Tag Archives | trading options

Iron Condors: Introduction to Risk Management

One of my oft-repeated messages to option traders is that it is easy to make money when trading options and the difficult part is keeping those earnings. Many of the income-producing strategies win a majority of the time. They are designed to produce more wins than losses.

The problem arises when the stubborn trader, doing whatever he/she can to avoid taking a loss turns a position into a giant loss. That’s the path towards blowing up a trading account. We all say that it will never happen to us because we are too smart, or too disciplined, or too anything else that you want to include.

The fact is that you must be able to apply that discipline when the pressure is on. That means when losses are mounting, the market is not moving your way, and you are pleased with neither what you own nor the chances of salvaging the position. If you cannot pull the trigger when that’s what must be done, then you are in trouble. Warning: pulling that trigger far too early – just to prove you can do it – is also ineffective.

With that as background, a discussion of risk management is necessary for option traders.

Introduction to risk management

Today’s video is a basic introduction to the concept of risk management. It’s 8 minutes of background and general advice, with no specific trade suggestions.



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Is it Easy to Make Money Trading Options?

Twitterfest

Today:1:30pm EST Twittercast. I’ll be answering all of your options questions via #smartoptions


Many claim it’s a cinch to earn money by trading options – practically guaranteed.
Are they telling the truth?



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Option Trading with Too Little Cash

Mark,

I have a very small amount of money invested with TDAmeritrade. I have some stocks, about 10, with varying amounts of each, but all under 100 shares.

In reading your book about options, I do not want to write covered calls or puts, but do want to use options to earn small profits from 1-5 contracts. Is the best conservative way to invest with options to buy a small number of contracts for an interesting stock or to start with collared positions to protect my money? Thanks for your response.

Teresa

***

Hello Teresa,

Very sound questions.

A good and conservative method for protecting assets is to use collars. They offer a limited opportunity to earn cash, and that is one reason why I don’t believe they are currently a good choice for you. However, the point is moot.

To use the collar strategy effectively, you must own at least 100 shares of stock.

The collar is made up of three parts. Buy stock, buy put, sell call

You already own stock, but it is less than 100 shares

You are allowed to buy a put option because stock ownership is not required to buy puts.

However, you cannot sell the call option unless you own 100 shares (your broker will not allow it, and it is far too risky for you. If the stock rises too far, you can lose a lot of money. When selling one call option, you accept the obligation to deliver (sell) 100 shares at the agreed upon (strike) price. You don’t own those 100 shares. If the stock rises, you can easily lose money.

Part of the collar?

If you try to do part of the collar and only buy one put to go with your stock, that is ill-advised. First, it will cost more than you would be willing to pay. Next, you would own too much put protection. Remember that each put option allows you to sell 100 shares at the strike price – and you don’t own that many shares. Thus, unless the stock takes a very big move higher (to compensate for the cost of the put) or lower (allowing you to profit by owning more put protection than needed – this trade is going to lose money. And that’s going to be most of the time.

Buying options

As far as buying 1-5 contracts in an ‘interesting stock’ is concerned, you certainly can do that.

However, you are asking my opinion and I strongly believe that the chances of finding the right stock, at the right time, and buying the right option at the right price – are so tiny, that it is truly a very bad idea. But it’s a common idea. Vast numbers of individual traders do buy options, hoping for a miracle.

In addition, some brokers make it impossible to succeed. The commissions are so high that the small trader has no chance. Do you want to pay $15 to buy the options and another $15 to sell? If you make a profit of $50, all you get is $20. And if you lose $50, the loss becomes $80. The numbers are stacked against you.

Theresa – please think of what must happen: Your interesting stock must make a move in the right direction. It must move quickly because your option loses value every day. It must move far enough to compensate for the cost of the option and the time decay. Do you recognize how the odds are stacked against you? This is more gambling than investing. I don’t recommend it, but it is your money and if you want to gamble you can do so. But for someone who is concerned with using collars to protect assets, gambling should be the last thing on your mind.

