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Iron Condor Trading: 3 Ways to Define Neutral

Hi Mark,

I know you're sometimes hesitant to provide too much specific info about how you choose positions, but this type of post is very helpful to certain people. I'll admit that when I started learning about Iron Condors and trying to determine my own comfort zone I did copy your method of taking $3 premium on a 10 point spread (or the equivalent for other spread widths). That allowed me to see how those positions played out and see if my risk appetite matched yours…if not, why not, etc. [MDW: That's exactly how I hoped readers would treat such examples: As examples worth considering]

Questions:

By consistently taking the same premium on ICs, isn't the trader indirectly following the standard deviation method for choosing strikes (assuming inner strikes are equi-distant from the current underlying price)? When IV is high, taking $3 premium will result in a "wider-bodied" condor than taking the same $3 when IV is low. Maybe you have a clearer wording?

However, following along this thought process, if the IC trader wanted to be truly market neutral shouldn't he position his short put slightly farther OTM and position the short call slightly less OTM? When the underlying price drops, IV will almost always go up (bad for a long IC) so the trader would need a bit more "wiggle room" from his puts to compensate. OTOH, when the underlying price rises and IV falls, the trader does not need quite as much "wiggle room" from his calls. So the trader collects a bit more premium on the call side and a bit less on the put side when compared to the equi-distant IC. The risk graph would look like the trader has a directional bias, but after IV is factored in he does not.

Marty,

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This is an important detail and I thank you for introducing it.  I've written about neutrality before, but it's a topic worthy of clarification. I'll get to it below, but I think there are at least three viable methods for defining a market neutral spread.

1) Because both standard deviation (SD) and option premium depend on implied volatility (IV) – then yes – basing strike selection on premium cannot is similar to choosing strikes based on standard deviations OTM.

I find it to be a simpler process to pick the premium than to think of it in terms of SD.

2) 'Market-neutral' is traditionally considered to be delta neutral.  And using that method, yes, the puts would have to be farther OTM because puts have a higher delta than calls – when the options are equally far OTM.

Volatility skew.  For readers who are not aware why this is true, it's based on volatility skew. To state it simply, the implied volatility of all options on the same underlying, with the same expiration date, do not have the same implied volatility.  In fact, the IV can be very different for various options.  The lower the strike price of an option, the higher is its observed IV.   When observing the IV of a string of options, you can see a steady – but not linear – increase in IV as you move from OTM calls to ATM to OTM puts.

OTM puts almost always have higher IV than OTM calls.  This occurs for one primary reason.  Traders have discovered that OTM puts are truly worth more than predicted by traditional option pricing models (Black Scholes).  Because they are worth a higher price, these OTM put options are bid higher .  Long-time option traders (me) who grew up in the era when skew was not part of the options game, have learned to recognize the importance of volatility skew, or else have long ago been blown out of the game (by selling too many puts).  In the 1970s, after puts were listed for trading) it was typical to value OTM calls as worth more than OTM puts.  The rationale was that markets tend to rise over time.  We now understand that even though that may be true, markets fall much more quickly than they rise, and those little puts can become very valuable in a heartbeat.

Bottom line:  Higher IV translates into a higher probability of moving ITM, and thus, delta is higher.  To trade delta neutral, the trader would have to sell fewer put spreads, or move the put spreads farther OTM.

Delta neutral.  Marty – you can trade delta neutral.  If you do, then – voltility skew forces you to do as you suggest – and that is move the puts farther OTM (or sell calls that are closer to the money).  As stated, most people accept volatility skew as rational and when trading delta neutral they own positions which reflect deltas based on real world implied volatility.

However, if you prefer to trade distance neutral, how can anyone argue with that?  It's a trading bias as any other.  The market has been on the rise for the past year and one half, so if trading distance neutral you fared better than if you were trading delta neutral – at least over that time span.  Obviously, you would have done worse over the prior period in which we had very volatile and declining markets.

It's also reasonable to trade dollar neutral.  That simply means that you collect equal premium for the call and put portions of the iron condor.  For my style (13-week options), that would mean collecting something near $1.50 for each side of the iron condor.

This is not an easy decision to make.  The truth is that I don't have any suggestions as to which is the best method.  I suspect that data is available to back test these various methods, but one would have to go back many years. It's probably a worthwhile experiment, but not for me.  I don't have the time.

I believe this is a comfort zone decision.  I know that right now, some traders with a bullish bias love selling puts because they are comfortably positioned for the steadily rising market.  Trading distance neutral works for them.  On the other hand, the bears may be afraid to sell puts that are too CTM, and prefer to be delta neutral because the puts are father OTM. 

One method for claiming to be market neutral may indeed be better than the others, but I lack the proof.  As much as I hated the idea in my early years, I've come to accept that current IV (barring special situations, such as earning news pending) provides as good of an estimate for future volatility as I can get.  Thus, I base my greeks on current IV, and that means taking the volatility skew into consideration.  I can find no argument against those who prefer to open delta-neutral positions. 

My compromise is to choose a position that its between distance neutral and delta neutral, but I do not dwell on this.  Whichever way you choose to initiate the trade, it should not be too far from 'neutral.'  I admit to fearing the puts and trade with the puts a bit farther OTM than the calls.  But this is truly a 'roll your own' decision.

This is a flexible situation.  I recognize that those who want to milk every last advantage out of options trading may want to keep careful records about neutrality and try to benefit from the data.  If you have the time and patience, it's a good idea.  If you have access to data and believe you can objectively select iron condors to trade – when you know the future, that's the best method for resolving this dilemma: How to be neutral.

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