Tag Archives | RUT

Front Month Iron Condors: Challenging to Trade?

Interesting trading points raised by Brian:


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)



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.

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.


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Ratio Spreads: Part IV. Broken Wing Butterfly

The first three posts in this series on ratio spreads (Part I, Part II, Part III) were published recently.

The broken wing butterfly spread (BWB) is a frequently used strategy for more experienced players.  Today I'll introduce that option strategy to readers of Options for Rookies.

In general, any butterfly spread is used when the trader wants to forecast a specific price range for any underlying.  It's also created as an adjustment for existing positions (as a risk management play to limit losses or lock in profits).

In the scenario under discussion (ratio spreads) the BWB is constructed to limit losses, always a good idea when trading options.  Buying options that are relatively far OTM is not done to 'take a shot' at a gigantic market move.  Instead the trade is made to convert a position that is already short naked calls or puts (a ratio spread) into a position that is no longer short any options.  In fact, You can always buy an extra contract or two to provide an unlikely, but nice profit when the market makes an unexpected large move.  If this concept is not obvious, that's not a problem.  Use your broker's graphic software to examine the risk picture. Do not forget to look ahead and examine risk one day prior to expiration.

The BWB differs from a traditional butterfly spread as follows:

Butterfly spread: A trading strategy consisting of the sale of two options, along with the purchase of one option with a higher strike price, and one option with a lower strike price. Necessary conditions:  All options are of the same type (calls or puts); the options owned are equidistant from the options sold, all options expire on the same date

Broken wing butterfly (BWB): Same as above, except that the options bought must NOT be equidistant from the options sold.

Although these positions frequently stand on their own, they can be traded by conservative investors who would like to trade ratio spreads, but who refuse to own positions with any naked short options.  The BWB comes to their rescue.


The ratio spread

Let's say you are bearish on the market and want to make a trade that suits your expectations.  Your guess is that the market will fall, but not too far.  With RUT (Russell 2000 Index) trading near 673, you decide to Buy 3 RUT Jan 650 puts (@ $8.20) and Sell 6 RUT Jan 630 puts (@ $5.70).  This is a 1 x 2 put ratio spread, and you collected a credit of $3.20 for each spread. [Most rookie traders think of this as collecting $960.  However, that makes the conversation awkward.  It's far easier to refer to this spread – as well as any other – in terms of its lowest common denominator. That's 1 x 2 in this example]

As discussed in talking about break-even points for ratio spreads, when the market moves too far, you may lose a significant sum.  I know that you (the person making this trade) really believe the market can move through 650 – that's why you bought the 650 puts.  You also believe it will not decline beyond 630 – and that's why you sold the 630 puts.

However, if your are correct about direction, but very wrong about magnitude, there is no reason to lose a lot of money.  This trade is naked short 3 puts, and that leaves you exposed to a gigantic loss if and when there is a big market collapse.  Why take that risk when it's unnecessary? 

If you take the more conservative approach, you can buy some Jan puts and accomplish two things

  • Limit losses
  • Allow you to maintain a cash credit for the whole trade
    • Allows you to earn a profit, even when wrong – and the market does not decline

You can buy RUT Jan 590 puts @ $3.  Or you may choose to save a bit more cash and take a bit more downside risk by buying a put with a lower strike price.

Such a trade turns your ratio spread into a broken wing butterfly spread.  You would own 'a 3-lot' of the BWB:

Long  3  RUT Jan 580 puts
Short 6  RUT Jan 630 puts
Long  3  RUT Jan 650 puts

Maximum loss occurs when RUT is below 580 at expiration, and that loss is $3,000 [per BWB] minus the credit collected when opening the position.

Why $3,000? [$9,000 total].  With RUT settling below 580:

The 650/630 put spread – and you own that one – will be worth its maximum, or $2,000.

The 580/630 put spread, which you are short – will be worth $5,000


There are two main ways to earn a good profit from this spread:

a) Expiration arrives and RUT is well under 650 but above 630.  This is the risky way to play because the Jan 630s would have a good deal of negative gamma (and lots of positive time decay) as expiration day draws near.  I don't recommend holding to the end, because this is the highest risk and highest reward play – and many traders are tempted to hold and hope.  I much prefer the next method (less reward and substantially less risk).

b) Hold the position long enough that theta works its magic and erodes the price of the options.  You hope to see the market undergo a slow decline, increasing the value of the Jan 650 puts that you own, but not far enough to offset the time decay in the Jan 630 puts.

