Profiting From Market Neutral Strategies. Part II

It's a historic day in our nation's history, but the markets are open and our trading lives go on.

When an individual investor adopts a market-neutral strategy, most of the time the investor is looking for a non-volatile stock market.  Unlike the professional trading firms that abhor risk and try to be neutral with respect market movement, time passage and volatility changes, to the trader, 'neutral' most often refers to being 'delta neutral.'

Of the six basic strategies that I recommend, only one is  established with zero net delta: the iron condor.  Not everyone wants to be neutral.  In fact, most traders have a market bias and intentionally choose strategies that are far from neutral.

In response to Bob's question about how the trader earns money from such market-neutral spreads, let's take a closer look at an iron condor.

Let's say an index is trading @ 609 and you want to trade an iron condor that expires in March and that the options you sell are far enough out of the money that they each have a 10 delta. [Please do not take this as a recommendation to use a 10 delta.  For some that's too high, while for others it's far too low.]

Next you choose the options to buy, and for the sake of simplicity let's assume you buy calls and puts that are 10-points further out of the money than the options you sold.  This spread is going to be near delta neutral.  If you truly want to be exactly delta neutral when this spread is originated, you can sell fewer of one spread than the other, to balance delta.

Example:  Let's assume the Mar 670 call and the 530 put have delta of 10 and -10 respectively.  Let's also assume that the Mar 680 call has a delta of 8 and that the Mar 520 put has a delta of -8.5.

If you construct an iron condor consisting of 10 of each of those four options, then you would be short 20 delta on the call side (10 x 2) and long 15 delta (10 x 1.5) on the put side.  To balance the iron condor, you don't have to sell 10 call spreads and 10 put spreads.  If you sell 4 put spreads for every 3 call spreads, you would begin delta neutral.

I don't recommend doing that.  My personal comfort zone calls for an equal quantity of call and put spreads.  But, if your comfort zone is better satisfied with unequal quantities and buying equal delta, then do it that way.  There are no strict rules (here are my 4 basic rules) when trading options – except one: Do not take on too much risk.


Show Me The Money

To this point, I have not discussed how to make money.  When you trade an iron condor (sell call spread plus sell put spread), you collect a cash premium.  The goal is for that premium to decrease so that you can close the position by paying far less than you collected.  Sometimes the options expire worthless and you keep the entire premium.

The idea is for time to pass and for the underlying asset to not move beyond (or even near) the strike price of either option you sold.

It's best when nothing extraordinary occurs.  That means the implied volatility (IV) of the options should be relatively unchanged as time passes.  If IV increases, your iron condor position loses money (premium increases).  That occurs because the options you sold, being closer to the money (price of underlying) increase in value by a larger amount than the options you own.  That makes the call spread and the put spread worth more, and because you sold those spreads, the position loses money.

On the other hand, if IV decreases, the spreads you sold lose value and the premium of your iron condor position decreases, and become more profitable.

As time passes, each of the four options that comprise the iron condor decay – that means each option has negative theta and loses some of its time value as the clock ticks.  Because you sold options with a higher value and a higher delta, they lose value more rapidly than the options you own. Thus, the passage of time is your ally.

It's very uncomplicated.  You sold options and you make money as time passes – as long as the underlying asset doesn't make an unfavorable move.  And I must tell you – it does make such moves.  If you sell calls and puts and each has a 10 delta, there's a 20% change that one of those options will be in the money when expiration rolls around.  Do not just buy iron condors and shut your eyes.  Careful risk management is necessary for long-term success.    

Back Spread

An exception to this discussion is the back spread: The trader buys more options than he/she sells.
 

Example:  Buy 20 XYX Apr 90 calls and sell 10 XYX Apr 80 calls. (Delta neutral)

If the underlying asset makes a giant move – to 120, for example – in the direction of the extra long options, then the profit can be substantial. 

The passage of time is the enemy of the back spread.

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