Tag Archives | equivalent positions

Condors vs. Iron Variety

Mark: If you will, address an options trading question (maybe a rookie question) to which I’ve never found an answer.

What is the benefit of selling iron condors (bull put spread/bear call spread) over buying condors (bear spread/bull spread – puts or calls, but not both)? The profit/loss graphs of the IC and the condor are identical. Clearly, with the IC the cash remains in your account and is increased by the premium collected rather than paying for the condor and collecting a profit (hopefully) later on, but the interest earned on the funds is, at least presently, negligible. Also, it appears that there might be a slightly greater premium for an IC over a condor, but I don’t have enough of a statistical sample to draw that conclusion.

So, why are iron condors so popular while non-iron condors are rarely mentioned? Thanks, as always, for your wisdom.

Cliff

That’s a very interesting question and the truth is I don’t know.

I believe it’s a trader mindset. I believe that most traders prefer to have the cash in their account (iron condor), rather than pay cash for a position (condor). In this situation, the positions are equivalent and there is no theoretical advantage to trade one over the other.

However, there is a practical consideration. Because the trader anticipates that all options will expire worthless (obviously only when the trade is held though expiration), there is an extra reward for winning: There are no exercise/assignment fees to pay.

When the condor buyer wins, one of the spreads is completely ITM while the other is worthless. That requires payment of one exercise fee and one assignment fee. We know that some brokers do the right thing and provide exercise and assignment at no cost to the customer. However, that is not a common situation. Thus, all things being equal, the iron condor is better by the amount of fees saved.

More on mindset

Covered call writing is very popular among rookie traders. It’s easy to learn and nearly all brokers allow their novice traders to adopt that strategy. Selling cash-secured puts is the equivalent strategy, and adds cash in the trader’s account, but most brokers don’t allow their beginners to make that play. That’s true despite the fact that the trades are 100% equivalent.

Where does trader mindset come into the picture? I can’t be certain, but I feel that most traders who get used to writing covered calls never make the effort to switch to selling puts – even when their broker would give them permission. There is a certain comfort in trading a familiar strategy.

I believe it’s the same with condors. More books are written on iron condors, more bloggers use iron condors as topics, and thus, people who adopt this strategy begin with the iron condor and never make the change.

In the condor case, it’s correct not to make the change, but writing covered calls is not a good idea when the trader understands the equivalence of selling cash-secured puts. What’s the edge? Fewer commission dollars per trade. To me, the other, and more important point is that it’s far easier to exit prior to expiration. when the stock rises above the strike, OTM puts become cheap (eventually) whereas it’s not easy to trade ITM, higher priced call options as a combination with stock.

Exiting not only locks in the profit, but it frees cash for another trade.

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Collars: Revisited

It's time to take a fresh look at collars.  In mid-2008, we wrote about collars and how they work.  As a reminder, a collar position consists of owning 100 shares of stock, one (almost always an out of the money) put option, and being short one out of the money call option.

The purpose of owning this position is to limit losses when the market falls.  The trade is slightly bullish and there is limited upside profit potential.

This is one option strategy that is preferred by those who want to protect their holdings from a devastating market decline.  It's very effective because losses are limited (the collar owner maintains the right to sell shares at the strike price of the put he/she owns).  There are two reasons that this type of portfolio insurance is so appealing:

  • It almost always costs no cash out of pocket to own the collar.  That's true when the investor collects as much cash when selling the call option as it costs to purchase the protective put option
  • This position provides both safety and the opportunity to earn a limited profit.  Investors who only buy puts must pay the heavy cost and have little chance to earn any money, unless there is a significant rally

Experienced option traders are probably aware that owning the collar is equivalent to two other positions, each of which is a popular strategy on its own.  However, many novice traders do not recognize that they may be trading collars in a different format:

  • Selling an OTM put spread
  • Buying an ITM call spread

Example (this is an example and NOT a recommendation) 

The Traditional collar:

Buy 100 shares of AAPL, paying $300 per share [$300 is not current price]

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 call

Sell the put spread – the equivalent position:

Buy one AAPL Dec 280 put

Sell one AAPL Dec 320 put

Buy the call spread – the equivalent position

Buy one AAPL Dec 280 call
Sell one AAPL Dec 320 call

For each of these three trades:

Maximum profit occurs when AAPL is above 300 at expiration
Maximum loss occurs when AAPL is below 280 at expiration

Profit and Loss are the same for each of the three positions when the options are priced efficiently.


