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New e-mail address: mdw6905@gmail.com

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So long,Farewell,Aufwiedersehen,Goodnight…

I’ll be removing all of my writings from the Internet very soon. I have not written any new posts since 2015, but am taking this opportunity to thank everyone who visited this site. I trust that you found the time here to be worthwhile.

I wish you happy and successful trading.

Mark

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Introduction to Options: The Video

The video embedded below is several years old and the video quality could be better. However, it remains an excellent introduction to options and I’m offering the lesson to everyone (at no cost).

I trust you will enjoy it.


The video is also on You-Tube

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The Art of Making Decisions when Trading

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

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

The question

Hi Mark,

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

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

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

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

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

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

My reply

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

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

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

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

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

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

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

That leaves some questions

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

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

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

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

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

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

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

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

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

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

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

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Recent News: About.com

I have two important announcements

One

Beginning today, Feb 4, 2014, I am the option blogger for about.com.

This project is so new that I do not yet have the URL, but I believe it will be: www.options.about.com

About.com provides articles and videos concerning a multitude of topics, authored by experts. With approximately 90 million users each month, this is one of the most-visited sites around. The new channel is part of the larger money channel.

My plan is to reach out to as many people as possible, the only requirement is that they have some desire to learn about options and how to use them effectively. I’ll be offering my usual high-quality lessons and commentary and the plan includes replying to every question submitted by readers.

Pay us a visit. I’ll add the official URL when I get it.

Two

I have been giving away an e-book entitled: Introduction to Options: The Basics. That book has now been expanded and updated as a Kindle ebook. Important note: This is a basic introduction to options for people who know nothing about the topic. There are no lessons that get the reader started with trading. Instead it is designed to give readers an idea of whether they have any interest in studying my favorite investment tool, options.

Amazon requires a minimum price of 99 cents for Kindle books.

Here is a link to the older, shorter (and free) .pdf version.

This book is part of the “Best Option Strategies Series”

IntroToOptions

http://goo.gl/uzfkVd

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Iron Condor Question

From a reader

Consider following 2 Iron Condors:

Trade-1:
Sell X index march 6600 Call
Buy X index march 6700 Call
Sell X index march 5800 Put
Buy X index march 5700 Put

Trade-2:
Sell X index march 6600 Call
Buy X index march 6800 Call
Sell X index march 5800 Put
Buy X index march 5600 Put

Underlying:6200 for both.
Lot size 50

**(see below) Maximum risk: $5,000 for trade-1: $10,000 for trade-2

** Premium collected: Approximately $1,700 ($5,000/3) in trade-1 & slightly less than $3,300 ($10,000/3) in trade-2.

Considering only the trades allowed to expire, it requires 2 winning trades for each lost trade with either iron condor. But earnings potential in trade-2 is almost double.

Considering overall risk factors which trade is preferred & why?

Excellent questions because it is common to think about a pair of similar-looking iron condors in this manner. And the truly important question is how does a trader decide which of the two spreads better suits his or her needs.

The first iron condor has strikes that are 100 points apart and the second uses strikes twice as far apart. Even though the widths in this example are extreme, the principles that I want to discuss remain relevant.

** But first:

    –The spreads are 100 points wide (not 1 point) and the risk per spread is $10,000, not $100.

    –Thus, 50-lots of the first spread is a humongous position with a risk of nearly $500,000. The second, wider iron condor, places $1,000,000 (less the premium collected) at risk.

    –Instead of collecting $1,700 (and $3,300) the true premium collected would be $170,000 and $333,000.

We can discuss the relative merits of the two iron condors, using your numbers for the cash premium and risk. We do that by changing the index price to $62 from $6,200.

Comparing the 2-point iron condor with the 1-point iron condor

When examining the wider spread, or the 56/58 put spread or the 66/68 call spread, the first thing to understand is that selling these spreads is exactly equivalent to selling each of the more narrow spreads contained within. For example:

    Buy 56 put; sell 57 put coupled with
    Buy 57 put; sell 58 put

    gives you the same position as

    Buy 56 put; sell 58 put.

We prefer to sell the 56/58 put directly because it involves only one trade instead of two. That not only saves cash on commissions, but it also is more efficient to make the trade. Remember that every time we place an order, we must face slippage, or the cost of buying an option at a price that is nearer to the asking price than the bid price; plus the cost of selling an option at a price that is nearer the bid than the ask. This cannot be avoided and is the cost of doing business. But we can be smart about it and when we want to sell the 56/58 put spread, we enter an order to do exactly that. We never sell the 56/57 spread and follow that trade by selling the 57/58 spread.

Trade size: Profit potential vs. risk

Yes, the profit potential of the second spread is almost double that for the first spread.

However, it is mandatory to understand why that is true. First the potential loss is twice as large and we should not be surprised that more risky positions provide for the opportunity to both earn a larger profit or incur a larger loss.

Second, the first trade is truly 50-lots of a 1-point iron condor whereas the second trade is truly 50-lots of EACH of two different one-point iron condors, or 100- lots total.

Thus, there is neither an advantage nor a disadvantage to trading the wider spread.
But, if you choose the wider, then it is essential to trade only one-half as many contracts (25-lot) when the iron condors are twice as wide. That is how we manage risk. We must not fall into the trap of believing that 50 spreads is the same as 50 different spreads. We should chose the size of our individual trades based on keeping risk at nearly equal levels. Thus, 50-lots of the 1-point IC is very nearly the same as trading 25-lots of the 2-point iron condor.

