OTM spread prices

Mark,

Interesting discussion.

Maverick talks about the fair value of the vertical spreads. I have been wondering about that recently.

For a real life example, at this moment (Dec 14) the Jan SPY 119 Put and the Jan SPY 128 Call both have a probability of expiring in the money of 25%. Yet the Jan 119/118 Put spread is about $0.17, and the Jan 128/129 Call spread is $0.25.

I would have expected that with both short strikes having the same probability of expiring, the vertical spreads would cost about the same, but this is not the case. Furthermore, it seems to me that the Call spread is probably reasonably priced (25 cent credit for 25% probability of expiring) but the put spread offers a poor reward for the amount of risk entailed when selling.

I am guessing that trading this condor or its equivalent would probably be a losing proposition over the long term, for the reasons Maverick points out.

sandeep

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s,

I agree that opening iron condors and ignoring them is probably a losing proposition.  However, no serious trader should do that.  It's pure gambling.  And that's okay for gamblers, not for traders.

When you own investments of any type; when your money is at risk as you seek to earn profits, closing your eyes and hoping that all will be well is simply not viable.  Note to passive investors:  You rebalance portfolios periodically, and thus do not completely ignore your holdings.

Iron condor trading requires active risk management, and that completely changes the odds of success.  So Mav may be theoretically correct, but in practice, a skilled risk manager can take care of business and earn money.  But I must emphasize that it is not a simple task.

 *

I am finding it very difficult to find the words to reply to your observation.  Let's try this:

The Jan 119P and the Jan 128C may each have a 25 delta, but the Jan 118P and the Jan 129C do not have the same delta.  In fact, the Jan 118P delta is more than two points higher than that of the Jan 129C. That affects why the spreads are not equally priced.

Let's consider looking at this from another perspective. Think of the SPY iron condor as positions in two different, but 100% correlated stocks: SPYC for which we sold a call spread.  Also SPYP for which we sold a put spread.

My explanation:

  • SPYC trades with a lower implied volatility than SPYP
  • The two stocks have an identical historical volatility (because each is really SPY), but history tells us that SPYP options are more valuable than SPYC options.  How is that possible?  SPYP put options have undergone huge price surges more often than the call options of SPYC.  SPYC option holders occasionally earned large profits, but that's the result of slow and steady movement in the price of the underlying stock – and not from sudden, large price changes.  Thus, when looking at options that are equally far out of the money, puts trade at higher prices than calls because both buyers and sellers know that there's an added chance for a big price change.  That's why there is a volatility skew
  • The volatility skew results in lower struck options having a higher implied volatility than higher struck options
    • Volatility skew is not linear, but the trend continues through the entire string of options.  The term 'volatility smile' refers to that non-linearity
    • The difference in implied volatility between the two calls (0.50) is less than the difference in implied volatility between the two puts (0.70)
    • That extra 0.20 volatility point difference boosts the price of the farther OTM put compared with the call [i.e., the put is closer in value to it's neighbor than the call]
    • Thus, the put spread is narrower and the call spread is wider
    • We did not use equidistant calls and puts in this discussion.  Instead we worked with equal delta calls and puts, but the reasoning is identical

    856



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    10 Responses to OTM spread prices

    1. sandeep 12/17/2010 at 8:21 AM #

      Thanks Mark, that is a very logical explanation. On another note that we had discussed earlier, SPY is ex-dividend today and it is indeed trading lower by the amount of the dividend in pre-market trading as one would expect.

    2. Mark Wolfinger 12/17/2010 at 8:54 AM #

      sandeep,
      Glad that’s cleared up for you.

    3. Antonio 12/17/2010 at 9:52 AM #

      Hi Mark
      Thanks a lot for your clarificaions about DaveĀ“s comments.
      Please, looking to open ICs in this low volatiliy enviroment, should be prudent tu open instead of a 90 days IC a 60 or a 40 IC askinkg for less credid or do you see OK a long time IC?

    4. Bruce 12/17/2010 at 11:06 AM #

      On a related note, I’m wondering about the wisdom of opening ANY IC’s given the current IV of around 16 which is extremely low by most standards, right? Mark, how much risk does an Iron Condor trade face if volatility went up to, say, 25 within the next 60 days? 90 days?

    5. Mark Wolfinger 12/17/2010 at 11:31 AM #

      Antonio,
      Dave notified me that my original interpretation was correct.
      He shuts down his trade when the loss reaches 33% of the maximum possible loss. In this case the max gain is $300 and the max loss is $700.
      He exits when he loses $233
      Yes, 60 day IC seems better to me when IV seems to be low. It may go lower, but who knows?

    6. Mark Wolfinger 12/17/2010 at 11:35 AM #

      Bruce,
      Complex question. By the time those 60 or 90 days pass, the iron condor opened today will have already expired.
      Thus the problem is a more rapid increase in IV.
      I cannot tell you the answer because it is trade specific. But if you are short 100 vega and IV moves from 18 to 25, all else being equal (which it never is), the loss (from vega) should be roughly $700.
      Of course you would earn something through theta and may lose something through negative gamma (presumably something happened to cause IV to move so quickly).
      IC is not for all market conditions. Alternative spreads may have a better chance of working well. However, if you abandon IC for the time being (I see nothing wrong with doing that), don’t just jump into some other play without having a good understanding of how that strategy works. Paper trade, if necessary.
      Thanks

    7. Robert 12/19/2010 at 6:44 PM #

      Hi Mark,
      I am inspired by your ‘Options for rookies’, I love this book. You are teaching in this book about selling CSP in anticipation to buy stock at desired price, lowering your effective price.
      I have a question regarding this subject, namely selling cash covered puts and covered calls.
      Let’s say that you want to buy a stock you want to own and the price is approaching support level, you sell puts, strike price is close to resistance. Few days later the price dropped below and you are assigned, this is fine you own half of what you intended to buy. Unfortunately price keeps falling, you still want to buy additional half of the shares but you also want to lower your price and add options selling to accomplish that. I understand that you can sell calls on your shares and sell twice the number of puts. Question I got is how to manage this trade, at what price to sell calls and puts? At the same time? At the same price? Could you please explain this to a rookie?
      Thanks,
      Robert

    8. Mark Wolfinger 12/19/2010 at 10:03 PM #

      Robert,
      Thank you. Writing cash-secured puts is a worthwhile strategy – only if you are truly willing to buy the shares.
      1) You won’t be assigned so quickly. Do not expect to be assigned an exercise notice prior to expiration, unless the put option moves very far ITM
      2) I’d like to provide enough details for you to have a good understanding – but I can tell you now that this is not an exact science. There are going to be choices for you to make.
      I’ll post a complete reply this week – probably Wed.
      Regards

    9. Robert 12/20/2010 at 11:31 AM #

      Hi Mark,
      Thanks for taking up this issue. I burned my hands trying to do it (although it is not a financial but emotional disaster), the strong support was not strong at all, I waited too long through expiration and was assigned instead of taking loss and buy the puts back.
      At some point I should (after I realized that the decision was wrong, and the shares went down a lot) either close this position or roll it down.
      I hope that there is a way, to write calls and puts at the same time to make recover some of the losses.
      Regards,
      Robert

    10. Mark Wolfinger 12/20/2010 at 11:38 AM #

      Robert: i want to follow your issue because I believe it is important.
      But look at this from the perspective of other readers: Look at your comment above. How is anyone going to know what you are talking about? The answer is that it is not possible.
      It is too soon to discuss this issue further. Let’s wait until the post appears Wed, if you don’t mind.
      Thank you