So What?  Who cares?

I approve of collars.  I believe they are an appropriate strategy for protecting a portfolio.  However, I know that some people adopt strategies without understanding how they work.

The point that I want to make today is that the collar looks good – and is good for the appropriate investor/trader.  However, many people who adopt collars would never sell a put spread nor buy a call spread.  Yet, they are making the identical trade.  It's important to recognize what you are truly trading.

Some collar traders would be better served by adopting one of the alternative strategies.  The margin requirement is low and trading a position with two legs is far more cost efficient than trading one with three legs. I suggest that collar traders make an effort to trade the corresponding call or put spread in place of the collar.

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More on the equivalency of covered calls and naked puts

A regular commenter, semuren, recently offered a comment that made an important contribution to a discussion:

"while what you say about naked puts being equivalent to covered calls is correct, there is a big issue here. In general people trade naked puts differently than they trade covered calls. Most sell a slightly OTM call for a covered call or an OTM put as a naked put.

Those are not equivalent and that is why people view these two strategies as different. In the end it is all about practice, how people actually do things, not about ultimately correct notions. But I do not want to go off on a discussion of epistemology in the social sciences so I will just leave it at that for now."

***

I have often stated, and sometimes offered proof, that the two option strategies: writing covered calls and selling cash-secured, naked puts are equivalent.

When positions are equivalent, the profit/loss profiles are identical.  In the real world, the pricing of options may allow one strategy to offer a slightly higher profit than the other, but that can be ignored for a theoretical discussion.

The one qualification that I mention is that the covered call and put must have three characteristics in common:

  • Same underlying asset
  • Same expiration date
  • Same strike price

For example, when the stock price is 38, that means that writing the Nov 40 covered call provides the same result as selling the Nov 40 put.

That statement remains true.  But in a practical sense it's not helpful to the majority of  individual investors/traders.  If it's true, why is it not always helpful?

As semuren mentions, most people who adopt these strategy are oblivious to the concept of equivalent positions, and tend to sell options that are out of the money.  There is a good psychological reason for doing so.

Traders, especially inexperienced traders, get a certain satisfaction out of seeing the options they sold expire worthless. Such results are 'pleasing' because a trade was made and completed profitably. To many traders, that's all that matters. It gives the trader a psychological boost.

The fact that the trader may have lost money on the overall position (example, sell a covered call, collect $200 in premium, and lose $500 when the stock price declines) is ignored.  The satisfaction comes from earning money on the call sale.

The experienced trader does not look at writing covered calls as two separate trades. It's a single position and the trader manages the position and its risk accordingly. This trader  understands that a loss has been taken and that there is no psychological boost in that.

Nevertheless, Options for Rookies is designed to guide beginnes towards making good investing/trading decsions, and the equivalency of covered calls and selling cash secured puts is important.

Expiring worthless

Because of this preference to make a trade in which the option expires worthless, both trades are most often made by writing OTM options.

Thus, the covered call writer sells the Nov 40 call and the put seller writes the Nov 35 put.

Those positons are not equivalent.  Although the equivalency issues is very important in understanding how options work, in this example, it's not really an importance trading principle to the rookie trader. 

That's because that rookie seldom considers selling the Nov 40 put.  In this trader's real world, the trade choices are the Nov 40 covered call and the Nov 35 put sale.

Again, it's crucial to an options education to understand equivalence.   However, there are times when theory gets in the way and may confuse a new trader.

