Tag Archives | front month

Front Month Iron Condors: Challenging to Trade?

Interesting trading points raised by Brian:

Mark,

I have been trading front month ICs (opening 4-6 weeks out), but at times am finding it too challenging to manage. So in Sept I experimented by opening a Dec position (3 months out). One thing I noticed is that the theta decay was almost non-existent the first 30 or so days. I could have opened the position 30 days later for almost the same credit. Not sure if this is a usual occurrence or not.

Also am curious as to why you say that SPX is difficult to trade. I would think that RUT would be more volatile and hence more difficult. (it seems to rise & fall more, %-wise, than SPX)

 

Brian
***

Hello Brian,

1) 3-month options have time decay.  And I know that you know that to be true.  It is not anywhere near zero, nor should it appear to be near zero.

Here's one way to see that for yourself. When you look at a 3-month trade (even if it is not a trade you make in real life), also look at the 2-month trade with the same strikes. Then you can compare just how much more time premium is built into options with a 4- or 5-week longer lifetime. That should provide a reasonable estimate for how much time decay to anticipate over the next month or so.

Be careful to keep an eye on the implied volatility (IV) for the underlying: VIX (for SPX options) or RVX (for RUT options). Longer-term options are more vega dependent, and if IV rises, you may see what appears to be zero time decay. It's not. It's just what can happen when vega affects the option price by more than theta.

Trumps
IV (hearts)  trumps theta (spades)

We have all seen examples in =  which a sudden market decline, accompanied by a surge in IV .  The result is a huge increase in the value of put options and even an increase in the price of call options as the market falls.  That's vega trumping theta, delta, and gamma simultaneously.

2) It's the negative gamma that makes spreads challenging to manage efficiently. Longer-term options have less gamma.  This may seem simplistic, but the truth is that when trading those 3-month options, you earn your profits more slowly (less theta).  In return, larger market moves result in less change in the price of individual options and option spreads – and less money is lost. 

If you want maximum risk and maximum reward, then you found it with front-month options.  If you prefer less risk and less reward, you can move out in time and initiate trades using 3-month options.  Then if you also plan to exit early – two to four weeks before the options expire – you avoid the period of maximum time decay and maximum effect of negative gamma. 

I know it's difficult to leave money on the table, but you are not really doing that.  From my perspective, early exit means taking a decent profit  – or perhaps a loss if you made an unfortunate adjustment or two earlier) – but the main benefit is eliminating all risk and being able to sell new, longer-term options with less risk. 

This philosophy is not for everyone, as short-term options constantly get the most play. If not convinced that this is true, the high volume of Weeklys ought to make it obvious that short-term options (when do the Dailys start trading?) are the favorite tools of most traders (and all gamblers).

3) I used 'difficult' to trade SPX in the context that it is more difficult to buy/sell the options at favorable prices.  The markets are wider, there are no exchanges making competitive quotes, and the last time I tried to trade these (a few years ago), they did not even have electronic trading.

I was not referring to managing the position. Yes, RUT is a more volatile index, presenting more management challenges.  However, option premium is higher, and that means the trader is compensated for taking additional risk.

844



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Elementary Questions on the Greeks

Don has some questions regarding delta and gamma that are worth posting (edited for brevity, when possible). 

If you understand the principles, then using the Greeks becomes far less frightening. 

The Greeks serve one purpose.  They allow a trader to measure risk.  That's it.  They do no more than that.  If the risk is within your boundaries, you can be comfortable with the trade.  If not, you can easily change any specific risk factor.  That's the beauty of using options.  Risk is readily measured and controlled. You cannot do that with stock, currencies, commodities etc.  Options are special.

***

Hi Mark,

You often mention the effect of Gamma on front
month trading. Are there strategies that use Gamma advantageously for
the trader? 

Don, 

Advantageously?  Are you saying that + gamma is advantageous and negative gamma is not?  If you want positive gamma, you must PAY for it.  It is not free. If you want gamma, there are strategies to suit: long options, buy straddles, back spreads etc.

You freely choose iron condors (and others) that benefit from positive time decay.  Negative gamma is part of the package. 


