beginner has no idea what makes him/her comfortable.  With no experience, how far OTM is 'safe'?  Or how much premium does he/she have to collect?  Certainly there's no clue about an appropriate position size, and trading 1-lots is often the default choice.  But there's no 'comfort' there.  It's all uncertain territory.

    The Winning Trade

     If this new trader is going to learn from making practice trades, There must be an understanding of how the trade was handled. 

    Let's say our trader opens an iron condor position and the market moves.  The short put option goes well into the money and even the long put is ITM.  Doing nothing – out of fear and inexperience, our trader sees the market reverse, the iron condor expires worthless and here is a winning trade.  Not only a winner, but a maximum winner.

    If the conclusion is drawn that this trade 'fits' into the trader's comfort zone and that the best way to handle iron condor trades is to wait for expiry, then this trader is already in trouble. 

    This is a simple example of why it takes many trades before viable conclusions can be reached and why the result does not describe whether the trade was 'good.'

    On the other hand, if the trader had felt queasy when the underlying declined and covered the entire position when the puts were 2% OTM (later than many would cover), he/she would have a losing trade and may conclude that this was a bad trade and that it was handled poorly.  Especially if the trader pays attention to what would have happened (I suggest not doing that).

    In reality, it was the same trade and cannot be good part of the time and a poor choice at others.  Either it was suitable for this trader, done in the right size, had a reasonable risk/reward ratio – or it wasn't.  In this extreme example, it's risk management that made all the difference.  And to make matters worse as a learning example, it was poor risk management that led to the profitable trade.

    Thus, profit or loss is not the deciding factor.  It's not to be ignored, but there are other things to consider.

    Please use judgment when evaluating your initial positions.  Do not allow the final monetary result to enter into the decision-making process. Take your time.  Collect data and learn to read your own body.  Discover trades that make you comfortable and those which don't. Most traders sense when there is too much risk.  That could mean 'too likely to lose money' or 'too much money can be lost.'

    That trader must also try to judge how well risk was managed because that's going to be an important factor in the trader's future profitability.  When first beginning to use options in a virtual account, it pays to take notes and try to gain something from every experience.  In reality, it's not easy to understand just what was done correctly (with the odds of success on your side) and where luck (good or bad) played a role.  However, the trader does accumulate knowledge as time passes. As he/she understand the trades better, the opportunity to ask questions accelerates the learning process.

    Bottom line:  There's data to collect, experience to gain, and time before a new trader can know him/herself well enough to place money at risk.

    877

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    Implied Volatility: Why does it change?

    I recently received the following e-mail question It's fairly simple, but on further analysis I find it most disturbing:

    Is it possible to find out who changed IV and why and for how long?

    Here's the background: Last week I posted a discussion based on a readers question about an iron condor position that immediately lost money (it's worth reading as background for today's post).  Because he expected to collect theta every day – especially when the underlying asset did not undergo a large move.  Basically, he didn't understand how this loss could have happened. The question above is the result of my telling him that the implied volatility of the options had increased.

    In other words, he was trading iron condors as if they were money in the bank. An increase in IV took him by surprise, prompting today's questions:  Who is responsible for the higher IV?  Why was it changed?  How long will it last?

    Every question deserves an answer, especially when an explanation may turn into an 'aha moment' for the questioner.  What truly disturbs me about this innocent-looking question is that it demonstrates a complete lack of understanding of how the markets work.

    When playing a game or when practicing some trade ideas with play money, there is no question that's out of line.  There are two types of trader who use paper-money accounts:

    • The beginner who is trying to gain an understanding of how to trade and what has to be learned
    • The expert who is fine-tuning strategies, looking for any additional small edge

    The beginner is expected to be learning as he/she goes.  Reading, taking classes, attending webinars – and asking questions.  I'oveheard very unsophisticated questions – and that's to be expected.  But the questioners learn from the answers and move beyond the basics.