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Covered Calls and Naked Puts Revisited

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When a rookie trader first becomes aware that some positions produce identical profits and losses, regardless of the price of the underlying asset, it's truly an 'aha' moment. 

It's as if a veil has been lifted and the world has become a brighter place.

  Because I believe this is an important concept and truly enhances a rookie's ability to understand options far more quickly, I devoted a chapter to the concept of equivalent positions in The Rookie's Guide to Options.  I also  provided a solid introduction to the topic in some earlier posts.

Because the primary purpose of this blog is to provide an education to option rookies, let's take a closer look at two different strategies: covered call writing and naked put selling.

But first a word of caution:  These two strategies are most beneficial to investors whose only investment experience consists of owning a portfolio of stocks, mutual funds, or exchange traded funds (ETFs).  Each of these strategies is a less risky method for investing in the stock market – when compared with owning stocks.  The investor earns a profit more frequently, loses less often and does well when the market rallies, trades in a narrow range, or even when it undergoes a small decline.  In each of those scenarios the covered call writer and naked put seller outperform their counterparts who simply own stock.

However, these are considered to be 'not-so-safe' strategies.  If the market tumbles, losses can be sizable.  In that respect, losses are similar to (but smaller than) losses incurred by thsoe who own stock.  And upside profits are limited, whereas the investor who owns stock has the potential for unlimited gains.

Nevertheless, these are both very popular strategies because they are safer than owning stock and offer an investing style that is easy to learn.  I use these strategies to introduce rookies to the world of options.  Once these methods are well understood, then I move on to less risky plays.

Comparison

If the simple algebra used in the proof that these methods are equivalent was not enough proof, let's take a look at the profit/loss graph for a pair of equivalent positions.  Although this is not strictly 'proof' I hope that seeing identical graphs goes a long way towards convincing you that these positions truly are equivalent.

Previous posts offered more details about covered call writing and naked put writing ('write' has the same meaning as 'sell' – when the investor is not selling an option that was bought earlier).

To be equivalent, the option part (the call or put option that is written, or sold) of each trade must have these elements in common:

  • The same underlying asset
  • The same strike price
  • The same expiration date

Risk Graphs

APPL Jan 300 covered call


 

AAPL Jan 300 naked put

These graphs are essentially identical.  Any minor difference occurs because the price of the trade execution always plays a role.  Our discussion is based on the assumption that neither trade is made at an advantageous price over the other.  

Interest rates are very low, but it does cost more to carry the covered call position (cash required to buy the position) than the naked put (cash collected when selling the put) and thus the CC should appear to be slightly more profitable by the cost of owning the position through expiration.

One myth that can be destroyed here is that a naked put is riskier than a covered call.  The positions are equivalent.

 

Other positions

These are not the only two option positions that are equivalent.  Keep in mind that calls are puts and puts are calls (all a trader has to do to convert one to the other is add stock – long or short – to any position).

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My Philosophy on Options Education

I recently created a new home page for the primary purpose of displaying the content in a single column, with no side columns for ads.  At the same time, I added extra pages with new content.

Most readers have not yet found the new pages, and I'm reproducing the page that contains some of my  thoughts on options education.


Education: An activity that imparts knowledge or skill.

When
I work with individual investors or write blog posts and books, my
objective is for the reader to learn something he/she does not already
know.  That includes providing enough details that the clouds disappear
and the reader gains a better understanding of the topic under
discussion.  

Careful and detailed explanations take
time to explain.  If you require instant gratification and the ability to attend
one webinar or lesson and then immediately begin trading, I cannot help
you.

Details?  What
does that mean? I stress the details that help you reach a better
understanding of the lesson material.   Unless the topic is risk
management (and that's a big topic) there is no reason to bother with
details of events that are extremely unlikely to occur.  My job is for
you to come away from a lesson with something of value for your trading
career.  And that's true for the trader who devotes only two hours per month to his/her investments as well as the full
time trader.

