Ligntning round: Questions answered

Hello,

I hope you remember me. I wrote to you in June
and got advice as to what a “straddle” was and I have another
question. 

Say I buy a stock selling for $4 and sell to open, a covered call with a $5 strike and collect $1.80; and sell a naked put for $2.40.  Is my math correct
in that I would profit $.20 for buying it?  Basically refunding the cost of the stock to my account to
reinvest while at the same time, my maximum risk would only be $.80 (i.e.
$5.00-$1.80-$2.

RB

***

Yes, I remember your question.

If you sell the straddle and collect $4.20 – all I can say is that this is one volatile stock. 

Yes.  If the stock rallies and you are assigned an exercise notice on the
call option, you have a big profit.  Your net cost is negative 20 cents
(you are correct) and you sell the shares @ $5.  Net gain $520.

If the stock tumbles to zero, you are correct again in that you only lose $80
on the straddle.  But you did buy 100 shares, paying $400.  So that
cash is also lost.  Maximum loss at bankruptcy:  $480.


Hi Mark,

Why do you prefer trading RUT over other indices eg. QQQQ? (do you really trade RUT only?)


Thanks, Deb


Hi Deb,


It's not that I have a big preference for RUT, but I prefer to trade a bunch of different positions in a single underlying. By doing so, I find it much easier to manage position risk because there is only a single set of Greeks to follow – instead of a set of Greeks for each underlying.

I want to use cash-settled options, so chose an index.
I'd prefer to trade SPX, but find the markets too wide and it takes my broker too long to let me know about being filled on my orders.
RUT is more volatile than SPX, but at least it satisfies my other needs.


Mark,


Is it a bad idea to trade options when the bid/ask spread is wide? Should these options be avoided?

WW

It's true that you should prefer to trade options with tighter bid/ask spreads, but don't let the wide spreads bother you.  You can do a simple test to learn whether the these options are worth trading.

Ignore how wide the market is and focus on the midpoint between the bid and ask prices.  When buying, bid 5 or 10 cents over that mid-point.  Only go as far as 15 cents if you are anxious to make the purchase.

Over a couple of days and a few attempts to buy and sell options, you will discover whether the traders of these options are willing to bend, or if they stand firm and only trade at their prices.  When none of your bids or offers is taken (single orders or spreads), give it up and find a different underlying asset to trade.

It's not the wide markets that's the problem.  It's the true market – and you cannot discover what the real bids and offers are, until you try to locate them by entering an order.

473

15 Responses to Ligntning round: Questions answered

  1. spreadcoach 10/05/2009 at 9:18 AM #

    Hi Mark,
    you said:
    “I want to use cash-settled options, so chose an index.”
    I’m working SPY options and I find those cheaper to trade that index options (narrower spreads).
    What do you thing about it?
    Thanks in advance.

  2. spreadcoach 10/05/2009 at 9:20 AM #

    Sorry, I forget: Why cash-settled options preference?

  3. Mark Wolfinger 10/05/2009 at 9:31 AM #

    Good question,
    Expiration:
    a) It’s my preference to not get involved with early exercise and assignment. That would be no problem, but prefer to avoid it.
    b) Cash-settled options are also easier to handle at expiration. The positions close automatically (although I never hold that long) and I don’t have any residual position to handle. Again, not important, buy just easier for me.
    Size:
    a) I would rather trade one SPX (or RUT) spread than 10 SPY (or IWM) spreads. The commissions are much less.
    b) If your account is not large enough to accommodate more than one or two index options, then adjustments are almost impossible because you cannot trade a fraction of an option. Thus, to make adjusting easier, it may be preferable to trade 20 SPY rather than 2 SPX.
    SPREADS
    I find that RUT options have a narrower spread than IWM – when you consider than it takes 10 of the ETF options to approximate one index option.
    Those are my reasons.