My best advice

Avoid options until you have more money. Assuming you have an income, add to your savings every week or every month). When you have more cash available, and if you want to own 100 shares of a single company that is the time to re-think your choices. The collar is very conservative and not for investors seeking growth. If you seek protection of your assets, I’d suggest avoiding the stock market altogether.

Although age is not a determining factor, if you are young with your whole investing future ahead of you, I urge you to wait until you are better funded before using options. If you are nearing retirement, then I believe the idea of buying options is a bad choice. This is when you can ill-afford to be taking chances.

Repeating for emphasis: Buying options is speculative, no matter how interesting the stock may look. It is a way to make some big money – but the odds against success are very long.

I hope you make a satisfactory (for you) decision.

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Trader’s Mindset Series I. How Much can I Earn when Trading Options?

Over the past week, I've encountered a group of questions and comments from traders that tells me that traders have a certain way of viewing the world.  These each represent part of the Trader's Mindset.  I've already responded to some of the questions, while others remain on the 'to do' list.

Today I'll tackle one of those questions:  How much can I expect to earn when using options?

I plan to reply to each question and will group them as part of the Trader Mindset Series.  Taken together, they represent how one  trading professional, but psychology amateur, views the psychology of how trader's think.

***

I understand the thought process behind today's question, but it always disturbs me.  It's just the wrong question.  It would be better to ask any of these:

  • How much time should I expect to devote to my options education before expecting to earn money?
  • How much cash do I need before opening an options trading account?
  • Do most new option traders find success?  Or do most give up?
  •  I've never traded stocks or anything else.  Will that make it difficult to learn to trade options?
  • Should I learn to trade options or pay someone else to trade for me?

These questions  demonstrate that the person who wants to become an options trader recognizes that this is not a gimmie, and that some time and effort must be expended before rewards can be expected.  The commonly asked question: 'How much can I earn?' suggests to me that the person asking 'knows' success is easy, and that the only thing holding him/her back from joining the game is wondering whether it's worthwhile. 

I seldom, if ever, receive a question along these lines: 'What does it take to succeed?'   It's always similar to: 'I'm going to succeed.  How much can I make?'

***

A recent letter from Jo:

Hi Mark,

Is it possible for an ordinary person to generate income from trading options if they are able to sustain themselves for a few months without a job while they learn the ropes? How much can one hope to earn through trading options on the conservative side, and how long does it take to become an expert on average?

Is it necessary to purchase special software for options trading (technical indicators and such)?

Thank you,

Jo

***

Yes.  It can be done.  You can generate income.  However, when you 'need' the money for living expenses, it often places too much pressure on the investor/trader to succeed, and succeed right now.  That added pressure can will lead to poor trading decisions.  I know you understand. And that's why you plan to have 'a few months' cash in reserve.

The good news is that you recognize that profits do not begin from day one.  The not so good news is that you are asking whether it's reasonable to learn enough to make a living – during those few months.  The first answer is that every student has a different ability to learn and some just have a better aptitute and can understand how options work more quickly than others.  So yes, it is possible to produce earnings within that time slot.  But not everyone can move that quickly.

To succeed, you must understand what you are trading, and that means taking time to learn options basics. You should have no trouble understanding that options are different from other trading vehicles.

But I must warn you that some traders never get the special characteristics of options and mistakenly believe that they can be traded as if they were stocks. Options are different.  Not difficult to understand, but they are different. 

If you are brand new to trading, that means there is even more to learn, including basic things such as how to enter an order, how to use your broker's trading platform, the different order types (market, limit, stop etc.).  Someone with stock trading experience is already familiar with those items.

Discipline

In addition to how options work, the trader must possess (or be able to develop) certain personality traits.

Jo, if you are willing to learn how options work, and if you believe you can demonstrate the traits listed below, then you may very well be able to succeed.  No guarantees.

I do want to mention one important point.  if you expect to make money (income) by buying options and then selling them for profits, let me tell you that this is an almost impossible path.  When earning an income stream, the methodof choice is to adopt specific option selling strategies – all with limited risk.