Under those conditions, you exit the trade, collecting more cash.  The profit potential is very dependent on how much time has passed, the current price of RUT, and the implied volatility of the options.  In other words, to estimate a profit, you must use an options calculator. 

One good method for establishing a rough idea of when to exit the BWB is to make a trade plan just before or after making the initial trade.  That plan sets your (flexible) profit goals, as well as the maximum loss you araae willing to accept.  Those targets make the exit decision easier – especially for the less experienced trader who may be encountering specific situations for the first time.

When the broken wing butterfly works well, deciding when to exit requires discipline.  It's always going to be tempting to wait 'just one more day' to collect that time decay.  However, the risk of a big move exists as long as you hold the trade. 

One major warning: don't ignore risk. If RUT approaches 630 far too early for your comfort, then risk of loss mounts (in fact your trade is probably already under water).  Sure, losses are limited, but that is no reason to own a risky position.  The thought process is similar to trading any limited-loss strategy, such as the iron condor.  Prudent investors take losses – by exiting, or adjusting, the trade – to prevent the occurrence of large losses.


The BWB is a stand-alone trade that gives the trader protection against unlimited losses while providing a very good profit when that trader is correct in his/her market forecast.  This forecast involves more than direction.  In other words, it's not the best choice when very bullish or very bearish.

This post provides the general idea of what a broken wing butterfly is and how it can be used to minimize risk whenthe trader owns a ratio spread.


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Stock Trader Moving into Options

Hi Mark,

I am a longtime stock trader, but over the past couple months, I have taken a real liking to the options game. Your blog has been a huge help in understanding many of the aspects I've been reading about.

So I was wondering a couple things:

1. I notice you trade RUT. What it is about this index that draws you to it? And a more general question is, what do you look for in a stock or index for IC/credit spread trades?

2. What are your thoughts on a strangle comprised of an out-of-the-money call spread and an out-of-the-money put spread, both bought in large lots at low delta, say .20-.25 per spread, both puts and calls? 

[See reply for comment on the word 'delta'.  It should be 'cost']

As long as I am confident of movement in the life of the options, one of the spreads will pay for the other, especially if one moves ITM… If the stock tends to swing, both sides can be closed for a nice profit.

Today's (Jul 16, 2010) hammering of the financial sector and the market in general, has made this very tempting, especially ahead of earnings.

I also own a 25 lot, low delta Jan 11 VXX call spread to hedge my portfolio, and it seems to be working okay as the spread moved from .70 to .85-.90. Is there anything I'm overlooking with this strategy?

I have not seen much advice online about using debit spreads to put on a strangle position, so I get the impression it is not used by many traders.

[Once again, 'strangle' is not the term you want to use]

My thought process is that buying a spread with ~ 25 delta and selling for $0.40 or .50 is like buying a $25 stock (albeit one that expires) and having it rally to $40 or $50, even though the underlying stock is only moving a dollar or two.

3. I am currently long PG Oct 60 calls. I paid ~ 2.50 on a market dip and when PG rallied three points, I sold Aug 60 calls for ~ 2.50 and plan to take advantage of time decay and exit both as a calendar spread. I may get a chance to buy to close the Aug 60 calls for a song, and still be long my Oct 60 calls.

Good move or is there something I'm overlooking? I am slightly worried that someone will exercise the August calls for the upcoming dividend, and am tempted to take my profit on the spread if there is a high risk of that.

Any advice or critiques would be most welcome. At this stage, my comfort zone is being long either naked options (giving me the option to leg into an instantly profitable debit spread, or sell to close) or debit spreads.



Welcome to the options world Andy. 

1) Regarding RUT: I prefer to trade European style options because they settle in cash.  I'd prefer SPX options, but trading those is inefficient for me.  

I don't trade stocks.  My requirement would be 'plenty of strikes' – and that eliminates all mid-priced stocks


2) I must
correct an error in terminology.  We must speak the same
language to communicate.

You are writing about low cost spreads, not low delta spreads. [Delta is the rate at which an option's price changes when the underlying stock moves one point].  Spreads can have 'low delta' but I see from your continuation that you are referring to spreads that are low priced.

