Q & A. Is Trading Iron Condors No More Than Gambling?

Hi Mark,  

Hope the trading is going well.  I've visited your blog from time to time and always enjoy the way you explain the world of options, especially when it comes to iron condors. It is this topic I am writing to you about, as I have been trading these for quite some time and find they compliment my trading style.

Whenever I discuss my options trading with others I tend to find myself justifying the way I trade options.  This isn't a concern to me as I am confident in how I go about my business and don't feel the need to argue my case. However, a recent discussion I had with a trader who works as a broker for a large trading firm was insistent that all the "pro traders" trade volatility only and go either long or short volatility and believe credit spreads, condors, butterflys etc… is just gambling.  

Seeing that you have been in the business a lot longer than myself and have also been a MM and now educator, I would like to know how you view this argument and how you would respond?   I value your opinion and would appreciate any feedback.    

Thanks,

HS

***

It's reasonable for different people to have different points of view on specific issues.  Politics, for example.

Some situations are known to be true, based on a large amount of evidence.  Yet there are those who choose not to believe the evidence and form their own conclusions.  The fact that global warming is a result of human actions, for example.

Is trading iron condors gambling?  I don't believe that there's room for two positions on that issue, but it requires a lengthy reply.

  • All attempts to make money by buying something (or selling it short) and then selling it to someone else at a higher price, is gambling.  After all, there's no guarantee of earning a profit (winning the gamble) and there's always a chance of taking a loss (losing the gamble).  That seems to be a good definition of gambling.
  • If you buy a poker hand, a parimutuel ticket (horse racing), some real estate, art, stock or option, you are – by definition – gambling.  Real estate agents charge enormous fees, auction houses charge fees to both the buyers and sellers, stock brokers charge smaller fees, while others (race tracks and casinos) take part of the pot.  Those fees reduce the chances that you can win.  But, despite the odds, we play.
     
  • We invest.  In fact, the prudent investor rule is a legal doctrine that guides investment managers, and one of its tenets is that the prudent investor should own a diversified stock portfolio.  There's virtually no one who would suggest that it's right for the prudent investor to gamble, and investing in the stock market is accepted as an intelligent and necessary thing to do.
  • Some gambles are simply bad bets – buying a lottery ticket for example. 
  • Here's a question for the trader who challenges your investing choices:  Is it gambling to buy stocks?  You say he is a broker for a large trading firm.  I doubt he will tell you it's gambling to own stocks.
  • If you own stocks, my opinion is that owning collars is a conservative, intelligent option strategy for investors who prefer to concentrate on preservation of capital, rather than on maximizing profit potential.  Ask your broker buddy what he thinks of collars.  If he has any understanding of collars, he will give that strategy a vote of confidence.  If he doesn't, then there's not much you can say.  You can try to learn why he disapproves of a conservative strategy that is as far away from gambling as an option trading individual investor can get.
  • If he agrees that collars are a conservative play (and not gambling), then you've got him.  The put credit spread (of which he disapproves) is a collar – i.e., it's equivalent to a collar and has the same risk and reward profile.
  • Selling a put spread is part of an iron condor.  The other part is selling a call spread, and that's equivalent to selling a collar.  Thus, your so-called gambling trades are composed of buying and selling collars – one of the most conservative option strategies available.  If your trader tries to tell you that collars are ok, but that iron condors are a gamble, then be prepared to wow him by whipping out pencil and paper and proving that an iron condor is just two collars (If you require help, post a request).
  • And here's some news you can share with him:  Not all professional traders trade volatility, and only volatility.  That's a very risky business – in other words, it's gambling.  The volatility swings of 2008 offer proof of just how right you must be when 'playing volatility' – or else you can get clobbered.  I no longer have many ties with professional trading firms, but the two with whom I have ties trade neutral – all the time.  And that means delta neutral, gamma neutral, theta neutral, and vega (the volatility component of an option's price) neutral.  They do NOT get long or short volatility.  That's just too much of a gamble.

Thus, if we ignore the fact that many of our activities are a gamble (walking across the street involves the risk of being hit by a bus or car), and that prudent investing represents an acceptable level of gambling, then any option strategy becomes more of a gamble when the trader ignores risk.  Thus, my assertion that trading iron condors is not gambling is based on the assumption that the trader has good risk management skills. 