There are
trading tidbits that you will accumulate and points of view that you, the trader will develop
over the years.  Rather than wait for traders to slowly gather insights on certain more advanced topics, I prefer to see that you get an inkling of the importance of certain features of options – even when it may be soon soon for some students. 

One example is the idea that two very different-looking positions can be equivalent, i.e., they produce identical profits and losses under all market scenarios. Most beginners don't get introduced to that concept until they are well into their trading.  I believe this idea is so important to an understanding of how options work that I introduce it early.  If anyone does not see the importance, or does not yet understand how equivalency works, no harm done.  The idea has been mentioned and soon enough, as specific trade ideas are introduced, the 'eureka' moment arrives and the concept becomes clear.  Accelerating the date of that moment makes better traders of those in the class.

We
all wish we had understood something more clearly,or recognized the true
risk of an innocent-looking position earlier in our trading careers.  For example, I believe the
successful trader must concentrate on risk as his/her primary focus. 
Many others prefer to concentrate on profit and loss, and do anything in
an attempt to achieve that profit.  That is dangerous for reasons that
may not be obvious.

When
you grasp the 'little extra stuff' early in your career, it often makes
a big difference in whether you succeed or ultimately give up the
game.  The very first rule to understand is: Don't go broke.  It seems
obvious, but it's something ignored by too many traders – until it's too
late. I help traders learn how to minimize the chances of going broke.  It's not as simple as: "Don't take a lot f risk in one trade."  Some traders lose their accounts slowly and end up just as broke as the person who blew up over a single trade.

When I clarify some previous misconception
held by a student, that is truly hitting the jackpot (for me).  Trading
is a business that punishes mistakes.  Everyone tells us that we learn
from our mistakes.  That's true ONLY when the mistake is recognized. If a
trader repeatedly acts on a misconception, those mistakes are difficult
to discover – and hence, are going to be repeated.

I love
the breakthrough when something under discussion results in an 'aha
moment' for the student.  As a writer, I never know when that happens,
unless you let me know.

So what do I mean by that introductory statement – to teach something you don't already know?  Here are some examples that appear frequently in my writings:

  • Explaining something from a different perspective
  • Including extra details, just in case they can provide a better understanding
  • Including information to answer questions before they are asked
  • Explaining the rationale behind my opinions. 'Why I believe it's true'
  • Outlining a philosophy based on common sense, and not on traditional rules
  • Being willing to take a minority stance – but always telling readers when most others have a different point of view
  • Encouraging readers to think for themselves before making decisions
  • Continuously stressing the importance of risk management
  • Explaining that choosing a good trading strategy is just the beginning
  • Why trading near-term (front-month) options is more risky that it appears
  • Why it's easier to make money by selling, and not buying, option premium
  • Why selling naked short options is too risky for most traders (unless you sell puts with the intention of owning stock)
  • Sharing the opinions of other option writers and bloggers


Individual consultation

When
working with a trader one on one (at very low rates), my philosophy is
to help with specific topics of interest to that student.

I
don't have 'lessons' prepared in advance. I don't have any specific
number of lessons planned.  These sessions are designed to answer your
specific needs.

I've
discovered that most people prefer e-mail correspondence because time
is used efficiently.  I reply to the questions and offer advice.  Then
you take all the time needed to think about what comes next (if
anything). I appreciate that time is money, and prefer to see your money
used to fund your trading account..

Risk Management

Concerned with capital preservation
At Options for Rookies we live and breathe risk management.  I stress
the importance of controlling risk from the very beginning of your
trading career.  This is not a topic suitable only for experienced traders. Why?

If you trade without measuring and controlling risk, the risk of ruin
is too high. Don't count on a lengthy trading career when being aware
of, and respecting, risk is not at the top of your priority list.

When
dealing with the stock market in any capacity, you are dealing with
statistics.  You must be alert for unlikely events.  By being aware
of the probabilities of winning and losing, you can trade only when the
reward justifies the risk. 