  4. spreadcoach 10/05/2009 at 10:24 AM #

    Mark, let’s see the numbers:
    10 SPY Options cost : ($0.7 comissions + $0.75 spread) x 10 = $14.50
    1 SPX Option cost : ($1.26 comissions + $15 spread) x 1 = $16.26
    And you know that is more reliable the SPY spread cost ($0.75) that SPX spread (more wide and hard to fill good trades)
    About cash-settled options, working OTM options, I don’t understand you: I don’t mind about early exercise, assignment or have to handle at expiration with these OTM.
    I guess it is a personal preference, but I don’t understand it.
    Regards from Spain,
    (my apologies for shakespeare’s language use :))

  5. Antonio López 10/05/2009 at 2:44 PM #

    Hi Mark, may be too many spanish here¡¡¡
    Cuold you explain with other words the reasons you don´ty trade SPX, plase.
    Regards fron Spain,
    Antonio.
    Tambien saludos para spreadcoach

  6. greg 10/05/2009 at 6:15 PM #

    Mark – can you give us an idea of the multiple strategies that you would have on a single underlying at the same time. I can see how you might have an Iron-condor and a vertical with insurance on both but would you add even more… I am trying to visualize even more? Do you run multiple IC’s with varying strikes or? Or are you running on multiple months?
    Just trying to understand how you would put a portfolio together from a risk point of view.
    Thanks

  7. Mark Wolfinger 10/05/2009 at 11:13 PM #

    SC,
    1) Yes, SPY trades are easier to execute.
    2) But what do you mean: “$15 spread”? The bid/ask diference is far less than $15. I just don’t know what you are telling me.
    3) When trading SPX, or any other option, you should never pay the ‘sask’ price when buying. You should never sell the ‘bid’ price when selling. If you enter a bid price that is a little above the mid-point, you should be able to get a fill. But “$15”??? I do not understand.
    4) OTM options are never exercised. When I mention ‘early exercise’ I am talking about options which may have been OTM earlier, but which are noe deep ITM.
    5) When you sell an OTM option, does it always stay OTM? Does SPY never move too far? Don’t your OTM options ever move ITM? Those are the options I am talking about. Those are the options that may be subject to early exercise.
    6) Do you understand now? Please tell me.

  8. Mark Wolfinger 10/05/2009 at 11:17 PM #

    Antonio,
    1) SPX markets are difficult to trade. RUT markets are easier to trade, but RUT is much more volatile, and that means more risk.
    2) My broker alwyays gave me very slow fills when I trade SPX. It took 5 minutes to learn that the trade was made. 5 seconds is far too long. 5 minutes was not anything I could accept.
    3) If your broker does a good job with SPX options, then you should use them. Mr broker (InteractiveBrokers) makes it impossible for me.

  9. Mark Wolfinger 10/05/2009 at 11:33 PM #

    1) Multiple months. I never add to front-month posiitons. I only reduce or close them.
    2) Right now, I am almost out of Oct. Have finished with Nov, and am adding some December.
    3) I buy an iron condor. Not full size. A week or so later, I add more. If the market moved, I will trade different strikes.
    4) When I open the iron condor, I usually add insurance.
    I also add new insurance as time passes – if I feel I need it. If the market ralleis, I like to buy one put and sell three (or four) farther OTM put spreads.
    On declines, I do the same with puts. It costs some cash, but makes everything safer and lets me use my positive gamma successfully.
    With that gamma, I also sell call spreads on rallies and put spreads on dips.
    5) Not doing it now, but could also add double diagonals at any time – that’s the equivalent of iron condor plus double calendar.
    6) It’s somewhat of a mess. Very difficult to manage each spread by itself – and I make no effort to do that. However, if part of an iron condor is threatening to move ITM, I usually adjust it – and at the same time, I unload or adjust some of my insurance options. Hopefully colecting enough cash to pay for the adjustment. But if there is not enough cash, that deos not prevent me from making the adjustment.
    Example: If I own the 700 calls in some index, and that index has moved to 720, I can take a profit in some of those 700 calls by selling the 700/710 or better yet, the 700/720 call spreads. I still own protection – and take a bunch of cash out of the trade.
    At the same time, if I am short the 730/740 spread, I may decide to cover all or part of those. Yes, at a loss – but all, or most of that loss is offset by the profit in the 700 calls that I bought earlier.
    No set rules. Just looking to stay OTM with short spreads; take cash from naked longs; own a position with positive gamma – but with small negative theta. You must decide whether collecting theta – as all premium sellers like to do. But, you may be willing to sacrifice some or all of that theta for a black-swan protected portfolio.
    Bottom line, as long as I trade a single underlying, the Greeks are esy to manage: either all in a sigle package, or each expiration month by itself.

  10. Mark McCracken 10/06/2009 at 10:29 AM #

    MW: “4) When I open the iron condor, I usually add insurance.
    I also add new insurance as time passes – if I feel I need it. If the market rallies, I like to buy one put and sell three (or four) farther OTM put spreads.
    On declines, I do the same with puts.”

