Addendum: For anyone who doubts that near-term gamma can be explosive, today's trading ought to take care of those doubts. DJIA was down 1,000 for a brief moment that rallied more than 700 points.
Previously posted at The Options Zone
I often mention that owning a position with short near-term options is extra risky (with a correspondingly high reward potential) because negative gamma can wreak havoc on the position. A recent email reaffirmed the notion that it's not enough to mention the problem with negative gamma. It's necessary to offer more details, allowing everyone to understand the situation.
In your book you make reference to
weekly options and I know people who are trading spreads and condors on those
options. As a beginner, I can see the advantage of a very short time exposure
to market change, but I can also see the disadvantage in the speed with which
you may have to carry out any position management.
What are you thoughts? Would you
example, what would you think about the SPX an SPX call iron condor:
- Shorts are each 50 points OTM
- Cash credit = allows for a 2% return ($50)
- Expiration is
Thursday of this week (today is Monday)
- Very high probability of success?
I was very disappointed at how difficult is is to trade those weekly options. Too little volume; bid ask spreads are too wide. I do NOT recommend trading iron condors or credit spreads with weeklies.
If you want a lot of bang for the buck; if you want high
risk and high reward position; then this fits the bill. But it's too risky for my taste.
When little time
remains in the lifetime of an option, time decay is obviously very rapid.
The problem is that you cannot collect much premium for selling these call and/or put spreads, unless they are not
far OTM. When those options threaten to move ITM, gamma explodes and
losses mount quickly (more on explosive gamma below). It's truly high risk/high reward.
If you believe you can manage those positions well, and if willing to take the
risk, they are viable to trade. I want neither that risk nor reward.
But this is truly a personal decision.
If you are new to iron condor trading, as you are, this is not a good situation to get your training. I don't even like them in a paper trading account. You want to experience calmer conditions when learning to develop good risk management techniques.
Your example. Margin is $2,500, so a 2% return is $50.
I am not willing to collect $50 when risking up to $2,450. To do that, I want
very, very high probability of success. More than 99%. You may feel
differently, and that's fine. But trying to collect these small premiums
month after month (or week after week) looks good and feels safe. But it's
Ask yourself at what point would you cover out of fear or necessity. How much would you lose in that scenario? How often
would that happen? Then, how much profit remains for you?
Too dangerous in my book. You don't win as often as you think –
because you will take losses to exit at least part of the time.
I did not look at the specific option deltas in your example. Are you aware that adding the delta
of the short options gives you a good estimate of the chances that either
will finish in the money? Total delta of 2 means 2% of the time. And if you are getting 50:1 odds when the true odds are 50:1, there's no advantage.
Expiration is NOT Thursday. This is a common misconception. Expiration is Saturday, but what concerns you is Friday morning. That's when the settlement price is determined for European options. Please know how that price is calculated. Novices frequently scream in anguish when they discover the rules.
NM continued: I am not interested in high risk/high reward trades that lead to management under pressure. I will continue pursuing
a method based on monthly condors.
Would you make the same comments about the dangers of holding a one
month iron condor near to or up to expiration? I don’t know the
reason for the explosion in gamma that you mentioned, so I don’t know if
it would apply to monthlies, but I can see that it should apply.
Is this the
reason that you tend to trade longer term condors and not hold them until near
the end of the expiration month?
YES, that's the reason. Current gamma – your position as it exists at the
time you look at it – is very dependent on the amount of time that
remains before expiration arrives. It has nothing to do with how much time remained (prior to
expiration) when you opened the trade. It's all about 'today.'
Correct. It does apply to monthlies.
Longer-term options have less gamma. Quick explanation:
Look at an
option with two months of lifetime remaining. Assume it moves into the money. Because there
is so much time remaining, it takes a huge move to get that delta up to
80 or 90. A 100 delta is seldom seen. Reason: Because there is lots of time
for the market to turn around, and the probability that the option will be in the
money (that's one definition of delta) at expiration time is less – when compared with an
option with two days to go.
Once that latter option is ITM, the chances
it will stay there are much higher – because there's less time for it to
retreat. So delta explodes towards 100 quickly. Thus, the option
moves point for point with the stock – and that means big losses.
the other end, an option that seems to be safely OTM and has a delta near 5 can quickly move to 50 delta, as the
option becomes ATM. With longer-term options, the delta
change (and gamma is the rate at which delta changes) is far less
The advantage to being short that explosive gamma is the rapid time decay. In my opinion, that decay is not fast enough to justify the risk. Many traders are very willing to take that risk for the reward.