Anyone can trade.  Anyone can enter the arena and place his/her bets.  But to have a chance of making money on a consitent basis, the trader must have

  • Discipline
  • The ability to recognize risk
    • how much money is at stake for a given trade
    • the probability of losing money
  • Patience to learn before trading
  • Patience to practice what you have learned, usually in a paper-trading account
  • Ability to control your feelings.
    • Fear leads to panic, which results in terrible decision making
    • Greed has you taking too much risk for too little reward
    • Pride has you refusing to recognize that you made a bad trade and must accept a loss
  • Recognize that a few successful trades does not make you a star trader
  • Understanding that you cannot make money every month
  • Understanding that low probability events do occur – just as statistically predicted
  • Recognize that a 90% chance of winning means there is a  very real 10% chance of losing
  • Accept the fact that you cannot make much money when you only have a small sum to invest
  • Knowledge that luck plays a role, and your job is to manage risk when luck is bad


Now, to your Question: How much can you make?

If you trade high risk strategies, you have a chance to earn a large sum (10+% per month), but that comes with a very high probability of going broke.  High rewards come with high risk.

If you are more conservative (as you are), you may try to earn 'only 2-3%' per month.  That's a very good return. Most professional traders cannot earn that much.  Brett Steenbarger once told me that the best professional traders earn 'in the low (emphasis on low) double digits' per year.  That sounds right to me.

Going by that, earning 1% per month is a realistic target.

However, to give you a better answer, I must ask: How much cash do you have for trading?  This is a key question that most beginners ignore.  They assume they can earn the same amount of money, no matter how much cash is in the account.  This is a huge fallacy. Why?  When you begin with a small sum, the risk of ruin, or the probability of going broke, is very large.  When you have extra cash, you can withstand a string of small losses and still stay in the game.

Also: When you have a small accout, if you have outstanding success and double the account in one year, the total dollars earned is small.  It does take money to make money.

Thus, I repeat, how much cash do you have?  If you have $10,000 and can do an excellent job and earn 2% every month, that's a grand total of $200/month.  That will not take you very far.  I assume you would want to earn a minimum of 10 to 20x that amount.  To do that you would have to take big gambles.  There's a chance that you could have a nice win streak and quadruple your money in a year or so.  But the most likely outcome of seeking such huge returns is the loss of all your capital.

Yes Jo, you can do it.  If you have the patience.  If you take the time to learn and are not rushed into trading.  And if you have sufficient capital to give you a realistic chance.  If you lack the capital, you can still learn and trade part time.  If you grow the account, if you save more cash over the years, if you show the talent and discipline, you may eventually have enough to try trading full time.

I wish I could offer better encouragement, but trading is not a business for everyone.  Being a successful investor can be very rewarding over the years.  Trading full time is different.

 

Becoming an Expert

On average, far more traders go broke than become experts.  Very few become experts. This question depicts another trader mindset that I believe demonstrates no conception of reality.  How long does it take to become an expert?  A lifetime. 

Experts are few and far between – assuming that by 'expert' you are referring to someone who knows how to make money and then actually makes it and keep it.  With that definition, few are experts.

Trading is a game in which you are continually learning.  And that's important because markets change over time and if you still do whatever it is that you are an expert at doing, eventually it will no longer work and you will cease being an expert.

It is not necessary to become an expert. You do not have to earn more than the next guy.  In my opinion, you can do well (earn decent income) if:

  • You have the ability to understand how options work.  This is not difficult, but some people just don't have the head for it
  • Trade with discipline and overcome emotions.  Fear and greed are harmful.  It takes a while to overcome those and trade with confidence
  • You take the time to practice.  That means using a paper-trading account with fake money.  But to gain useful experience, you must  believe it is real money and trade accordingly
  • If you don't have to win right now, you need the time/patience to learn.  I don't know if a few months are enough.  That depends on you

Technical Indicaors

No.  I have NEVER used technical indicators. I know that some traders are very skilled in doing just that.  But they do not learn overnight, and anyone who tells you it's easy to learn is not telling the truth.

I use no trading software, other than risk management software supplied by my broker.

