Straddle, Strangle Or Reverse Iron Condor (RIC)

[Kim]

I'm asked many times how I choose between Straddle, strangle or RIC for my pre-earnings plays.

 

It's always a balance between risk/reward. As we know, those trades are supposed to be sold before earnings. They benefit from IV jump and/or price movement. The biggest (and basically the only) enemy is the negative theta.

 

When buying a strangle, we are buying calls and puts with different strikes. The strangle will have the largest negative theta (as percentage of the trade value, not absolute dollars). Further you go OTM, the bigger the negative theta. If the stock moves, the strangle will benefit the most. If it doesn't it will lose the most. I found that if I have enough time before expiration, deltas in the 25-30 range for both puts and calls provide a reasonable compromise.

 

For lower priced stocks, I would prefer a ATM (At The Money) straddle (buying the same strikes). For example, strangle on a $20 stock might be very commissions consuming, plus the negative theta might be too big. 

 

Please note that when I'm talking about the theta being larger or smaller, I'm always referring to percentages, not dollar amounts. In absolute dollars, the theta is always be the largest for ATM options. However, since those options are also more expensive in dollar terms, percentage wise the theta will be the smallest.

 

For higher priced stocks (over $100) I will usually do RIC. Since you sell a further OTM strangle against the purchased strangle, this reduces the theta of the overall position. It might be the least risky position and still benefit from IV jump like AMZN trade. I prefer to have spreads of $5 for RIC. 

 

Since I don't know what will happen with the stock I play, I prefer to have a mix of all three. In case of a big move, strangles will provide the best returns. When IV is low, RIC will provide some protection against the theta while still having nice gains from time to time.

 

Remember: those are not homerun trades. You might have a series of breakevens or small losers, but one down day can compensate for the whole month. This is why I want to be prepared when it happens. In August I had 4 doubles in two days (but I played mostly strangles).

 

Generally speaking, RIC is the most conservative trade due to lower negative theta (the sold strikes reduce the negative theta). But if the stock moves sharply, strangle will produce the highest gains. It also might lose the most if the stock doesn't move and IV increase is not enough to offset the theta.

 

Let me know if you have any questions.

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[guarneri]

Kim,

I understand that your model portfolio is based on a $1000 of allocation per trade, and you do straddles/strangles for lower priced stocks and RICs for higher priced stocks.

My question is: Would you change anything if you had a much bigger allocation amount per trade? Say if you allocate $20K or even $50K allocation per trade, would you still use RICs or would you just use straddles/strangles to minimize the commissions.

Anything else you would change or would need to consider if you had large allocations such as these?

Thanks.

[Kim]

Except for reducing the cost, the RIC has an additional purpose: to reduce the negative theta. Since you are selling options against the options you are buying, the sold options significantly reduce the negative theta. This is especially important when the options are very close to expiration.

Of course reducing the theta reduces the positive vega as well, so RICs come with reduced risk and reduced profit potential. The gamma is smaller as well, so if the stock moves, the straddle will usually make more than RIC.

I have seen many cases where RIC lost 12-15% while strangle would lose 30-35%. The opposite is correct as well. Some RICs made 20% while strangles would make 40-50%.

Since we don't know in advance if the stock will move, and IV will increase enough, I want to have a mix to have smoother results.

If you decide to trade strangles instead of RICs with short expiration, I would recommend to enter no earlier than 2-3 days before earnings.

[Mikael]

Hi Kim, i was just wondering how you select the strikes for the strangles. 

 

Thanks.

[Kim]

Lately I'm not doing many strangles, but when I do, it is mostly based on the trade cost and theta.

[Klenko]

RE: "I have seen many cases where RIC lost 12-15% while strangle would lose 30-35%. The opposite is correct as well. Some RICs made 20% while strangles would make 40-50%."

 

Comparing parameters:

1) RIC with profit 20%/risk 15% and.. 

2) Strangle with profit 40%/risk 30%.

 

Isnt it still better investing half dollar amount to Strangle and have the same dollar risk like in RIC. Taking into consideration you have less legs to open which means less slippage and commissions too.  

[Kim]

Correct. Slippage and commissions are definitely an issue with RICs, this is one of the reasons I rarely trade them anymore.

[candreouTrade]

Correct. Slippage and commissions are definitely an issue with RICs, this is one of the reasons I rarely trade them anymore.

 

Kim, is this no longer the case?  I have only been a member shortly, but i can see through January we have mainly traded the RIC.

[Kim]

It is still the case, but I'm trying to limit those trades to the most liquid stocks so liquidity is less an issue. We need to adapt to constantly changing market conditions. Calendars are mostly pretty expensive, and RICs should provide good protection in this volatile market.  

[Amos]

If I am reading this correctly, this is my summary I gather from the initial post:

1. For a Straddle, we want the price of the underlying to be $20 or less.
2. For a Strangle , we want the price of the underlying to be between $20.01 and $99.99.
3. For a RIC, we  want the price of the underlying to be above $100.

Would this be a correct assumption?

[Kim]

I made some changes to the original post. The prices are examples only, it also depends on IV - for example, straddle on high IV $100 stock might be still too expensive for small portfolios (if you want to keep 10% allocation) and strangle might be more appropriate. Since we are running 10k model portfolio, I'm trying to set trades that don't exceed $1,000 (or slightly more). So selecting between straddle or strangle will also be impacted by your portfolio size and risk tolerance, with strangle being the most aggressive trade out of the three.