Time decay of options is not linear, and graphs show that the last six weeks prior to
expiry has the most dramatic theta effect. Would you explain the positive
and negatives of this trade and have you ever considered trading IC's
in this time frame? 

1) That is not anywhere close to having the 'most dramatic theta effect.'  Any position with less time is even more dramatic. 

The 'most' dramatic theta effect occurs when your option is exactly ATM, it is one minute prior to the closing bell on the 3rd Friday, and news is pending within the next 10 seconds.

2) The positives and negatives of this trade are exactly the same as ANY OTHER iron condor trade.  More time = higher premium, less theta, and less negative gamma. It's always a compromise.  Choose the combination of pluses and minuses that suit you.  Don't let anyone tell you that there is a 'best' time frame for you.

3) I consider trading iron condors in ANY time frame.  For me, front-month trades almost never survive the first elimination round.


Buying LEAPS and selling calls against them: Let's say that an option
trader believes that a stock will rally in less
than 24 months.

If a trader continued to sell options against LEAPS [MDW: assuming the shorts conveniently expire worthless], by the time the long option approached expiry, that could pay for the call and he/she would still own the Jan 15 calls – an ITM option.

Yes,the stock may go below 15, with the LEAPS losing value – but are there other negatives to this strategy? 

Don, I have discussed the idea of using LEAPS in 'covered call' and collar strategies a bunch of times.

Bottom line: Yes, there's big risk.  A big market move or a big decline in implied volatility demolishes this strategy.  See those, and other, posts for explanations.


PUT: if a trader were bearish on a stock, how would the LEAPS work with
Puts? Buy the ITM Put and sell OTM puts against it? 

That's one method.



A web site I saw recommended selling calls and puts on a stock
you like – at the same time. I get worried about this. Anytime you sell,
you have an OBLIGATION rather than a RIGHT and you never know when a
black swan event will hit an individual stock. But I was thinking that
this may be more acceptable on an index, I'd like to hear your opinion.

Who in his/her right mind would sell a naked call on a stock he/she likes?  I assume you already own, or are willing to buy the stock to make this play.  Don, this is merely covered call writing.  The long stock and short call is a covered call.  The naked put is equivalent to a covered call.

Covered call writing has downside risk.  If you don't like the risk, don't make the play.  If you don't want to be obligated to buy shares at the strike, then don't sell puts.

Indexes tend to be less volatile than individual stocks, so yet, this idea is a bit better when using index options.  You would have to buy something to represent the underlying stock.

A follow up on Gamma. Today F is trading at 13.20 and the
Sep 13 Call has a 57 Delta and 22 Gamma (am I correct that like Delta
you simply remove the decimal to factor in Gamma?)  Meaning (to me) that  Delta of the 13 Call will be 77
if it moves up and 35 if it moves down. Is this right? 

The gamma is per share, so multiply by 100 to get gamma per contract. 

Is this right? To a point.  I thought you would know that gamma is not constant and changes as the stock price changes.  Thus, the call delta changes by more than you anticipate (higher gamma at the end of the move than at the start) when the stock rises and by less when it declines (final gamma declines during stock price slide).  But what you have is a reasonable estimate.

If I move out to Dec, gamma is
less. The
reasoning behind this is: as the front month option moves into the money and it is
near expiration, gamma is more pronounced due to the reduction in
time, is this the correct view? 

Yes.  When there is less time, there is less chance that the option will move OTM or ITM.  Thus, delta moves towards 100 or 0 much more quickly.  For delta to change so rapidly, gamma must be higher. 

756

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Establishing Trading Rules: How Much Experience is Needed?

Mark,

Based on what I learned and thought about over the past few days due to my
trades:

  • I would now only buy calls/puts in the front month. The
    odds are more with us [MDW: Us? How did I get involved?]  because of gamma. Is this thinking correct?
  • The
    loss is limited to premium paid, but the upside is huge

     
  • I would
    never buy otherwise because theta is the enemy

  • I am not sure what I
    would buy though, ATM or 2 levels OTM.

