Know Exactly What You are Trading

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I recently ran into an unexpected situation that affords an excellent teaching opportunity for less experienced traders.  I suspect each of you believes that you would never make that trade.  But is that true?  

The lesson here is that it's important to pay attention to parts of the trade, and not just to the trade in its entirety. It's also important to understand when it's a good idea to break a trade into smaller parts.  I am not referring to taking,legs and incurring market risk.  I am referring to situations in which one part of the trade is far more important than another part.  Example: An iron condor that must be adjusted becasue the market has soared.  It's the call spread that is of immediate concern.  The put spread should not be ignored, but there is no urgency to do anything. 

Let's take a typical iron condor situation.  The underlying asset has moved farther than you prefer, and your adjustment decision is to exit the trade.  Let's also assume you prefer to roll positions [I've blogged on the advisability of rolling positions]

Example:

a) Original iron condor:  INDX is trading at 870 and each short option is 80 points OTM.  For now, please accept the idea that this suits your personal comfort zone.  There are 60 days before expiration arrives.

b) Two weeks later, INDX has declined and is trading near 810.  Once again, assume that your comfort zone calls for making an adjustment at this point.  [Of course some would already have adjusted and others would already have closed the trade.  A third group would have no intention of adjusting this soon]

Sell INDX 950/960 call spread

Sell INDX 780/790 put spread

c) Adjustment

Obviously the risky portion of the trade involves the puts, and the difficult decision is how much to pay to get out of the put spread and which new put spread to open.  This is not the main topic for today.

The careful, risk averse trader does not allow the (currently) far OTM call spread to remain open, and exits that portion of the iron condor when closing the put side.  The big decision is whether to sell another call spread – risking a market reversal, or whether it's best to simply remain short the put spread.

There is no right answer.  Selling a new call spread gives you a more balanced (market neutral) iron condor, and who can argue with that philosophy?  However, it does give you a decent chance to get burned again, if the market turns around.  Thus, the decision of whether to sell a new call spread is important – but it's also not the topic under discussion.

d) Pay attention

Let's say you decide to roll into a brand new iron condor, perhaps choosing the same expiration (now 46 days in the future) and choose:

Sell INDX 730/740 put spread

Sell INDX 880/890 call spread

The new put spread is 70 points OTM and you feel comfortable with that.  You wanted to be 80 points OTM earlier, but there was more time remaining.

The new call spread is also 70 points OTM.  

When entering orders, the put side is the problem side.  Thus, I strongly urge you to take care of the put spread first.  How much debit you choose to pay or which specific strikes are traded is a decision-making process all to itself.

Here's the problem that can be overlooked by some traders when entering orders for trades. If you enter an order to close the first iron condor and then enter an order to open the second iron condor, you can get some very bad executions.  And this is especially true for the inexperienced trader who may not have a good feel for just how much to pay to exit the original position.

Let's say that (these are fictional numbers) you decided to pay $2.00 to roll the iron condor to the lower strike prices.  You make the trades, and paid $4.00 to exit the original trade and then collected $2.00 for the new iron condor.  For most traders that's the end of the story.  It cost $200 cash, that's your limit price, and I assume that you now have a position you like better than the original (or else you would not have made the trade).

When examining the exact prices at which your order was filled, you may discover something unsettling.  How would you feel about this trade if it turns out that you paid $0.40 to close the INDX 950/960 call spread and sold the 880/890 call spread, collecting $0.50?

Net result:  You collected $10 per spread, paid commissions on 4 options, and your safe price range has been decreased by 70 points?  Would you ever make that trade?  I hope not.  Under slightly different scenarios, you may wind up paying more to exit your farther OTM spread than you collect when selling the less far OTM new spread.

How is this possible?  It can occur when you enter the 'wrong' order.  

I recognize that you are wiling to pay $200 for this roll and you did pay that price.  Most of the time, paying the price you are willing to pay is all you need to know.  Get that price and be happy. 