    Is there a typo here? During a rally, do you buy one put and sell 3-4 OTM CALL spreads?
    I’m just trying to understand whether you are fading the move or following the trend of the move – as an option seller, it seems most likely you are fading the move, but I want to be sure I understand.
    Thanks.

  11. Mark Wolfinger 10/06/2009 at 10:55 AM #

    No. The typo is that on declines, I do the same with CALLS.
    With these trades, I am fading the move, using the positive gamma to buy a few deltas on declines and sell a few delta on rallies.
    Buying (for example) one 700P and selling 3 times as many 670/680 put spreads affords downside protection and the only risk of loss is the debit paid for the spread. It’s a cheap way to own ‘good’ puts and calls – and by that I am referring to the fact that the options I buy are not as far OTM as my shorts.

  12. Mark McCracken 10/06/2009 at 11:25 AM #

    Huh, OK… now I’m really confused, so let me check with my own example:
    You have a 670/680/720/730 iron condor which you entered when the underlying was at 700. Let’s assume no insurance after the initial position entry. Now the market has rallied to 715.
    You would sell more put spreads, “farther” OTM? So, like, 650/660? Seems like the gamma from these would be pretty tiny, since they are now 6-7 strikes out of the money. Wouldn’t fading the up-move mean that you want to sell some (slightly less than previously) OTM call spreads, hoping to profit from the drop in gamma when the underlying moves back down again?
    The reason I’m beating this expiring horse is because I’m trying to develop my own risk-management style, and common sense tells me that I want to sell call spreads (and close put spreads) into a rally, and sell put spreads (and close call spreads) into a decline. By selling higher-priced-strike call spreads as the market rises, I am basically betting that it will reverse – fading the move.
    It feels like doing the opposite, selling far OTM put spreads after a rally, is giving you a high-probability position with a terrible payoff. What do you expect to get out of those OTM put spreads after a rally? 20c? That gives you 80c you could lose if the market reverses. That doesn’t feel like fading the move to me – it feels like following the trend.
    I have to admit I’ve only been reading your blog for a few weeks, and your use of insurance hasn’t really clicked for me yet. So I’m sure I’m missing something important, here. If you’ve previously discussed it, please don’t be afraid to just say “go look at my 10/6/04 blog post” or something and I’ll go do my homework instead of taking up everyone’s time in the comments.
    Thanks again.

  13. Mark Wolfinger 10/06/2009 at 11:38 PM #

    Mark,
    I replied to this question, but it seems to have disappeared.
    Very strange. I’ll try again.
    1) Farther OTM refers to the put option just purchased. It has nothing to do with original iron condor.
    2) In your scenario, I would:
    a) buy one 700 put
    b) Sell three 670/680 put spreads.
    See: http://tinyurl.com/kr4h8f

  14. Mark McCracken 10/07/2009 at 8:35 AM #

    Mark:
    Thank you. I think I finally get it, but it took re-reading your linked entry, and then some time with TOS’s position analysis tool. I put on an OEX iron condor “approaching trouble” (Dec 440/450/490/500 x5, OEX=488), and then added a long call (x1 Dec 490) and the credit call spreads (x3 520/530). I opted to hold the 490 call, but moving it ITM-OTM had no major effect on the shape of the graph.
    After puzzling over this analysis graph for a while, I finally figured out why I’m having so much trouble understanding your insurance style. I tend to think in terms of the p/l at expiration rather than the current open p/l. This is simply because until very recently all my option trades were one-legged [gamble] plays and I had to do the valuations in my head. Mental calculations are much easier with hard corners than curves. You, on the other hand, [almost] never hold until expiry, and your positions max out at least a month or two prior to expiry. That gives you a very smooth open p/l curve, which you use instead of the expiry p/l line to value your position.
    When I stopped focusing on the saw-tooth pattern made on the right side of the condor by the expiry p/l, and instead focused on the nice smooth inflection curve of the open p/l, it finally clicked. Now I have a lot more homework to do!
    Thank you very much for your patience and persistence.

  15. Mark Wolfinger 10/07/2009 at 8:54 AM #

    Mark,
    I’m sure you are aware of this, but just in case: OEX options (in my opinion) are the least desirable index options to trade. There is the possibility of an early exercise – and with cash-settled American style options, that can represent a big risk.
    You are very welcome. Hope this information proves to be valuable.