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.
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:
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.
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.
Tuesday October 27, 2009 at 6:00 PM (Eastern Time).
Title: Collars; Combining Covered Calls and Married Puts
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