 

I suggest getting started by reading or atteding some free seminars.  If you like what you read and hear, if you understand what you see, then go for it.  Plan to spend some time in the education mode.  Especially if you set a few months as the time limit.  There's no time to waste.  I wish you good trading.

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Ebbets_Field_Outside2

 

 

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Trading and Liquidity

Hi Mark,

I have a few questions on option liquidity that I was hoping you could clarify for me:

1) Before I enter a trade, should I look at the options volume of the strike I am buying (or selling) to determine whether that option is liquid? Or should I be looking at the option’s open interest? Or a combination of the two?

2) Should the bid/ask spread also be taken into account to determine how liquid the option is? Also, typically, how tight should the bid/ask spread be for the option to be considered liquid?

3) If I am interested in entering a spread trade (e.g. a vertical credit spread) and one of the options in the spread has very high volume and very high open interest, but the other option does not, would it be a good idea to look for a different spread where all the legs are liquid?

4) I have seen strikes with very high options volume but very low open interest. Does that mean that the options at those strikes are not liquid enough because the open interest is low (even though the option volume is high)?

5) Which one of the two indicators (option volume or open interest) should I be looking at before entering a trade in order to ensure that, if I need to close out the position, that will happen quickly and at a good price?

6) Are there any rules in the exchanges that limit how wide a bid/ask spread can be? For example, if I enter a trade when the bid/ask spread is fairly tight and then, due to lack of liquidity, the spread gets wider, is there a maximum limit to how wide that spread can become? Also, is there a risk of not being able to close out that position due to lack of liquidity?

Thanks

DC

***

Hello DC,

I never paid much attention to liquidity when trading options on individual stocks, and continue to believe that low volume is not important for most traders.  However:

1) Liquidity is important when you believe that you may want to trade those options again, prior to expiration. For example, you may want to close the trade to limit risk, lock in profits, or roll the position to another month. If you plan any of those trades, then liquidity is important from the perspective of efficient trading.  It's easier to get your orders filled when the market makers want to trade, rather than avoid trading, the options of a given underlying.

If you avoid trading options with limited volume or open interest, you may (and may not) save yourself some grief.  In other words it's a safety play that may avoid trouble later.  It's a good idea to avoid trouble.

However, if your plan is to trade these options once and forget about them (not good risk management technique), then liquidity does not matter.

OI on the specific strike is not important. If the OI is decent for the options of this underlying, that should be good enough to encourage you to make the trade. I believe a high OI is more important than high volume but I cannot truly explain just why this is true.

2) Yes bid/ask matters to a point. I cannot tell you how wide the idea bid/ask spread 'should' be – because the bid/ask is not that important by itself. What counts is the TRUE bid/ask, and that is always invisible.

In other words, where do the market makers trade? How far above the bid can you sell? How far below the offer can you buy? That's what matters and you cannot know that without attempting to trade these options and learning the true bid/ask spread (referred to as the 'inside market').

3) No. If one option has good liquidity, it is almost guaranteed that the spread will have good liquidity because the market makers will take the other side of your order.  Warning: You must enter the order as a spread and not as two separate orders.

4) Difficult to say. If someone buys 10,000 calls and then the OI remains near 10,000, there is not much liquidity – for your purposes. Sometimes large blocks are crossed by professionals and neither market makers nor individual investors take part in the trade. So if the volume is low, you never really know how easy it will be to make trades at fair prices. The usual case is that high OI and high volume go together, but as you indicate here, that's not always the case. If he market makes want to trade, they will make good markets.  If the public doesn't want to trade, there will be low volume.

Because you don't know the mindset of the market makers, you can only discouver the truth by entering orders.  When you discover poor quality markets, cross that underlying off your list.

5) You cannot get any such guarantee. If it hits the fan, bid/ask spreads widen and no matter how high the quality of previous markets, the market makers may back away from trading, leaving you poorly placed when attempting to exit or adjust.   But, if either OI or Vol is high, you 'should' be okay. But 'should' is not a 100% assurance.