Correct: If you get a big enough move and if you get it quickly enough, you can earn a nice profit.
To get a profit from both sides, you need a pretty good-sized swing. Plus, you must have a good knack for exiting one side at an opportune time. Double profit is a rare bonus.  Don't think about it. The game is to win on one side.

I have nothing against that strategy in principle. However, I take exactly the opposite position in my trading.

I sell those credit spreads (that's an iron condor position, not a strangle) and hope to profit from lack of movement, time passage, or shrinkage in implied volatility. In reality we can both win when taking opposite sides of the same trade – depending on how adjustments are handled and on our timing of trades.  However, I obviously prefer my side to yours – but I am NOT suggesting that you change.  You are okay preferring your side.  Our results depend on how well we handle position risk.

I am not paying enough attention to VIX and VXX to give a good answer and don't want to say the wrong thing. But VXX is much better to trade than VIX. In addition, you have it right. A down market should result in an increase in the implied volatility of the options, and that moves VXX higher.  When VXX is higher, your spread should gain value.

You have not seen much advice online about 'using debit spreads to put on a strangle.' That's because you have the terminology wrong (no big deal).

A strangle consists of naked options (long or short), not spreads. The position you are describing is the iron condor, and not a strangle. The iron condor is VERY popular.

Buying a spread @ $0.25 and selling @ $0.40 is similar to trading penny stocks and paying 25 cents and selling at 40 cents.  It's not like a $25 stock and a $40 stock.

3. Your PG plan is viable.

But you must know this: calendar spreads get narrower (lose money) when the stock runs away from the strike price in either direction.

In my opinion, it's easier to take your profit by selling the Oct option, but selling the August call does give you a position with the opportunity (that's all it is) to earn extra profit.

I suggest you consider an alternative when you own a profitable trade.

First, do you still want to remain long this option at the current price level for the stock? If no, sell the option, take your larger profit and move on. If yes, then it's okay to do as you suggest and find a hedge.

But know this: You are not locking in an instant profit. This is a common misconception.

You are taking your own personal money, the profit you already earned, and reinvesting it into the call spread – when you could have sold and kept the entire profit. When you exit, the cash belongs to no one but you (and the IRS).

When you hedge the trade – even at a wonderful price – you do not have an INSTANT PROFIT.  You earned that profit.  So decide:

  • Sell and take the money
  • Reinvest part of it into a a new, hedged trade

In other words, do as you suggest – ONLY when you believe the new position (in this case a calendar spread) is the place to invest your cash.

Enjoy your options.


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Plunge Protection Team? Pump and Dump?

Hi Mark,

Recently I have been seeing a lot of the classical pump and dump
scheme in RUT. The futures usually went much lower compared to previous
day's close, then RUT opens by gapping down, and then rising back up
again, usually to previous level. And all this happens with a lot of
rhetorical delusions on the news, like 'futures down on euro woes',
'stocks up amid whatever nonsense'.

So my question is, do you see this as a concern? My opinion is 'I
do'. I think the zig-zag behavior is hurting people with stop losses.
That means the guys with proper risk management will be toast.

On the
side note, do you believe this is the undoing of plunge protection team?



Plunge Protection is a giant topic all by itself. I have no proof it
really exists. But plenty of people are convinced. From Wikipedia:

"The Working Group on Financial Markets (colloquially the Plunge Protection Team) was created by executive order on March 18, by Ronald Reagan.

The Group was established explicitly in response to events in the
financial markets surrounding October 19, 1987to give recommendations for
legislative and private sector solutions for "enhancing the integrity,
efficiency, orderliness, and competitiveness of [United States]
financial markets and maintaining investor confidence".

"Plunge Protection Team" was originally the headline for an article
in The Washington Post on February 23, 1997,
and has since become a colloquial term used by some mainstream
publications to refer to the Working Group.
Initially, the term was used to express the opinion that the Working
Group was being used to prop up the markets during downturns."

In my heart, I believe the Obama administration wants to do the right thing.
However, I think in our horrible financial condition, there is just no
money available to support the markets. Thus, I don't believe the PP team would be doing much, if their mandate is to actively support the markets.


Pump and dump works for the stock of small companies. I don't see how
it can work for a gigantic index. Perhaps I am merely being naive.


I do believe, as you obviously do, that the stock markets are no longer a
safe place to invest. Trading is still viable.  But investing for a
decades-in-the-future retirement account: That's just a gamble.