But how would it feel if you tried to trade only the put portion of the iron condor and were able to make the trade by paying the same $2.00?  If you make that trade instead of buying the iron condor and selling a new one, you would be out of pocket the same cash, but you would have reduced commissions (no call spreads traded) and you would be short the 950/960 call spread instead f the 880/890 call spread.  The market may not rally during the lifetime of these options, but isn't it better to be 70 points farther OTM – at zero cost?

The lesson to be learned here is that it is necessary to consider how to enter orders when making trades.  Most of the time, the obvious approach is simplest and best. However, a situation such as today's example is an exception.

Sometimes (NOTE: This does not mean always) it's more efficient to separate the trades into (very low risk) segments. In this example, if (after taking care of the put situation) you entered a bid to buy the call spread, you may have been able to pay only $0.25.  You never know until you try.  That's better than paying $0.40.  Then you could decide whether to sell a new call spread, and if the answer is yes, you can choose an appropriate spread to sell.

Or you could have chosen to roll the call spreads, asking $0.50.  That cash credit is too low for my comfort (i.e., I'd prefer not to trade the call spread). but it's a whole lot better than collecting only $0.10.

The key to this trade, and the key to managing risk for this iron condor position, is taking care of the risky portion of the position first.  Thus, entering an order to buy one put spread and sell the other is far more important than worrying (at this point in time) about the call spread.  Take care of the puts – paying an appropriate price.  Then go after the call spread.  You may decide not to bother with the calls because you can get so little cash for rolling.  This method costs nothing and can easily prevent making a bad trade.

768

6 Responses to Know Exactly What You are Trading

  1. Rajesh 08/20/2010 at 9:45 AM #

    Excellent article! I think you put a lot of thought into the articles that you write and make inexperienced option traders think about so many different aspects of options trading that one may not think about. I remember one time when I was automatically closing out some puts that had lost most of the value after I had bought them and were available very cheap and quite OTM with a few days left to expiration. So without thinking much I hastily sold them for a meager price with a relatively higher commission broker and found out to my chagrin that I ended up paying a small amount for the pleasure of selling the puts. Felt like an idiot for many days!
    Thank you again for taking the time to discuss not oft discussed topics

  2. Mark Wolfinger 08/20/2010 at 9:52 AM #

    Hello Rajesh,
    That’s the goal. To recognize that there’s much more to the trading process than one sees at a glance.
    The problem is present this (sometimes complicated sounding) information and be certain it’s not confusing.
    Thanks for sharing your experience,
    Regards

  3. Kim 08/20/2010 at 1:20 PM #

    Mark,
    Each of your posts is a real gem. I learned so much from you, and I’m really grateful. Many people wouldn’t even think about the whole idea of closing the spreads early (the usual argument is “they are so far OTM, why bother?”). I learned the hard way that the only thing you should take care about is risk management. If you do it properly, the profits will come almost automatically.

  4. Ann 08/20/2010 at 1:43 PM #

    Im looking to sell puts on the IWM for Sept around 58. There are Sept10 options and QSept10 options showing. The Sept10 58’s are selling around 1.29 and the QSept10’s are selling around 1.78. I assume the Q means they are quarterly options but if I am wanting Sept expiration anyway would there be any reason not to sell the QSept since they are at a higher premium? Im sure I am unaware of something. Do they expire differently?

  5. Mark Wolfinger 08/20/2010 at 2:13 PM #

    Kim,
    Thanks so much.
    It’s true. However, some things must be learned the ‘hard way.’ I guess that’s the way people are wired.
    Thanks for sharing your thoughts.

  6. Mark Wolfinger 08/20/2010 at 2:28 PM #

    Ann,
    The quarterlies expire on the last trading day of the month, Sep 31. Thus, they have a longer lifetime.
    The difference in premium is simply a reflection of that later expiration date. I see nothing wrong with trading quarterlies, but be certain that the bid/ask spreads are not so wide that if you are forced to exit in a hurry, it may be difficult to get a better execution price.
    Unsolicited comment: Those are very close to the money puts. I assume that means you are bullish.
    Thanks for asking