Trader Mindset: Choosing an Adjustment Method

[Kim 7,943]

From Mark Wolfinger, Options For Rookies

An interesting discussion that started in the forum.

I came across an interesting point of view when it comes to adjusting Iron Condors. Iron Condors were looked at for 31 expiration cycles. The Iron Condors were initiated 50 days from expiration. They were also one standard deviation when put on. If a short strike was threatened (touched) in either direction,

the non-threatened side

was rolled up to 40 delta, 30 delta, and 20 delta. The threatened side was not adjusted. The Iron Condors were allowed to expire.

This was compared to adjusting the same Iron Condors on

the threatened side

to 40 delta, 30 delta, and 20 delta. By threatened I mean touching the short strike.

The results came out to be that

• when rolling the tested side, there was no advantage over a long period of time (31 expiration cycles).
  
• When rolling the non tested side. There was an advantage if rolled to the 20 delta.
  

I think this is very interesting. It is also very controversial but maybe worthy of discussion.

I brought this up because an adjustment is definitely likely in the iron condor I have on in this post and am curious to the thoughts of others on this topic.

Jim

Hi Jim

thanks for that, do you have any thoughts about why that would be? Because in a significant number of cases the underlying changed direction completely?

cheers

Greg

My thoughts

Jim, Greg,

There is a lot of meat to discuss from this short story.

First, we know that there are different adjustment methods. Your question allows us to look at rolling up the side not in trouble vs. rolling down the side that is in trouble (underlying touched strike).

Second, we know that we like the idea of selling premium (that is what iron condor and credit spread traders do) and later covering our trades at a profit.

Adopting this roll-up strategy allows to sell premium at adjustment time. That should be a feel good method. In general, I do not like this approach. I prefer to reduce negative gamma as well as reduce delta exposure when adjusting. However, that is no reason not to look at a study made by someone and to comment on the findings.

This discussion allows us to think as a premium seller when it comes time to adjust.

Rolling Up

When chosen as the primary adjustment method, rolling up is a dangerous mindset. It does not prevent occasional large losses. But more than that, it requires that a trader demonstrate great discipline. I know I would find it difficult to see a trending market and be forbidden by system from exiting the trade.

There is always an offset, and the ‘rolling up as the one and only adjustment’ method does provide an opportunity for a big win.

I have not seen the data, but apparently 31-exirations later, the roll up apparently works when the roll is to 20-delta options. And this is the least aggressive of the roll-up strategies.

The negative aspect of adopting a roll-up mindset.

• Some premium sellers REFUSE to buy premium.
  
• They REFUSE to pay cash to reduce risk, and this strategy is exactly that.
  
• The only defensive action taken during the lifetime of the trade is to reduce immediate risk, and that involves bringing in more cash when the profitable portion of the iron condor is adjusted. The are no other adjustments because the position is held to the end – once such an adjustment is made.
  
• It does not feel right to adopt a system that prohibits the trader from reducing risk
  

The question becomes: Is this ‘limited action’ roll-up strategy viable? The data says it is. But I’d like to see that data.

Premium Selling, in general

1) We know from experience that index options tend to be over-priced. Translation: Realized volatility, on average, has been less than the implied volatility at which we sold the options. Thus, we have a statistical edge. It may not be a large edge, but it is real. However, collecting the edge requires a large number of trades. Over the shorter term, we can get hurt badly when waiting to collect the edge.

2) Passive risk management (essentially buy and hold investing) can truly hurt the trader. Consider three consecutive big losses. That possibility could wipe out an account. I find it very difficult to adopt a system – even when I know it has a theoretical long-term edge – when required to sit idly by and watch losses mount.

3) Even the part about ‘holding to the end’ is bothersome. I want to cover short option positions at very low prices. That also makes it difficult for me to endorse this plan. However, I am willing to be convinced and want to see the data.