6) Yes, there are limits. However, for the life of me I cannot understand how bid ask spreads can be as wide as they are. The exchanges allow exceptions to the rules, and it seems to me that the rules have been ignored for years. To find out the official rules, you can ask that question: options@theocc.com

The truth is simple:  If the market markers become afraid to trade – and that should be very rare – there is nothing you can do.  Thus, good OI numbers and good volume should make it easier to trade, but unusual circumstances (flash crash for example) may cause any options to become diffficult to trade.

 

Keep this in mind:  If you are attempting to trade 5-lots, you need not be concerned with any of this.

818


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Trading Options for Special Situations

Mark,

A service that one of my friends is following is promoting so called
“Special situation” trades. The three criteria that all Special
Situations have in common is where a temporary market imbalance creates a
scenario where:

A) It would be extremely improbable for us to lose money
B) The return on investment is unusually high
C) A credit spread is determined to be the best vehicle for the trade

Examples:

1) FAZ has been trading in an up-and-down range from 13 to 18 for the
past three and a half months. To get below 13.00 things have to be
REALLY BULLISH in the financial sector. To take advantage of this
imbalance, he is proposing selling the FAZ Oct 13/12 put spread for about 40
cents, or 68% potential profit.

2) SDS has been reversing right around the 31.00 level for the past four
months. The trade would be to sell SDS Oct 30/29 put spread for
about 34 cents or 51% potential profit.

3) VXX is likely to go up because it's near a significant low and
there's a lot in the coming months for the market to digest. The trade would
be to sell VXX Oct bull 19/18 put spread for 47 cents or 90% potential
profit. [NOTE: 47 cents on 53 cents margin MDW]

4) TBT will go up because it's at the low end of a range and interest
rates just can't go lower. The trade would be to sell TBT Dec 30/29 put spread for 35 cents, or 55% potential profit.

What do you think about this strategy in general?

Kim

***

Hi Kim,



In general, the strategies are fine.  IF YOU WANT TO MAKE DIRECTIONAL PLAYS BASED ON THE INFORMATION PROVIDED, then go for it.   That's the key.  Do you have confidence in the market predictions implied by these trades?  I have no reason to tell you that this service is good or bad, but…

The scenario sounds good.  My only concern is that A) and C) are obviously based on opinion. Thus, you must trust the service's opinion.

1) The FAZ spread: Remember this is a triple weighted ETF, and those come with a built in tendency to trade lower as time passes.  Before jumping into this trade, take a look at the corresponding ETF – i.e., the one that is NOT triple weighted.

The return is excellent.  If you want to take this bet, then it's a good trade.  Recognize that the 13 put is not too far OTM, and my concern is:  What's the trade plan?  Hold to the end (not unreasonable here)?  If not, when would you adjust, and what is the probability of reaching that adjustment price?

2) I don't get this services fascination with leveraged ETFs.

To me, this is NOT a special situation.  It's a market bet based on recent price history.  I'd ask the service: "What makes this a special situation, other than your opinion that it's special?"  The same can be asked for the FAZ spread.

3) VXX is near a recent low?  Based on what?  This is a new product without much history.  Likely to go up?  Who says so?

Look at the chart in the upper 50s.  Couldn't the same argument have been made at that price level?

Kim, these are just a market timer's opinions.  I would want to know if he/she has a good track record before placing bets on his/her opinion.  I see nothing special about any of these trades.  Note: I am not a technical analyst and if you want to bet on chart reading, I wish you well.  I cannot provide any help there – because I do not pay attention to charts.

4) 'Can't get any lower'  Listen to yourself.  Who says it can't?  I have no opinion, but beware of people who tell you this or that cannot possibly occur.  Don't ignore Keynes: "Markets can remain irrational longer than you can remain solvent."

There is no outlandish danger here – other than a) making a market bet based on someone's chart reading, and b) a huge decline.

Regards,

Mark

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Trading Mistakes: Did You Make One? How can You Tell?

Mark,

Sorry to be off topic a bit. But the only way I learn is by putting
money on the line, making mistakes and not doing THAT mistake again. Got
caught in a squeeze, extricated myself with considerable difficulty.
Licking my wounds right now.