 

Slightly off-topic: Based on looking at my trades, time decay is not
linear. The more the underlying is at a particular strike, the more the
time decay at that strike.

Is the time decay calculated per day or week
to week?

The time decay graphs given in most literature gloss
over the fact that those decay graphs are concerned with an option which stays
exactly ATM all the time. Why?  The real spot price gyrates?

Thanks

Amit

***

I get it.  You are an eager student.  You want to trade options right now and make money today.  Every time you see a piece of evidence about a specific strategy, you believe you found the Holy Grail.  I can only tell you that you are making a huge mistake.

You are FAR TOO INEXPERIENCED to make these decisions.

This is learning time.  This is experiment time. 

You cannot make a few trades and reach a permanent-sounding decision such as: 'I would only buy front-month options.'  If you reached this decision, on what is the thought process based?  How many times have you traded 2nd or 3rd month options?  How did the results compare?  Did you make good money by correctly predicting direction, or did something else happen that made the trades profitable.

It is wrong to assume that a profitable trade means you are a genius. 


It is wrong to assume that a losing trade is the result of a mistake.

You must compare the trade with others and discover why the trade was profitable (or not).  The 'why' is how you learn.

NOW is your chance to trade a variety of ideas, analyze the results, keep detailed records, think about the results and make an attempt to get a feel for what works and where to establish risk limits you can handle.

1) No the odds are not with you because of gamma.  The odds are not with you, period.  You have much less time to be right in your prediction.  If it does not happen soon, time decay will eat away at the value of your options.

How can the odds ever be with you when you must predict the direction of the move, the timing of the move, the size of the move?  You must be a very skilled market timer with a PROVEN track record before you can have any expectation of making money when buying options.

I'd hate to see your enthusiasm disappear down a sink hole.  Didn't you try this 'buying options' strategy once before?

2) Yes the Reward to risk ratio is excellent.  But the probability of success is not.

3) I don't understand the 3rd point.  When you buy front-month options, theta is the big enemy.

4) This is your problem in a nutshell.  You want to buy. You think buying and owning positive gamma puts the odds of success on your side.  But you give no consideration to how far the stock must move.  You don't know which options to buy.

It doesn't work that way.  The whole strategy requires knowing which options to buy, or having a method for deciding.  It's not a random selection.  It you cannot estimate the size of the move you should not be buying options.

Buying out of the money options is very much a gamble.  Some players succeed. I have no idea where your talents lie, but if you are excellent (proven track record), you can win this game.  Otherwise, not a chance.  Especially when you buy OTM options.

Off topic:  Time decay is NOT linear.  ATM options have the most time premium and thus, the most rapid time decay.  Time decay of American style options is based on the amount of time remaining until the market closes for trading on expiration Friday. 

The decay can be determined for one week, one day, one second, or any other time period you care to mention.  However, the Greek theta measures the time decay for one day.  Theta tells you how much value the options loses overnight.

Most option analytical tools that measure something specific, such as theta, assume all else is constant.  It MUST be this way.  If you want to know about theta, then if anything is not constant, that item will also affect the option price, and you will NOT be able to tell what part of the option price change is due to theta.  Please tell me that you understand this is true.

One of my basic tenets is that it is very foolish to trade when you don't understand the rules.  Some rules (automatic exercise) can come as quite a surprise to the novice. Other properties of options (how quickly they decay as expiration nears; or the sale of options is not free money) may not be immediately obvious.  But it makes no sense to use tools  when you don't know how to use them.

What's your hurry?  You have the rest of your life to trade. 

Practice in a paper-trading account or trade small size in your real account.  But don't go jumping to conclusions based on one or two trades.

746

July 2010 Expiring Monthly.  Table of Contents:

1007_TOC

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Negative Gamma. How much is enough?

Mark,
What values of gamma do you consider as high?


Cheers

John


Hi Mark,

When I am looking at my brokerage
account I have the same questions- what is considered high
(risky) Gamma and what is low (safe) amounts of negative Gamma.

Knowing
what you say about Gamma, is there a method of factoring in the effect it
has so that it is used to advantage when trading or adjusting?

