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OTM spread prices

Mark,

Interesting discussion.

Maverick talks about the fair value of the vertical spreads. I have been wondering about that recently.

For a real life example, at this moment (Dec 14) the Jan SPY 119 Put and the Jan SPY 128 Call both have a probability of expiring in the money of 25%. Yet the Jan 119/118 Put spread is about $0.17, and the Jan 128/129 Call spread is $0.25.

I would have expected that with both short strikes having the same probability of expiring, the vertical spreads would cost about the same, but this is not the case. Furthermore, it seems to me that the Call spread is probably reasonably priced (25 cent credit for 25% probability of expiring) but the put spread offers a poor reward for the amount of risk entailed when selling.

I am guessing that trading this condor or its equivalent would probably be a losing proposition over the long term, for the reasons Maverick points out.

sandeep

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s,

I agree that opening iron condors and ignoring them is probably a losing proposition.  However, no serious trader should do that.  It's pure gambling.  And that's okay for gamblers, not for traders.

When you own investments of any type; when your money is at risk as you seek to earn profits, closing your eyes and hoping that all will be well is simply not viable.  Note to passive investors:  You rebalance portfolios periodically, and thus do not completely ignore your holdings.

Iron condor trading requires active risk management, and that completely changes the odds of success.  So Mav may be theoretically correct, but in practice, a skilled risk manager can take care of business and earn money.  But I must emphasize that it is not a simple task.

 *

I am finding it very difficult to find the words to reply to your observation.  Let's try this:

The Jan 119P and the Jan 128C may each have a 25 delta, but the Jan 118P and the Jan 129C do not have the same delta.  In fact, the Jan 118P delta is more than two points higher than that of the Jan 129C. That affects why the spreads are not equally priced.

Let's consider looking at this from another perspective. Think of the SPY iron condor as positions in two different, but 100% correlated stocks: SPYC for which we sold a call spread.  Also SPYP for which we sold a put spread.

My explanation:

  • SPYC trades with a lower implied volatility than SPYP
  • The two stocks have an identical historical volatility (because each is really SPY), but history tells us that SPYP options are more valuable than SPYC options.  How is that possible?  SPYP put options have undergone huge price surges more often than the call options of SPYC.  SPYC option holders occasionally earned large profits, but that's the result of slow and steady movement in the price of the underlying stock – and not from sudden, large price changes.  Thus, when looking at options that are equally far out of the money, puts trade at higher prices than calls because both buyers and sellers know that there's an added chance for a big price change.  That's why there is a volatility skew
  • The volatility skew results in lower struck options having a higher implied volatility than higher struck options
    • Volatility skew is not linear, but the trend continues through the entire string of options.  The term 'volatility smile' refers to that non-linearity
    • The difference in implied volatility between the two calls (0.50) is less than the difference in implied volatility between the two puts (0.70)
    • That extra 0.20 volatility point difference boosts the price of the farther OTM put compared with the call [i.e., the put is closer in value to it's neighbor than the call]
    • Thus, the put spread is narrower and the call spread is wider
    • We did not use equidistant calls and puts in this discussion.  Instead we worked with equal delta calls and puts, but the reasoning is identical

    856



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