A few days ago when you or somebody else said
"Waiting for expiration is so retail" is absolutely right. What
shenanigans they play, I gotta hand it to them. Had a sleepless night 2
days running yesterday & day before wondering if I would be
assigned. I should have taken the 70% of premium.

Chalking this to
experience.

Is this why you dabble in RUT only? I was thinking of dabbling in
SPY.

Thanks,

Amit

***

Hey Amit,

You are never off topic.

I trade a single underlying for only one reason – a reason that may not be applicable for others.  If I get into trouble, if the market is going nuts, I want to have as few decisions to make as possible.

Even if planned advance, three underlying assets may be responding to the market situation differently.  I don't want to take too much time to put out fires.  I want to be efficient and quick.  Thus, one underlying asset.

Yes, it's a bonus that RUT is a European style option that settles in cash. SPY options are American style and settle in shares.

Per your opening paragraph: I want to play Devil's Advocate: 

Your plan is not efficient because:

a) How do you determine when a mistake was made?  Because you lost money or could have made more money with a different decision?  This is a terrible method for deciding if the action taken (or not taken) was a mistake.

Just because exiting at 70% of the maximum profit would have been a good idea this time does not make it a reasonable strategy.  I surely hope you agree with that statement.  The only thing you learned is this:  This time, this one time, exiting at 70% would have worked best.  

Now examine 99 similar occurrences, and when you have 100 examples, then you can decide on an exit strategy.  That means you must keep a trade journal and record each trade.  Keep tabs on what action would have achieved the maximum profit.  Keep track of your actual decisions.  Eventually you will have a clue about what to do.  Act accordingly when trading.  Just remember that no valid conclusions can be drawn until there are a significant number of data points. Be ready to modify your methods as you gain experience and have many more trades under your belt.

b) You can draw no valid conclusions from a single data point.  Doing so is dangerous.  In fact, it's a mistake.  If you want to avoid a mistake, here is an opportunity to avoid one.

Suppose riding the position to expiration would have worked this time.  Does that mean you would feel differently about waiting for expiration to be 'so retail' (nice phrase; not mine)?

c) It takes repetition and statistical evidence before you can draw valid conclusions.  This is even more true for inexperienced traders who don't have a background of many trades to use as a filter for the decisions being made.  Do not decide that something that resulted in a loss is a mistake.

d) You should recognize a mistake when you make one: You took too much risk.  You traded too much size.  You traded too little size because this situation was special and 10 to 20% more contracts would have been justified.  You got too greedy. You were far too cautious for no good reason. You ignored your trade plan for no valid reason.  You felt uncomfortable with position risk (more sleepless nights?) and did nothing to alleviate the risk.  Those are mistakes.  Even if the result is a huge profit, these are mistakes.

e) If you sell premium, you will get caught in squeezes.  Your job, as a risk manager, is to anticipate the squeeze and alleviate some of that pain in advance.  You may decide to reduce the effects of a squeeze by reducing position size.  You may exit the trade and eliminate the risk of a squeeze.  It locks in a loss?  Who cares?  You know some trades will lose money.  Minimizing those losses is NOT a mistake.

Your job is not to hold on to a bad trade stubbornly, hoping for the best.  Your job is manage risk well.  Succeed at that, and most of your 'mistakes' will disappear.

You will take losses.  The market will move in a manner that does not suit your hopes or expectations.  These are not mistakes unless you missed the obvious and refused to take appropriate action.

Sometimes, the market will behave in a manner that suits your positions.  That makes you neither a good trader nor a genius.

Recognize the facts:  You will win some and lose some. If you manage risk well, you are doing your job.  If you lose money despite taking good, appropriate action, you did the right thing and it is not a mistake.

One more point: Unless you are short OEX options, why are you afraid of being assigned an exercise notice?  Early assignment reduces risk and is often a gift.  If that assignment would result in a margin call that you cannot meet, then your positions are far too large. Assignment is nothing to fear.