Thanks,

Don

***

Gentlemen,

When using options, there are many strategies that a trader can adopt. Some come with positive gamma and positive curvature (risk graph = smile) and the trader makes money as the underlying makes significant moves.  One benefit that comes with these positions is the absence of tail (unlikely event) risk.  In fact, black swan events offer substantial rewards when the trader has both upside and downside curvature.

The cost of owning such positions is the daily time decay in the value of those options.

Examples

  • Buy calls or puts
  • Buy calls and puts (strangle, straddle)
  • Back spreads (more options are bought than sold)


Other strategies come with negative gamma, negative curvature (risk graph = frown), tail risk and positive time decay.  The trader who prefers this type of trade usually takes precaution against tail risk by owning positions with limited losses – i.e., no naked short options.  Nevertheless, a big market move is the enemy and the trader loses money when the underlying moves too far (or too fast).

Examples

  • Naked short options
  • Covered call writing
  • Credit spread*
  • Iron condor*

* Limited loss strategy


Delta represents the anticipated change in the price of an option when the underlying moves one point.

Gamma represents the anticipated change in delta when the underlying moves one point.  And gamma is not constant and also changes as the underlying changes.

When short (long) delta in a rising (falling) market you expect to lose money.  However, gamma makes it worse.  With negative gamma, delta accelerates and losses accrue more rapidly.

This is why I believe adjusting a trade to delta neutral is not good enough.  It's better to reduce gamma.  In other words, buying shares of the underlying doesn't do it for me.  I want to reduce negative gamma, and that means I elect to spend money on options when adjusting.

Another way to reduce negative gamma is to trade options that have less gamma.  Front-month options come with high gamma and high theta.  In other words, more risk and more reward.  To lower negative gamma, consider avoiding front-month options.

That brings us back to the question: When is gamma too high?

 'High" gamma does not necessarily have a 'number' associated with it. Look at it this way. You have a (premium selling) trade and it goes
against you. You adjust delta back towards zero.
Assume you are going to adjust again when the stock moves another X% or Y
points higher.

You will lose money on the move and be short more delta since the last adjustment. 
If you are short too many delta and if the loss is
larger than you are willing to accept between adjustments, then gamma is HIGH.
It means delta changed by too much.
Choices: Adjust sooner or reduce negative gamma.

Thus, 'high' is a relative term. Your comfort zone tells you when gamma is too high.  I cannot supply a number.

If you are trading a $5 stock, then the $4 call undergoes a huge delta change when he stock moves from 4 to 5.  Gamma is high.  If it's a $100 stock, delta does not change much when the stock moves from $99 to $100 and gamma is much smaller.  Thus, gamma is not the only risk factor to be considered.

Don, there's no method for using negative gamma to your advantage.  However, if you manage the position such that losses incurred due to adjustments are less than the gains from positive time decay, then negative gamma is not going to hurt.

745

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Front Month Iron Condors Bite Again

Question from Mark:

Assuming you did open some RUT spreads. Let's say you have
some on the books around the 580 level. Market gets crushed today.
Shorts double. 12 days to expiration. Still some breathing room but been
stung before.

Adjust now and quick big loss. Wait for market to bounce and
adjust/close down the road. Wait and market falls, suffer more.

When do you mostly make your adjustments?

***

Mark,

I have many comments explaining how I feel about your situation and my way of dealing with it.  Obviously my method may not be suitable for you.  I cannot tell you how to trade, but hope to offer some thoughts that you find useful and logical.


1) Two of your phrases are: 'shorts double' and 'quick big loss'

  • That tells me that you sold these spreads recently and at a relatively small premium
  • You are paying careful attention to the price at which the original trade was made

I strongly believe that it is bad policy to pay any attention to the original trade price.  Your primary concern right now – is the risk and reward potential for this position – as it stands right this minute.   Are you comfortable holding, or it feel too risky.  If too risky, would you hold anyway just because closing locks in a loss?  I hope not.  My point is that you are either comfortable holding this trade or you are not.  Original cost is immaterial.