Viability

The single factor that may make this plan viable is that it is a CTM (close to the money) iron condor. As I use the term ‘one standard deviation,’ the option sold is one SD OTM at the time of sale. The time period used to do the calculation is the option expiration date. Thus, these options carry a delta of ~32. Question: if we begin with 32 delta and one side touches at a 50 delta, what is the delta of the other side at that time? How much cash is generated to roll the short on that side up to 20-delta?

For me the jury is out. I do not have enough information to evaluate this method. However, I issue a warning. If we allow judgment to enter the picture; if we exit part of the time and follow the given strategy another part of the time; if we are not consistent – then we cannot evaluate the results.

If considering this ‘roll-up once and quit adjusting’ method, you must be extra careful with trade size because two losses can be painful and they may knock you out of the game.

Mark Wolfinger

Options For Rookies

[Guest Epsilon Options]

Mark,

Many thanks for your post - and being involved in the forum...

I agree with you that the proposed adjustment is unattractive. Adjustments, as a rule, should reduce risk, and potential reward, not add to it. What's proposed seems to be a version of the dreaded doubling down/Martingale strategy...

I have one question for you re your post: where would you normally start your iron condor? I presume, from what you imply, that you start it out at 1 STD (i.e. a delta of around 32). Personally I start at the 2STD (approx 15 delta) level where it becomes almost a scalping trade (low risk, low reward) and adjust if the delta gets to 40 (i.e. still well away from touching). This tends to work well and is relatively easy to manage with a boring stock. But is it too conservative?

Chris

I also assume that IV is a consideration

[cwelsh 1,549]

Chris:

I'm so happy to see your post -- I've been trying to make the case for several years now that the 1SD trades are much more risky than people believe. I always start any of the trades of this ilk at the 2SD level.

[Kelly Park 10]

Wouldn't a 2SD trade be closer to a 5 delta, instead of 15. ( approx. 95% probability)

[Kim 7,943]

I think there is some confusion here. When open with both short strikes at ~15 delta, this is 1STD.

[cwelsh 1,549]

But some of us advocate 2 SD openings, but yes, I think there were a couple typos by the authors above.

[Kim 7,943]

But some of us advocate 2 SD openings, but yes, I think there were a couple typos by the authors above.

I think it depends on the context. If you are talking about post-earnings ICs, then 2SD make sense. For indexes, I feel you don't get enough credit for the risk you take with 2SD ICs.

[Guest Epsilon Options]

Apologies, yes here was a typo in my post.

I counteract the 'little credit' issue by doing 2STD ICs over 3 months an taking off after 6-8 weeks. Unlike ATM options much of the decay is upfront for options so far OTM.

Not sure if now is the right time for this strategy though - IV is very low.

Chris

[Marco 223]

Apologies, yes here was a typo in my post.

I counteract the 'little credit' issue by doing 2STD ICs over 3 months an taking off after 6-8 weeks. Unlike ATM options much of the decay is upfront for options so far OTM.

Not sure if now is the right time for this strategy though - IV is very low.

Chris

what spacing do you use say on RUT if you trade that, what sort of credit do you target and at what debit do you usually close it then?

thanks,

m.

[Guest Epsilon Options]

I haven't traded RUT ICs (I have used SPY or stocks i believed to be range bound) but I would look at doing something like 680/690/1000/1010 for Dec12. I'd look to get 0.75 minimum and get out when it hit .10. Small but 6.5% on margin over 3 months for 5% risk (plus you can adjust of the strike is anywhere near threatened) but not very exciting.

The current prices, and low IV, are not good for this trade (current price is 0.65). I have used this in the past in high IV environments when collapsing IV assist greatly - but I wouldn't put this trade on now.

I don't trade ICs much - I've heard too many horror stories - hence my conservatism. Happy to be put right (I see Kim goes the other way and trades less than 1STD to collect lots of premium up front as a buffer) though...

Chris

[Marco 223]

I haven't traded RUT ICs (I have used SPY or stocks i believed to be range bound) but I would look at doing something like 680/690/1000/1010 for Dec12. I'd look to get 0.75 minimum and get out when it hit .10. Small but 6.5% on margin over 3 months for 5% risk (plus you can adjust of the strike is anywhere near threatened) but not very exciting.