741

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Coming in the July 2010, to be published next Monday: July 19, 2010

Interview with Charles Cottle

Book review: Volatility Trading by Euan Sinclair

Bill Luby discusses the suggestion that volatile markets are coming

Guest article by Tyler Craig – Adjustment Trading

New Contest.  Win a year's subscription to Barron's

Lot's more

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Gamma, Vega and Risk Management

When trading options, holding positions with too much gamma – positive or negative – can be dangerous. It's necessary to avoid getting hurt by the two most destructive emotions for traders: fear and greed.

On Monday, Jun 28, 2010 the markets fell hard.  That 1040 SPX price level – that many believe is a vital support area – was tested.  Option prices rose sharply as is seen in the performance of VIX and RVX.

Tuesday (as I write this) the markets are slightly higher and option prices are once more coming down to earth.  I had better rephrase that.  Option prices and implied volatility are decreasing, giving up a significant portion of yesterday's gains.  In my opinion, prices are still high.  ADDENDUM: By the end of the day, the markets closed lower.  SPX broke down by trading below 1030.

When IV moves sharply higher, the trader who is not vega neutral, and that includes most of us, must demonstrate the ability to handle and manage risk.  If you are a clear thinker and make good trading decisions, your portfolio is probably in good shape.  The same can be said for most traders who prepared a trading plan in advance.  That plan is designed to save any trader (and especially the inexperienced) from panicking in a stressful situation.


Positive gamma and vega

As the markets get more volatile, and especially as markets decline, traders who own positive gamma and positive vega are well positioned to profit.  Nevertheless, that trader cannot afford to idly watch the markets as the days pass and theta takes its toll. 

Positive gamma is a delight in that it allows the trader to pick the time and place for making an adjustment.  This adjustment locks in profits and can include the sale of some options to reduce both gamma and vega, or it can be made in the form of shares of the underlying (stock or futures contracts).  It's tempting to hold the position, but a minor reversal, such as seen Tuesday morning threatens much of the profits.  Greed makes the trader hold out for larger gains.  Fear makes the trader panic and sell (what is probably) an inappropriate portion of the position.

However, a well-thought out plan, or sound risk management, allows the trader to reduce risk by moving closer to neutral in gamma, vega, and delta.  Ignoring greed, the successful trader adjusts the position – retaining some vega and gamma.

Negative gamma and vega

Iron condor traders seldom find themselves in the positive gamma/vega boat.  The only exception occurs when extra options are owned as insurance, and these extra options are in play (not too far away from being ATM).

Thus, they (we) may be floundering when the positive gamma group is sailing along smoothly in those choppy waters.

If your positions have too much negative gamma, if your short options are not too far OTM, then it's time (or past time for many conservative traders) to adjust the position.  Panicking in a sudden meltdown is unlike to produce good results.  However, ignoring problems, hoping they will disappear, represents a different type of panic decision – being too afraid to act.

If you have a trade plan in place, it's probably right to take the action as prescribed in the plan.  Lacking a plan, it's not too late to create one now.  If you are capable of making sound decisions as losses mount, then good for you.  Take advantage of that skill by taking sound steps to protect your assets.  Be aware of potential loss, your pain threshold and comfort zone boundaries.

If you lock in a loss and the market reverses, so be it.  Your goal is to pay attention to rule #1: Don't go broke.

If you are not yet in trouble on this decline, you have the luxury to plan ahead.  I'm planning to sell extra vega by doing a ratio roll down* for some RUT Aug and/or September put spreads.

* Close current short put spread and sell a larger quantity – perhaps 3 for every 2 bought – of farther OTM put spreads.  I prefer to move the strike of the short option by at least 3 strikes.  Collect a small cash credit for the trade.  I only do this when my portfolio is not already at its maximum size.  Make no mistake about this trade: it does increase ultimate risk.  it looks good because the probability of the large loss is reduced.

Example buy two 560/550 put spreads and sell three 500/510 (or perhaps 510/520) put spreads.

730

Kindle book available:

Lessons of a Lifetime: My 33 Years as an Option Trader;  $10


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