If not comfortable, one decent option is to reduce position size.  It is not necessary to cover the entire position. 

Alternative suggestion:  Roll down:

  • Perhaps you can roll down by covering
    the 570/580P spread and selling the 550/560P spread.  It appears that
    you can make this trade for about $0.50
  • If size is not the issue (but how far OTM is), and if your position is less than your maximum size, you may want to roll down on a ratio:
    buy 2 570/580P spreads and sell 3 550/560P spreads.  Cost is approximately zero cash – but do not ignore the real risk associated with this trade, and that's being short additional spreads

Although it is the method of choice for most traders, using front-month iron condors is much more risky (yes, it's also more rewarding) than trading positions with a longer lifetime.  I believe that the high negative gamma is too difficult for the majority of traders to handle.  As you say, hold and you may be saved by a market reversal.  Holding may also result in additional losses that quickly mount on a further decline.

This risk is much less when options have a longer lifetime (gamma is less).  For my comfort zone, that makes them easier to trade and more comfortable to hold.  In addition, I collect a larger premium for spreads that expire later, so if I am concerned with P/L at a later date, I may still be able to exit profitably. [Honest, I pay no attention to original entry price.]

I recommend avoiding front-month options despite the rapid time decay.  But that is a decision for you and your comfort zone.

I also recommend against selling spreads
and collecting a small premium.  We each have our own comfort zones,
but front-month options have far too much negative gamma to suit my taste.  Sure, the rapid time decay is nice, but I prefer to trade the
less risky 2nd and 3rd month options. 

I'm not telling you what to do, but I do suggest that you consider your choices and decide whether front-month is the way you want to go.  You probably will not change styles, but at least when you consider alternatives, you should be more confident that your eventual choice is appropriate for your needs.

Having 'been stung before' I know you understand the problems of trading with increased negative gamma

2) I don't have set rules for making adjustments because I find that market conditions can be so different from one time to the next that I only have basic guidelines.

I tend to adjust early, but not always.  I may make a stage I adjustment when my short RUT options are 4 to 5% OTM.  At other times, I may wait for 3%.  Much depends on which adjustments are available at favorable prices.  When IV is high, I am more willing to roll down on a ratio because the roll can be made at a low cost and I can roll on a small ratio (when I am not 'all in' and have room to expand my position size).  It's amazing how high IV allows a good-looking roll down opportunity.  I recently rolled my short RUT options down by 3 strike prices on a 2 x 3 ratio for essentially zero cash cost. 

This opportunity is available when options are vega rich – and that means they are not front-month options.  

I do not enjoy moving the position by selling more spreads than I buy (to close), but will do that when IV is high and the prices are attractive.  But watch out for position size. This is not risk free – the black swan is in hiding – he has not disappeared.

3) Being a poor market prognosticator, I do not hope for a bounce in this situation.  It's strictly risk of holding vs. likelihood of earning a reward, and the size of that reward.  That's a discipline that does not come easily.  Trading without emotion (fear and greed) is also essential for the successful trader, but not so easy to achieve.

 

4) To avoid being in his situation, my trade plan calls for exiting when expiration is three weeks away.  I don't always meet that objective.  But, if my risk management persona is okay with the trade, then I hold a bit longer. 

I covered some Jul call and put spreads when they became inexpensive (25 to 30 cents in this volatile market is cheap in my book) but  I never was able to buy the Jul 570/580P spread.

5) Like you, I am short a some of these RUT Jul 570/580 put spreads, and if I felt compelled to cover, paying near $1.50 would be a relatively inexpensive exit for me.  Yet, I feel no urgency to exit. 

The Jul 580P has a 21 delta, and at that
level I'm willing to hold longer.  However, this is a small part of my
portfolio, and if this specific spread gets into trouble, the loss is
well within acceptable limits.  If this is your only position (and I
understand that is likely) then you must think about your ability to
withstand the potential loss.

NOTE:  I don't know whether holding is within your zone.  This is a personal trade decision each trader must make.  I hope you can base the decision on something other than fear.

Good trading.

729

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