So, how do we decide between trade-1 and trade-2?

Once you understand that the trade consists of 50 one-point iron condors, then the decision becomes relatively simple.

Look at the 57/58 and the 56/57 put spreads. Which one is more appealing? The former provides a larger premium, and that is attractive when selling the spread. However, the options are also closer-to-the money, and that means there is an increased probability of incurring a loss on the trade.

The bottom line becomes: Do you feel more comfortable with the higher probability of losing money coupled with the higher reward when the trade works as hoped? Or do you prefer a bit less premium in return for a slightly greater chance of earning some profit from the trade? that is the choice and that is how you should go about deciding which trade to make.

If you like the 57/58P spread better, then trade a one-point iron condor. Go ahead and compare the two call spreads with each other and chose the one that you prefer to sell. Trade either of these iron condors: 57/58P//66/67C; or 5758P//67/78C.

If you prefer the 56/57P spread, then trade a one-point iron condor that includes that put spread and one of the call spreads: 56/57P//67/68C; or 56/57P//66/67C.

When you cannot decide; when either of these iron condors appeals to you, that is the time to trade half as many of each, or 25-lots of the two-point iron condor: 56/58P//66/68C.

Longer-term break even

It is not correct to look at the long-term situation as winning trades will always earn the maximum amount (the $1,700 credit) and that losing trades will always lose the maximum amount ($3,300) because

    –Sometimes the underlying is between the strikes (i.e., 56.25) when expiration arrives and the loss is less than the max. This does not happen often.

    –The prudent iron condor trader actively manages risk and does not allow his fate to be determined by luck. It is seldom a good idea to hold these positions until expiration arrives. Part of the time we take a large, but less than maximum profit early. At other times, we take a loss early, as a defensive measure when the risk of holding becomes too high.

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New Focus for the New Year

Welcome to 2014. It’s time for something new at Options for Rookies.

I can no longer post a daily lesson because I have run out of ideas. However, please feel free to submit a question (in the ‘Comments’ below), and the response may turn into a mini-lesson.

The focus of this blog is now going to involve

  • Replying to questions
  • Discussions of the several books that I plan to write this year
  • Tidbits about my trading activity when I believe it would be of interest

Lower Prices

Two of my ebooks (Kindle format) are now $3.99 at Amazon.com (reduced from $9.97).

Other ebooks

Pearson published two other e-books that are available at Amazon.com

Important note: Why Trade Options? is for people who know nothing about options. It discusses why anyone may want to use options and is not intended for any regular reader of this blog.

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A Settlement Question

Mark,
I have a question for you: Yesterday (Thursday), 6/20/13 the NDX closed at 2890, with settlement this morning on the opening prints. At 4:15pm yesterday the 2875/2865 bull put spread mid-price was $1.25. And just seven minutes before the close that spread could be sold for about $3.50 for only $6.50 risk.

Would it not have been a good idea to short the spread because one could keep the whopping $3.50 premium and then could hedge with futures if necessary to cover a gap down open? Would that not have been a good trade yesterday or other days before SPX or RUT settlement with high IV?

Hello James,

Excellent questions, but these are the situations that one has to fully understand before taking the risk, so I am glad that you asked.

There are two major points:

First, there is no need to hedge after a gap down. Once the market opens Friday morning, the value of NDX may change, but the settlement price (NDS) does not change. Therefore, there is nothing to hedge because the profit or loss has already been determined by that opening and you have no remaining risk to hedge. Of course that NDS value is not yet known, but will be calculated from the opening prices of each stock in the index, and announced later in the day.

Note that NDX did open lower on settlement Friday – probably because (this is merely an educated guess) that one of the major components issued bad news just after the market closed on Jun 20. The ‘whopping premium’ did not appear out of nowhere as a gift to premium sellers. Something had to cause that change in the option prices.
In other words, whatever it was that happened was expected to be bearish for NDX the following morning and the puts were bid higher (and I assume that the calls were bid lower).

As it turns out, NDS for this cycle is 2957.95*** and anyone who sold the spread that you mentioned lost the maximum. I hope this is just a theoretically question and that you did not sell any 2765/2775 spreads.

    ***I don’t know how this is possible, but when double-checking that NDS value, I discover that it is now (Jun 23, 1pm CT) listed as 2961.91, making the put spread worth $8.09. Saturday, the settlement price was much higher, indicating that the put spread expired worthless. The fact that the CBOE cannot list a final, unchangeable NDS (that’s settlement for NDX) price is very unsettling.

The true bottom line is that the sudden (after the market closed) surge in the value of such spreads should be a warning that something happened. I am not suggesting that you never make the trade that you suggested, but it is not a good idea to make it without knowing exactly what happened to cause that bearishness.

Continuation

In a further discussion I learned that James was considering adjusting the position, using futures, prior to the market’s opening on Monday. The problem with that idea is that by the time the futures markets begin trading, any anticipated decline in NDX has already been priced into the futures, and it is too late to hedge the position.

However, I have an alternative to suggest:

    Let’s assume that you wanted to sell 30 put spreads (i.e., trading the bullish put spread) and hedge with an appropriate quantity of futures contracts. How about avoiding the hedge (eliminating upside risk) and selling a far smaller quantity (perhaps 5) of put spreads? That gives you a chance to earn a decent profit, but without being concerned with hedging. That may not work for you, but it is an idea to consider.

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