I believe the quants have demonstrated the ability to take much of the
inefficiency out of the markets, and if they had not been over-leveraged
and greedy, they would still be doing so.

My point is that the
individual investor, as well as the professional money manager, has
virtually zero chance to win.

And the thieves still run the place. Allowing the banks to survive, and
now prosper with zero remorse and zero appreciation for being saved –
that's just too outrageous for words.

Sure investors can profit, but the game has changed. Careful research no
longer matters. Things we cannot comprehend rule the markets.  It's a
brave new world in which trading with open-ended risk (such as being
naked longs stocks) is unacceptable.


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How Kite Spreads can Become Embedded Back Spreads

James and I have had a back and forth discussion regarding whether certain positions are back spreads.  The discussion began here and there's an interesting aspect that's worth consideration:

How can a kite spread – in which you own a limited number of long options (on top) turn into a position with back spread properties?

First, some definitions:

a) A kite spread is generally purchased as insurance when an iron condor or credit spread threatens to move into the money.  It's either a bullish position using calls, or a bearish position using puts.  It's constructed by buying one option (the kite string) and selling (usually) 3 or 4 farther OTM vertical spreads (the kite sail).  A more detailed description is available.

b) 'On top' means closer to the money.  It's a call option with a lower strike  than the options being protected.  Or it's a put option with a higher strike than the options it is protecting.

Example:  Please note:  These are randomly selected fictional trades, generated today, with RUT @ 675.  I don't have prices for these 'old' trades. The discussion involves the appearance of the portfolio, how it came to be constructed and says nothing about profitability.

Assume you sold 20 call spreads:  RUT Apr 650/660 when RUT was trading below 600. 

As RUT moved above 620, you became concerned about the position and decided to make an early adjustment (a Stage I adjustment). The trade you chose was to buy 2 RUT Apr 640; 670/680 kites [This is the C4 variety]

Adjustment I:

Buy 2 Apr 640 calls

Sell 8 Apr 670 calls

Buy 8 Apr 680 calls

You now own 2 Apr 640 calls and are short a total of 28 call spreads

The market continues to move higher, and when RUT passes 635, you are very uncomfortable with your position.  It's time (you decide) to get out of some of those 650 calls.  The simplest trade is to buy back a few of the Apr 650/660 [typo corrected] call spreads, but you decide to buy kite spreads instead.

You buy 5 Apr 650; 670/680 C3 kites.

Adjustment II:

Buy 5 Apr 650 calls (to close)

Sell 15 Apr 670 calls

Buy 15 Apr 680 calls

Comment:  Increasing position size is usually a poor choice.  The reason it's acceptable with a kite spread is that the adjustment trade (as a stand-alone position) adds no additional risk to the upside, other than the debit incurred when placing the trade.  It does provide plenty of upside profit potential when RUT is not near 680 at expiration.

When RUT moves past 640, one reasonable trade is to sell the 640/650 C spread.  This feels counterintuitive, especially when the upside is where risk lies and making the upside worse doesn't feel right.  But if you sell this spread between $6 and $6.50, the maximum loss is only $350 to $400 per spread and it does make the down side better.

The true rationale for selling the call spread is to use the proceeds to buy more kites, reducing my short position on the 650 line.

Adjustment III

Sell Apr 640/650 spread 2 times

Buy 3 more Apr 650; 670/680 kite spreads

The position now looks like this: [with errors corrected]

– 10 Apr 650 calls

+20 Apr 660 calls

-32 Apr 670 calls

+32 Apr 680 calls

James calls this a back spread and I'd prefer to describe this position as one that contains a back spread within.  The characteristic that gives this backspread-like properties is the fact that the extra long options are no longer 'on top.'  The long option is the April 660 call.

To completely eliminate backspread characteristics, there are alternatives:

a) Buy 5 Apr 650; 670/680 C3 kite spreads.  My preferred choice

c) Buy 5 Apr 650/660 C spreads. Perhaps sell one extra Apr 660 call to offset the cost cost, but only if the risk graph and your comfort zone allow that trade.  I see no good reason to make this trade

c) There is no necessity to make these trades, but if looking at the 'backspread' portion of the position is uncomfortable (too much negative theta), you can take steps to alter the position

That's how kite spreads can turn into positions that resemble back spreads.  And the process continues.  With RUT currently trading near 675, it's likely that anyone holding this position would have repurchased many of the 670 calls as part of a kite that sold more 690/700 spreads.


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