Hi Mark,

Can you tell me how to arrive at a fair value for an Iron Condor?

Ivan R

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Ivan,

This is a topic I have long ignored. It's a very good question.

In my opinion, it's not worth the effort to determine the theoretical value of each of the four options. You would have to make a very good estimate of the future volatility of the underlying asset because you need that volatility number for the calculator.

If you don't already know, let me assure you that it's not so easy to make that volatility estimate. Those who are truly skilled in predicting future volatility have a huge edge over everyone else who trades options.

But, if you want to do the math, you can still get yourself a free option calculator and make the calculations for each of the options that comprise the iron condor.

Another choice is to use the theoretical values offered by your broker. The only problem with that is you never know how they chose their estimated volatility – or whether it's a reasonable estimate.

I prefer to look at trading an iron condor this way:

1) When you trade an iron condor, you are a net seller of vega, and that's the component of an option's value that changes as implied volatility changes.

Clarification: When IV increases, the market price of an iron condor increases. When IV decreases, the market price of an iron condor decreases.

2) If you believe the current implied volatility (IV) is high (and likely to move lower), then you are going to get a good price for the iron condor. In other words, using the current IV, the market price for the IC will exceed your calculated theoretical value.

I recognize that you may not have a good feeling for whether current IV is high, but if you cannot do that, then you would not be able to determine a theoretical value for the iron condor. Thus, you are no worse off.

3) If you believe current IV is low, that's not the best time to be trading iron condors – unless you believe IV is going lower. Note, it's not a terrible time – but you probably don't have any theoretical edge going into the trade.

4) If you truly don't know whether IV is high or low – and most traders don't know, you have two choices:

a) Trade the iron condor anyway. Over time you will get good prices part of the time and poor prices the rest of the time. On average you should be okay.

b) Look up the stock's historical volatility over the past 20, 50, or 100 days. If you believe those numbers give you a reasonable estimate of future (from the present time until the options expire) stock volatility, then compare that volatility with current IV. If current is high, trade. If it's low, pass.

Here is how to use those numbers from Lawrence McMillan's web site:

The columns hv20, hv50, and hv100 represent the actual stock volatility over the past 20, 50, and 100 days.

curiv is the current implied volatility.

Percentile is the percentage of the time that the current IV has been LOWER. A high number means that IV is relatively high.

564

Good practical discussion.

Congratulations on a year of excellent and detailed teaching about the nuances of options trading. You’ve created a daily must-see site for anyone that wants to learn how to make a living in this field.

Best wishes for a happy new year.

Hi Mark

Is vega a derivative of Gamma or is vega a derivative of implied Volatility? Am I also correct in understanding that Gamma is a derivative of Delta?

Regarding vega, do you want to see it negative rather than positive or do you want it as close to zero as possible.

Is vega as important for vertical credit put spreads with pre-insurance as it is for IC’s which you have been discussing?

Thanks

Thanks Bill.

Much appreciated.

Happy New Year and good trading to you

Greg,

1) Vega is not a derivative of gamma.

Vega is the derivative of a change in the value of an option with respect to a one point change in the implied volatility.

2) Yes. Gamma is a derivative of delta.

Delta is the derivative of the change in option value with a one point change in the stock price.

Gamma is the 2nd derivative and is a measure of the change in delta when the stock price changes by one point.

3) I only keep vega close to zero when I have no true feeling for which way implied volatility is going to move next.

When I have no opinion, I am short vega. I trade my iron condors and am short vega.

If I believe IV is just too low to sell, then I’ll add some positions with positive vega to neutralize vega risk.

See Wikipedia for some practical information on derivatives.

Hi Marc,

Happy New Year, and thanks again for the blog. When you say IV, do you mean IV for the specific strikes, or do you mean IV as per (say) the VIX/ATM strike? It seems like taking the average IV of your short legs as a quick rule of thumb might help adjust for skew, or is that not really a big problem?

Jason,

Skew is an issue I have not touched upon. I’ll share my thoughts in a blog post.

Happy New Year. Thanks for being a visitor.