The current prices, and low IV, are not good for this trade (current price is 0.65). I have used this in the past in high IV environments when collapsing IV assist greatly - but I wouldn't put this trade on now.

I don't trade ICs much - I've heard too many horror stories - hence my conservatism. Happy to be put right (I see Kim goes the other way and trades less than 1STD to collect lots of premium up front as a buffer) though...

Chris

okay that's pretty wide indeed and the odds you collect your premium should be high (as per definition on a 2 SD trade) however how do you get to 5% risk? Above IC could end up being worth 10$. If you deduct your credit of 0.75 your risk is 9.25$ (however you want to express that in %) so that trade would suffer badly in a drop like we've seen in summer last year. So as always with IC strategies the question is how you survive that sort of moves.

The other problem I have with this low credit is that in order to rise the premium I usually want from my short strategies (even though I probably could do a little less as the odds to keep it are much higher than with 25 delta IC's) I would have to do a large number of contracts and that size would blow up my account in a black swan event (and probably still severely damage it in a 10-15% drop over 2 weeks or so combined with a big rise in IV). So I simply couldn't do it from a risk management perspective.

[Guest Epsilon Options]

5% risk comes from the 95% probability of a 2std iron condor. Ie that's he chance that one of the short options will expire ITM. Your way is another,probably better calculation).

I agree there's lots of issues with the trade - which explains why I don't trade ICs very often! I'd add commissions/slippage, liquidity and the reliability of the base normal distribution assumption at such outliers to your issues too.

So I wouldn't do this trade either (the previous similar ones I did were more attractive possibly due to higher IV and/or a different vehicle).

Chris

[Guest Epsilon Options]

Cwelsh,

Sorry to disappoint you but your fellow steadyoptioners seem to have convinced me that in general 2std condors aren't very attractive (on RUT anyway).

Can you convince me back to believe in them. What are we missing?

Chris (apologies for stealing your name too)

[cwelsh 1,549]

5% risk comes from the 95% probability of a 2std iron condor. Ie that's he chance that one of the short options will expire ITM. Your way is another,probably better calculation).

I agree there's lots of issues with the trade - which explains why I don't trade ICs very often! I'd add commissions/slippage, liquidity and the reliability of the base normal distribution assumption at such outliers to your issues too.

So I wouldn't do this trade either (the previous similar ones I did were more attractive possibly due to higher IV and/or a different vehicle).

Chris

BE VERY CAREFUL MAKING THAT ASSERTION (sorry for the caps). The reason we can make money in options is because either the 95/5 or 90/10, while the "math" tells you that to be the case, is not the reality -- at all. I haven't done a full analysis in a while, but last year, I traded just north of 200 2 SD RICS (so 95/5). If the 95/5 held, you would expect 10 or so trades to have hit the strikes and finish where they were not supposed too. Yet the number was closer to 30.

The same held true when I traded the 90/10's.. In a 100 trade universe, I'd have closer to 20 trades hitting the strikes and finishing above/below the expected range.

This is simply because the option market and MOST models assume normal distribution (or even logarthimic distribution) of stock price movement and that's an absolute load of bupkis.

The one exception to this is RUT -- I've NEVER had RUT hit a 2SD move (I'm not saying it hasn't, because it has, I'm just saying I"ve never had a trade on that did).

And what I think you're missing is the risk/reward. I do the 2SD trades only if I can get a 10% (or preferably more) on margin up front, and then look to exit once earning 5-8% (sometimes I hold, but not typically). In these times of lower volatility, there are not as many trades available, but once I stuck that rule in on needing at least 10% on margin, I started being quite successful in trading the RICs.

However, you MUST stay on top of them and take your losses before they hit the 90% mark. Sure the price reverts 2/3 of the time (and nothing pisses you off more than taking a 50% loss on a RIC only to have the price revert the next day back into profitable territory), but a 50% loss is infinitely better than a 95% loss.