You
will have many winning trades by doing just that.  However, long shots
have their day and black swan (unexpected) events do occur.  Your
task as a trader (and mine as a teacher) is to see that you are prepared
for the unlikely event. 

As a premium
seller, gigantic market moves represent the enemy.  Portfolios can be
protected against disaster, if you are willing to pay the price of
insurance.  One alternative is to be very careful when sizing trades. 
Be aware of the worst case and you can limit losses to an acceptable
amount.

It's all part of risk management.

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Trading SPX Shares

Options for Rookies Home Page



Mark,

Question on the SPX. Can one buy the SPX outright in place of buying SPY
ETF? Not the options but the SPX itself. If I wanted to allocate
$20,000 into the S&P 500 in a taxable account I could just buy 20
SPX contracts (assuming the SPX was at 1,000). If so, would this qualify
for that 60/40 tax treatment if sold at a gain even if the options aren't
used?

Ann

***

Hi Ann,

You cannot buy 'SPX' in the sense that you can buy shares.

The best you can do is buy an index fund that comes very close to mimicking the performance of SPX.  One such a fund is the Vanguard S&P 500.  You simply buy $20,000 worth of shares.  However, this is a (low fee) mutual fund, and not what you truly want to own.  It's nearly what you want, but so is SPY.

Yes, if you buy SPX calls, you get 60/40 tax treatment. 

But please (PLEASE) remember that when you buy calls you are not 'investing' in the index in the typical meaning of the word.  $20,000 worth of calls may expire worthless while SPX remains unchanged.  You apparently want to own shares – and that is VERY different from owning call options.  

If you can meet the margin requirement, and if your broker allows the trade, you can buy calls and sell puts.  The puts and calls must have the same strike price and expiration date.  That is exactly equivalent to owning shares, except they you do not collect any dividends.

The fact that you may be ale do this does not suggest it is a good idea.  You can easily lose the entire investment.

Let's look at ATM (at the money) options.  If you buy 2 SPX Oct 1070 calls and sell 2 SPC Oct 1070 puts, your would own a position that behaves the same as owning 200 shares, or $21,400 worth of a portfolio that is based on the S&P 500 Index.  This trade would cost a small cash debit (but a much larger margin requirement). 

At expiration, these cash-settled options would be worth the closing value of the index, and you would have a profit or loss based on owning 200 'shares' of SPX with a purchase price of $1,070 per share.

If SPX > 1,070, then you get the intrinsic value for your calls – in cash.  With SPX = 1100, the calls are in the money by 30 points each, and your account gets $6,000 in cash.  That's the profit you would have earned if you could buy 200 shares at $1,070 and sell them at $1,100.

If SPX < 1,070, your calls have no value, and you would have to pay cash because you are short the puts.  A closing price of 1020 means you would owe $10,000, and the value of your investment would be the remaining $10,000. 

When you own shares and it declines by 50 points, you lose 50 X $100 per point, per 100 shares. That's $5,000 per 100 shares, or $10,000.

Note:  If SPX declines by 100 points, you lose your entire investment.  Not only that, but as the value declined, you would get margin calls and possibly be forced to liquidate at an inconvenient time.

You did not state why you want to buy SPX 'shares' – but if it is to save commissions on buying SPY shares, that's not a good enough reason.

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Banning Short Sales. The Insanity Moves to Germany

It's happened again. Short sellers get the blame. Recently Germany's prime minister, acting alone and without support from any of her Euro zone allies, enacted a ban on the naked short selling of specific
euro area debt and of naked purchases of CDS (credit default swaps) on sovereign debt. These bans apply only to trades made on the German markets, and traders can get short these items elsewhere.

 

Options

We'd like to point out that option traders can take short positions in these securities using option strategies. The simplest idea is to sell synthetic stock. That means buying one put option and selling one call option – with the same expiration date and strike price. That combination is equivalent to being short 100 shares of stock. Unless the ban is extended to the option markets, these short sale bans don't ban anything.  The amazing part to me is that people who favor banning short sales don't recognize that options can be used as a stock substitute.  

