This post is based on the very thoughtful comment/questions posed by Chris O.
I have been thinking lately, If one always exits an IC early, say one month before expiry on an IC that was opened three months before expiry, is it useful to do the following:
As the short legs of the IC ought to be closed one month early and I want to discipline my self to do so, why don’t I select my protection, the long legs of the IC, at one month earlier expiration.
Such wings of the Condor are cheaper to buy. The wings of an IC chosen the normal way, extending to the same expiration, are mostly worthless when I sell them one month before expiration, together with buying back the short legs of the IC.
So using shorter duration long legs on the IC takes away any hapless covering of the entire IC, and allows me to make more money?
Looks like Free lunch = I must be overlooking something.
Not so free lunch
This is not a free lunch, and there is likely to be significant margin problems. However, the strategy has a great deal to recommend it.
You envision an iron condor similar to the following:
Buy X INDX Jul 1050 calls
Sell X INDX Aug 1040 calls
Buy X INDX Jul 880 puts
Sell X INDX Aug 890 puts
Your long options expire before the short options. This has a lot going for it, per your description above. However, the margin gods don’t like such positions. When the long option expires after the short, they are considered to be naked short. That uses up a ton of margin for the average investor.
However, if your account uses portfolio margin, you are granted many special advantages regarding margin. Such accounts are margined by looking at the overall risk associated with the portfolio – and not by looking at each individual position. The bad news for many is that the account must be at least $100,000 to qualify. But readers should ask their broker about portfolio margin, just in case they do something different. [IB follows the rules mentioned here]
If you want to ‘discipline yourself’ to exit one month early, this is certainly a good way to do it. However, do keep in mind that when INDX is near 880 or 1050 (the strikes of your long options), the longs are going to expire worthless and it is going to cost a lot of money to buy back your shorts.
Nevertheless, that specific result will not occur very often and over the longer-term this may well be a winning play. This trade allows the position to be opened for a large cash credit, and there are obvious benefits in doing that.
1) one spread, put or call, might be too close to the money and have to be bought back at a loss or a additional wing must be bought for that side to cover a short position during this last month. Does not make sense as an argument, I want to stick to the rule of closing the short legs on month before expiration, so closing at a loss is “biting the bullet”. I definitely don’t want to stick around in a high gamma last month environment with a short option close to the money, even when it has a long option covering to the final month.
Yes, it makes sense to me. However, I urge you to take the worst case scenario, estimate an implied volatility for the August calls, and get yourself a good estimate of how much can be lost. If you size this trade properly (that loss is acceptable, not devastating), then you will be in good shape when using strategy.
It’s easy to back-test, if you have the data. Or you can accumulate data in a paper trading account. To gain data quickly, do three different indexes simultaneously.
2) IV might have jumped on the underlying, and both short options may have higher value than I collected – even with one month to go. Does not matter? If IV is so high I don’t want to remain in the last month when gamma is also high. Wild swings can happen. So again, why bother buying wings on an IC when the plan is to carry the IC to the final expiration?
Are long legs of an IC carrying to to the last expiration date worth anything, one month before expiration at a high IV?
Yes, it matters. Yes, IV may become a problem. And yes, those one-month options would have a very high value in your high IV scenario.
However, a low IV offers an occasional extra profit. The key to survival here is being very careful about position size.
There is a point you are missing. If you own the traditional iron condor in a high IV environment, one month prior to expiration, your remaining long call would significantly cut the loss when exiting. But, as you say, your plan is to earn extra profit all those times when IV is not extra costly and your long option is not near the stock price. Probability is important for a good analysis of this play, and having he ability to back-test this method for a bunch of years would be helpful.
3) I am trying with a small position, now running until final expiration in May, at Interactive Brokers and see little effect on margin requirements. No argument either.
Can you shed some light?
Thanks a lot for your efforts
I don’t understand why there is no problem with margin. Please let me know if you are using portfolio margin.
Do keep in mind that there is little to be learned from a single example. You can develop some novel adjustment ideas, but this study requires a good deal of data.
P.S. On Options for Rookies Premium, is the planned content difficult to organize for people in a very different time-zone than yours?
[Visit the link above for a short video that describes live meetings (and the problem of time zones), one of the important features for Gold Members. You must become a free member (Bronze) to gain access to the video]
Yes, different time zones present a problem when planning live meetings. We already have members from Hong Kong, Singapore, and the Netherlands. Therefore, I am requesting that members suggest times that are best for them and I’ll do what I can to make it convenient for as many as possible. If necessary, I’ll add extra sessions. For now, I’m promising four live sessions per month, but I suspect it will have to be more than that.