P.S.  Let me know how the conversation goes.

214

8 Responses to Q & A. Is Trading Iron Condors No More Than Gambling?

  1. Bob 01/16/2009 at 11:56 AM #

    Hello,
    I’ve been reading your posts and appreciate what you do to educate us about options. Regarding a recent post, and at the risk of asking a dumb question, how are profits generated by trading neutral? Is it by premium decay? Could you provide some details in your blog and are the profit possibilities available by trading neutral addressed in your book? Thanks for any info.
    Bob

  2. Mark Wolfinger 01/16/2009 at 1:09 PM #

    Bob,
    That’s an excellent question. I never realized that being ‘neutral’ in an attempt to make money – is something most investors never consider. The norm is to be long, or occasionally short.
    Yes. The profits come from premium decay.
    The idea when selling a credit spread (so-named because you collect cash) is for the stock price to move (or remain) away from the strike price of the option you sold. As time passes, the options lose value. Because you sold the higher-priced option, it loses value faster than the option you own. If you hold through expiration, and the options expire worthless (that means out of the money), you keep the entire premium as your profit. You may also buy back the spread before expiration when you so choose. That can result in a profit or loss, depending on the price paid. Yes, The Rookie’s Guide to Options discusses profits, but per your question today, I’ll beef up that discussion when the book is updated. Thank you for the idea. I will dedicate a blog post (soon) on profit possibilities and how to collect them. I’ve written about credit spreadsbefore.

  3. Bob 01/16/2009 at 2:14 PM #

    Mark,
    Thanks for the response. I’m looking forward to your follow-up. I’m realizing that the Wall Street Machine prefers that people must be long to profit but exploiting probabilities and using risk management can be a better way to go.
    Bob

  4. Mark Wolfinger 01/16/2009 at 3:34 PM #

    Unless you are in a surging bull market, the individual investor would be better served by adopting option strategies.
    Unfortunately, too few professional advisors see it that way and options are available only to those who make the effort to learn about them.

  5. Tyler 01/17/2009 at 1:56 PM #

    Mark,
    Great Stuff! Thanks for all the informative posts. Just had one question for clarification on the neutral trading. You mentioned the trading firm is always neutral (delta, gamma, vega, and theta neutral). In you’re response to Bob’s question, you mentioned they make money based of premium (time) decay. Would this imply that there positions/portfolio is positive theta, not neutral? Thanks!
    Ty

  6. Mark Wolfinger 01/17/2009 at 10:07 PM #

    Ty,
    In response to Bob, I was explaining that credit spread and iron condor traders make money by benefiting from time decay. I trade those strategies.
    But those are NOT neutral strategies. The trading firms I mentioned would never hold a portfolio of those spreads.

  7. Tyler 01/17/2009 at 10:53 PM #

    Mark,
    Thanks for the reply. The other thing that is stumping me is assuming a portfolio is neutral on all the greeks, how would it make any money? I understand that by neutralizing the greeks, we’re essentially neutralizing our risk. But wouldn’t the flip side to that be that we can’t make any money either?
    Ty

  8. Mark Wolfinger 01/18/2009 at 1:18 PM #

    1) Those ‘all neutral’ methods are NOT for you. Don’t even think about trying to generate income for yourself along these lines. For us, we must take some risk. We minimize and manage risk, but we cannot afford riskless trading.
    2) That method is for HIGH volume traders, with on floor representation – i.e., market maker or trading firm that is represented on the exchange floor via computer.
    3) They get to buy on bid and sell on offer. That gives them a theoretical edge on a trade.
    4) They have computers manage their portfolios. They have computers manage their bid and ask for all options. Thus, if they make a trade (with edge) that has negative gamma, the computer finds a good way to get some positive gamma without upsetting the values of the other greeks. It may raise the bids of several options – giving them a better chance to buy. It way raise the offers of some options, so they won’t be selling more of those (yet). It’s sophisticated, proprietary, and not for you or me.
    5) they trade big size for tiny profits per trade. This is NOT for you.
    6) And I’m sure they do other stuff of which I am totally unaware.