Q and A. Choosing Strikes; Iron Condor vs. Double Diagonal

Finishing Josh's lengthy set of questions:

Third, how do you pick the strikes for your positions? Do you use the delta of the short option? Do you look at chart support and resistance?

Fourth, though it seems that you mostly trade RUT, I wonder if you have a comment on why most people trade index ETF ICs (IWM, QQQQ, SPY, DIA) with two point wide spreads. I understand that one wants the hedge (the long strike) to move along with the short, and that two point is an effort to save on the commission that one would need to get the same credit for one point wide strikes, but why does everybody use two points, why not three? What I really want to know is is there a mathematical reason for this? Or is it just custom?

Fifth, you seem to talk mostly about ICs on the blog. I have asked you about calendars before and you said that you did not trade those very much, but I think you have mentioned that you trade double diagonals. If possible could you give a bit more information on how you trade double diagonals.

***

The Rookie's Guide to Options contains a discussion on strike selection, but I don't have iron clad rules.  If you are a user of technical analysis, then by all means sell calls just above resistance, and puts a bit below support.

My method – again, this suits my comfort zone – is to go as far OTM as possible when choosing options to sell.  But, I have a minimum $ requirement when selling 10-point wide RUT call or put spreads.  I try to collect $300 (for the whole iron condor) as a bare minimum for 12-13 week spreads.  That works out to a potential profit of $100 per month.  I don't hold long enough to collect all of it, but that's how I choose my strikes.  

Traders who prefer to trade options that expire sooner (and that's the majority of iron condor or credit spread traders), have their own methods, but I believe it's a bad idea to sell spreads for small premiums. 

 

I don't know where you get the data that 'everyone' uses two-point spreads when trading ETFs, but when trading, the options must be sufficiently far apart to allow you to collect a decent credit when selling.  It may be okay to trade an index spread for $150, hoping to make $100, but selling a QQQQ spread for 15 cents, hoping to earn a dime, is commission intensive and much more difficult to accomplish.

ETF traders may like the idea of tighter bid/ask spreads.  But, if an option with a strike price of 500 had a bid/ask spread of $1, that's the same as trading an option with a $50 strike and a 10 cent bid/ask spread. 

The advantage to choosing two-point spreads, rather than three, may simply be that three-point spreads make the options either too close to the money or too far OTM.  I know of no other edge.

I prefer European style index options and that's a big part of my decision.  ETFs are Amerian style.

I trade double diagonals ONLY when I feel IV is low enough so that there's little risk that it will go lower.

Others may trade the DD when looking for IV to be increasing over the lifetime of the position.  Because I prefer to predict as little as possible, and because IV is so much higher than it was just a year ago, I may not be using DD any time soon.

I choose my strikes as with iron condors.  I keep the difference between the calls (also the puts) as tight as possible (20 or 30 RUT points for calls and 30 or 40 for puts) – plus, I avoid paying a big (a relative term) debit for the DD.  That means I'm shut out when IV is high.  Your comfort zone may allow you to play in today's environment.  Mine doesn't.

241

2 Responses to Q and A. Choosing Strikes; Iron Condor vs. Double Diagonal

  1. income trader 02/11/2009 at 3:18 PM #

    Hi Mark,
    Just a point to add to your answer of Josh’s questions.
    There are some important tax considerations to trading the index as opposed to the ETF equivalent whenever possible. It has to do with the way the IRS categorizes broad based index options (RUT, SPX, etc) and equivalent ETF options (SPY, DIA etc).
    Index options settle in cash and therefore are not considered securities (as far as the IRS is concerned)whereas ETF options do settle in shares of a security and therefore are taxed as such. Short term cap gains on ETF index options are taxed as 100% short term capital gains. The index cash settled options are taxed 60/40 short/long term cap gain rates.

  2. Mark Wolfinger 02/11/2009 at 7:06 PM #

    Good point, and 60/40 is beneficial to most investors and traders.
    And there’s something else: These broad-based index options are ‘marked to the market’ at year end. That means taxes must be paid on unrecognized gains.
    Thanks.