More questions from Don:
IV [implied volatility] and the pricing of IC [iron condors] and DD [double diagonals], you mentioned that trading IC works
better when IV is high and that DD are better when IV is low…but
those are relative…yes the IV affects the price, but it affects
ALL four components relative to each other so that their relative
profitability towards each other is the same?
with DD's but it may be different because of the calender component.
Doesn't IV affect the front month more than the back
For my comfort zone I prefer to trade iron condors when IV is elevated. When I believe (obviously I cannot be certain) IV is at the lower end of its range, I prefer to trade double diagonal spreads.
This concept is explained in The Rookie's Guide to Options.
For those unfamiliar with the strategies, the iron condor is constructed by selling a call spread and a put spread in the same underlying asset and for the same expiration.
The double diagonal is similar to the iron condor, except the options you buy still have the same strike price, but they expire one month later.
1) The major reason that my strategy selection depends on IV is based on the nature of these positions. When you own the double diagonal, you effectively own the iron condor plus two calendar spreads.
When IV increases, the value of a calendar spread increases. That's another way of saying that DD spreads have positive vega. Positions with positive vega do well when IV increases.
Thus, I buy these positive vega positions when IV is low and the chances are good that IV will be higher (than it is now) when the front-month options are about to expire. If IV has increased, I will get a good price when I exit the position and sell my longer-term options. If IV has declined, I will be forced to exit my position at less favorable prices.
Iron condors have negative vega and do well when IV decreases. If that IV decrease is significant, it's often possible to exit the trade with a quick, but good-sized profit. Because these spreads do well in a falling IV environment, I prefer to own them when I believe IV is high and likely to fall.
It's not complicated.
If any iron condor trader wants to own a portfolio that has very limited volatility risk, it's a simple matter to add some double diagonals to the position mix – enough to turn the portfolio vega neutral.
2) Your point about the option prices moving in tandem is not accurate. When you are selling OTM call and put spreads, those spreads widen as IV increases because the options which you sell have more vega than options you purchase. That's why the spread has negative vega and it's the reason that higher IV means you can get a higher premium when you sell these put and call spreads.
3) It is true that a rising IV environment usually imparts a larger percentage increase in the IV of the front-month options. But you do not trade percentages; you trade dollars. Longer-term options have more vega than their front-month counterparts. Thus, even though the IV increases by a smaller percentage, it increases by more dollars. In other words, the premium increases more for the long-term option than the short-term option. That's why calendar spreads widen (become more profitable) as IV increases.
I have difficulty reconciling "buying a spread" netting me money and "selling
a spread" costing me money so I have just used trading a spread for ease of
When you buy an iron condor you sell the call spread and the put spread. That means you are buying the iron condor and collecting a credit.
There is no official nomenclature for the options world, and to me, that's a shame. Many people feel as you do and use the term 'sell' an iron condor when I would say 'buy' the iron condor.
There is a rationale for this, but it's lengthy. In summary, when you buy a condor spread, you profit when the stock remains between the strikes. The 'iron' variety of the condor should profit under the same circumstances. Thus, logic tells me that if I'm buying the condor, hoping the stock remains within a price range, then I'm also buying the iron condor when I also want the stock to be range-bound.
One further point. Suppose you want to trade a diagonal spread – for example the XYZ Dec 100/Nov 95 call spread. Your goal is to own the Dec call and sell the Nov call, and you tell the broker to buy the spread and pay a 10 cent debit.
When your broker comes back and reports that you 'bought' the spread at your price, a 10 cent debit, and that you own the NOVEMBER call and sold the DECEMBER call, you will be very disappointed.
What do you do if his explanation is this: You said 'buy' the spread, so I bought the higher priced option (NOV) and sold the lower priced option (DEC). How can you complain? Doesn't that fit your description of buying the spread? You bought whichever option was higher priced and therefore paid a debit.
That's why 'pay a debit' is insufficient to distinguish between buy and sell orders. At least in my opinion.
there's still more from Don…