    Today's question comes from someone who is using real money (although I don't know the size of his positions).  This single set of question tells me that he is not yet ready to trade.  The whole concept of options trading, options markets, how prices are determined and what options are worth has not yet been grasped.  There's nothing wrong with that when using play money.

    It's fun to win and there's no harm done whe losing money.  Asthe trader plays, he/she gains playing experience, and insight into some subtle strategies tha had not yet considered, etc.  That's how one becomes a better player at chess, monopoly, backgammon, or any other game.  As long as you are not playing for money and the game is taken seriously by the participants, it's a good learning experience for everyone.

    However, when trading with real moneyy, some elements of the game change.  There is the possibility of earning some serious cash, and that's fantastic.  There is also the chance of losing far more than the player realizes is at stake, and that can be devastating.  Trading is not a game and one must have some basic understanding of the rules of engagement – and in this case, it's a basic idea of how the markets work.

    In the previous post, I explained that his trade is losing money because his negative vega position is being hurt by a rise in the implied volatility of the options in his position.

     

    Who changed IV?  Why?

    No one individual changed the implied volatility of AAPL options.  Many thousands of contracts trade every day, and if anyone tried to bid prices higher or offer them at steadily lower prices, that person would be stampeded by everyone else in the marketplace who thought he was wrong-headed in his efforts.

    It takes much more than a single 'who' to 'change IV. Changes occur for basic reasons, and subtle factors make a difference. 

    • Supply and demand is often 'blamed' for IV changes.  Look at it this way.  If option buyers – and that means calls and/or puts – far outnumber sellers, then sellers must demand a higher price – even when the stock has not moved.  If buying continues, prices move higher again.  This is normal market behavior, no matter what product is being traded
    • Market maker positions:  When they sell options to the buyers, their primary job is to reduce risk.  They must buy other options, preferably on the same underlying

    It's true that most of today's traders use computers to generate orders to buy/sell options in different underlying assets.  However, after selling to public or institutional buyers, the market makers preferable next move is to buy, rather than sell more options. So they raise their bids and offers.  To do that, they raise the estimated future volatility estimate built into their trading algorithm. This is not a conspiracy.  Each trader independently raises or lowers bid according to his/her need to own/sell vega, gamma, theta delta, etc.

    Those algorithms tell their quote-generating computers to raise or lower the trader's bid/ask quote

    It's true that different market makers make different quotes, but when there is more demand for the  options, then prices move higher

    • Fear/complacency.  When 'people' [individual investors, market makers, speculators, hedge funds etc.] are afraid that the market may do something drastic, or when they fear that their portfolios are not well-hedged against potential losses, they buy options as insurance.  It doesn't matter whether they buy puts or calls [Remember that puts are calls and calls are puts], the purchase of any option can drive prices higher – when there are enough buyers.

    We have all seen SPX volatility (as measured by VIX) decline from over 80 to 15 over the past two years.  And even traders who have not been in the market that long have seen IV decline over recent times.  They've seen it, but do they understand why this has happened?  Today's questioner apparently has not given it a moment's thought.  It happened because the markets have been dead.  Extreme low volatility begets option sellers.  But, at some point, sellers become buyers.

    I don't know if the decline in IV is ended, or if the current increase is just a bump in the road.  I do know that someone traded an iron condor without any understanding of what could happen to his position – other he would collect time decay.

     

    For How long?

    Another impossible question.  Until there are enough option sellers to satisfy the buyers without prices moving higher.

    I  truly hope this gives you a more clear understanding of the markets.  They are very complex and not easily understood.  I guarantee this: Neither you nor I will ever understand them well enough to be able to just print money.  Trading is difficult work and it takes training and education and skill to succeed.  The sad fact is that some people have no chance.

    If you take the time to understand how each trade makes or loses money, what must occur for that profit or loss to be realized, and if you can discover how to estimate the probability that such events will occur,  then you are ready to trade options.

    If you open positions based on theta alone, you will not be one of the success stories.  You have work to do.  Good luck and good trading.

    871

    TylersTrading

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