This is going to be the subject of my first column, which I'm HOPING to work on today .

[Marco 223]

well if you get a chance of a 10% return on margin that basically means you get 1$ credit on a 10$ spaced IC. If the strikes are at 2SD (so 5% delta) you should in theory only get about 0.50$ credit. Thing is SD is backward looking where delta of your options (=implied probability) is forward looking - so clearly the market thinks the future is more volatile and/or has more tail risk.

If you sell the 2SD IC you are betting against that. If you can be profitable over well over 100 trades you clearly beat the odds. I personally prefer to place most of my trades (long and short) on the other side of the 2SD as I prefer to deal with probabilities that are well in their double digits.

[cwelsh 1,549]

well if you get a chance of a 10% return on margin that basically means you get 1$ credit on a 10$ spaced IC. If the strikes are at 2SD (so 5% delta) you should in theory only get about 0.50$ credit. Thing is SD is backward looking where delta of your options (=implied probability) is forward looking - so clearly the market thinks the future is more volatile and/or has more tail risk.

If you sell the 2SD IC you are betting against that. If you can be profitable over well over 100 trades you clearly beat the odds. I personally prefer to place most of my trades (long and short) on the other side of the 2SD as I prefer to deal with probabilities that are well in their double digits.

I also think the markets mis-allocate IV and even historic volatility. For instance, we know that volatility increases around earnings times, so when we are in a non-earnings period, and calculating SD moves, why do we include moves immediately after earnings? That doesn't make sense. I don't completely throw it out because of post-earnings movement adjustments, but I do weight my SD periods based on whether or not I'm in earnings or not, and for other known market events.

And when you say you prefer double digit probabilities, I'm not sure what you mean there, could you explain further? (I always want to know other peoples reasoning, frequently makes mine readjust).

Thanks!

[Marco 223]

I also think the markets mis-allocate IV and even historic volatility. For instance, we know that volatility increases around earnings times, so when we are in a non-earnings period, and calculating SD moves, why do we include moves immediately after earnings? That doesn't make sense. I don't completely throw it out because of post-earnings movement adjustments, but I do weight my SD periods based on whether or not I'm in earnings or not, and for other known market events.

And when you say you prefer double digit probabilities, I'm not sure what you mean there, could you explain further? (I always want to know other peoples reasoning, frequently makes mine readjust).

Thanks!

well I don't know who 'the market' is but HV is just a number and as we don't trade HV you can't really see how 'the market' really treats it. What you can see is IV and there you see a sharp drop after earnings even if you had a big move, maybe even higher than implied before earnings - IV still will be much lower. So while all the (dumb) vol scanners at your broker will show all stock that have reported on the 'most volatile stocks' and 'highest IV-HV spread' lists, 'the market' knows that there won't be another earnings related move until the next quarter and prices IV accordingly.

What I meant with 'double digit probabilities' is that most of my trades have higher deltas than say 20%. If I trade combos obviously the combo could have any delta but the strikes I chose have usually 20%+ delta - I might BUY options that have lower delta in that combo but I'm unlikely to short them. in fact when ever I sold an option I'm very likely to buy it back should it drop below 15 delta.

That's not SO much of a strategy but the way I look at risk. Before I trade I always look at the WORST case scenario. And that's not a 5 or 10% move that is: "what if the stock goes to zero tomorrow or goes up 100%" - however unlikely that is. I'm only trading since ~15 years and I've seen it both happen more than once so I want to make sure I can even survive that scenario. Usually selling 5 delta options doesn't look too attractive if you look at them that way So I rather take a smaller position with a higher premium/delta (and make or lose my money there)

So often when I sell an option I OWN the 5 delta option against it for a few pennies to protect me against that tail risk. I've seen many people blow up over the years and quite a few of them were 'picking up dimes in front of a steam roller' (selling that 'expensive' 5-10 delta put) I'm not saying that's what you do but when in doubt I rather own the 2SD move (not only after reading Nicholas Taleb)

Edited September 26, 2012 by Marco