Options are versatile investment tools and can be used by investors to accomplish a variety of investment needs. That not only includes hedging (reducing risk) but also synthetically selling short.

What is short selling?

Selling short is the sale of an asset that is not owned by the seller.  The idea is for the seller to borrow the asset from someone who is willing to lend it (for a fee), sell it, and then repurchase that asset at a later date. The short seller believes the asset is over-priced and that he/she will be able to buy it back at a lower price. At that time the asset is returned to the person (or institution) from whom it was borrowed.

Naked short selling occurs when the short seller neglects to borrow the asset and sells it anyway.  That's against the law, but it's an easy loophole.  Brokers don't enforce this rule on their favored clients.

Short selling has been widely used in stock markets all over the world as a legitimate method for betting stock prices will decline. The rationale for banning short sales is that it alleviates selling pressure on the shares of certain assets – thereby making it less likely those shares will get pummeled by other market participants.

It's easy to understand the idea behind these short sale bans. In the US, one was enacted as recently as September, 2008. Here is part of the official press release from the SEC (Securities & Exchange Commission):

 

Washington, D.C., Sept. 19, 2008 — The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence.

 

They don't make any attempt to hide it. The short sale ban is issued to 'strengthen investor confidence.' No doubt about it, anything and everything seems to be fair when the goal is higher stock prices. Don't misunderstand us. We enjoy a bullish stock market as well as anyone, but the market has to be a fair playing field. We all must understand that markets rise and markets fall and government intervention is not the answer.[Intervention is not the same as regulation]

Let's hope that the SEC has learned something in the year and one half since they issued that ban.

Has anyone ever seen any attempt to limit a run-away bull market? Of course not. Bull markets are good – isn't that the theory? The SEC apparently believes that boosting confidence and encouraging investors to jump onto the bullish bandwagon is good for America. The fact that the bubble bursts and huge numbers of investors are hurt does not seem to faze them.

 

Blame the bears?

Instead of blaming over-enthusiasm by the bulls; instead of placing some restrictions on the rate at which markets can rise, instead of doing what they can to prevent bubbles from forming, the SEC, and now the German government, take action by banning the practice of short selling specific securities related to the financial markets. In effect this places the blame on those 'nasty' short sellers.

They blame short sellers for the fact that markets were over heated and over extended and that if only those short sellers would go away, the bull markets would last forever. Never blame the bulls for building a bubble and always blame the bears for ending a bubble. It just doesn't seem right.

And these are our government leaders who make these decisions. How does that instill confidence?

Everyone believes that rising markets are nirvana. When markets rise, people feel wealthy, spend money, and invest in business as prosperity reigns. When markets fall, consumers feel less wealthy – and that's true even when any stock market investments are tucked away in a retirement account and won't be needed for decades. Under those conditions, optimism fades, spending and new business start-ups are reduced and that leads to unpleasant results on Main Street. The current high unemployment rates are a result of the lack of confidence on the part of those who would ordinarily help the markets grow.

As we see it, that means the banks. They do not lend money to those who want to grow the economy. No loans for business start-ups or expansion. No loans for those who want to hire others. World governments rescued banks when they faced bankruptcy and the banks feel that there is no need to return the favor. No need to provide benefits to the taxpayers who bailed them out. No effort to build wealth – with the obvious exception of their own individual wealth.

We are not alone. From the May 19, 2010 Wall Street Journal:

"We've been here before—and the parallels are hardly reassuring. Germany's decision to ban naked short-selling of euro-area government bonds, sovereign credit default swaps and 10 German financial stocks until March 2011 is a desperate move that comes too late to prevent a deepening of the euro-zone crisis—and may make it worse. "

There is something wrong with this system. Banning short sales, even when the number of issues banned is small, is not the solution.

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