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By Kim
Steady Condors first goal is to manage risk and to prevent big losses.
Nice recovery!
"Another nice month for those who have hung in there with Steady Condors. Good job, Kim, and to those of you who are sticking with it. And a good opportunity to share some things about the limitations of a relatively small sample size of live trading and backtesting...
A lot of people bailed on Steady Condors last year because of a drawdown and losing year. Think about it this way:
What if the only data you had access to on the S&P was since 2009? You'd have returns of 26%, 15%, 2%, 16%, 32%, and 14% (rounded). That would obviously be a very misleading sample to draw conclusions from. The disclaimer of "past performance does not guarantee future results" is not just a legal requirement, but a true statement. Past performance does matter, but it's NOT the limitations of what is possible.
I posted this on the LCD forum last week from Ben Graham: "The essence of investment management is the management of risk, not the management of returns."
You can't control returns, only manage risk
I really dislike when people make trading sound like if you are really good at it you somehow have control over your returns. The only thing you can do is build a winning strategy (better yet, multiple winning strategies with low correlation) and then manage your risk and position size so that you stay in the game long enough to let your edge work out over the long term. But a lot of people will make ridiculous claims in order to sell a product with no accountability to a regulatory body like I have to deal with as an investment advisor.
And you must have realistic expectations and a proper mindset which I believe is:
Selling options and iron condors can be a very good strategy when the risk management is robust. With most of the services out there it's not, and if their track record doesn't have a big loss in it, it probably just hasn't happened yet. Selling OTM options and then rolling losses forward is incredibly misleading to the uninformed. No different than the S&P example above to where if we extended the sample size by one year to 2008 you add in the second worst year in history where many people locked in devastating losses to their portfolio because they never considered it possible for markets to go down that far and fear took over. Those unaware of history are doomed to repeat it. It will happen again, we just don't know when. The S&P has experienced two 50%+ drawdowns since 2000 and a max drawdown of over 80%. Selling options and iron condors can add value and diversification to your portfolio. They aren't the holy grail. Just like everything else. Your maximum drawdown is ahead of you, not behind you. We do have a limited sample size with Steady Condors, that's obviously why I brought up the S&P example. The reality is that backtesting complex options strategies is a LOT of work and sufficient option data just really doesn't exist for us to go back much farther than what we have displayed. Many drew too many conclusions about the future of steady condors based on limited past data. Again, have realistic expectations."
There is a lot of wisdom in Jesse's post.
And now I would like to explain how Steady Condors performance reporting is different from most other services.
We report returns on the whole portfolio including commissions
What does it mean?
When you trade Iron Condor (or any other options strategy), you NEVER can allocate 100% of the account to the trades. You always need to leave some cash reserve in case you need to adjust. This cash reserve usually varies from 15% to 30%.
Lets assume cash reserve of 20% and see how we would report the performance.
Our 20k unit has two trades each month (RUT and SPX). With 20% cash, we allocate ~$8,000 per trade. If both trade made 5%, that means $400 per trade or $800 total for the two trades. In our track record, you will see 800/20,000=4%. Other services will report it as 5% (average of the two trades). In addition, our returns will always include commissions. If you see 5% return in the track record, that means that $100,000 account grew to $105,000. Plain and simple.
To see how this method can have dramatic impact on the performance, let's examine a hypothetical service that claims to make 10%/month and have up to 3 trades.
With 3 trades, it is reasonable to allocate 25% per trade and leave 25% in cash. If all 3 trades made 10%, they would report 10% return (average of all trades). However, the return on the whole portfolio is 7.5%, not 10%. That's before commissions, which might take another 1-1.5% from the total return. If they have only 2 trades, and both made 10%, they would still report 10%, while a real return is 5% (half), and even less after commissions. There are months where they might have only 1 trade, but if that trade made 10%, they would still report 10%, although the real return was 2.5%.
Another point worth mentioning is rolling. If you look at some services, you might see few last months of data missing. That would usually mean that the trades were losing money and have been rolled for few months, to hide losses. In some cases, the unrealized losses can reach 25-50%. You will never see those losses in their track record.
It is very important to know how returns are reported, in order to make a real comparison. Always make sure to compare apples to apples.
Related Articles:
Can you double your account every six months?
Can you really make 10% per month with Iron Condors?
Should You Leg Into Iron Condor?
Exiting An Iron Condor Trade
Iron Condor Adjustments: How And When
Iron Condor Adjustment: Can I "Roll" It Forever?
Is Your Iron Condor Really Protected?
Click here to read how Steady Condors is different from "traditional" Iron Condors.
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By Pat Crawley
They're selling options to traders looking for big wins, and when those options expire worthless, the seller of the option gets to keep the premium he collected.
Many traders use these spreads to trade range-bound markets, where there’s a sustained technical range with well-defined support and resistance levels. These are winning trades should the market remain within the defined range through the life of the trade.
While Iron Condors and Iron Butterflies both take advantage of the same market dynamics, there are situations where it makes sense to use one over the other.
Selling Options: Shorting Volatility
Both Iron Condors and Iron Butterflies are non-directional, limited risk option spreads. Instead of trying to profit by being bullish or bearish, these option spreads are tools to make money from options you think will expire worthless.
If you had the chance to look at the options market during the GameStop madness in 2021, you witnessed insane option prices. So many traders wanted to bet against the stock but didn't want to get destroyed in a short squeeze, so they preferred to buy puts. This made put options insanely expensive to the point where you could be right on the trade and still lose money.
As a result, selling puts was a prevalent strategy to take advantage of overpriced options. These situations occur every day to varying degrees.
When you short an option, you're selling it to another buyer. For example, let's say you sell a call with a strike price of $20 on a $15 stock for $1. The stock is still at $15 at expiration, and the option expires worthless. You get to keep the entire $1.
It's well-known that most options expire worthless, so this is a compelling trade to many traders. However, the downside is your unlimited risk when shorting options. Suppose the stock in the example above was $30 at expiration. The option is now worth $15, and you're $14 in the hole.
For this reason, many traders use spreads like Iron Condors and Iron Butterflies to cap their downside. These spreads involve shorting options but buying further OTM options to limit risk.
What is an Iron Condor?
If you're familiar with other options spreads, an iron condor combines a short vertical call spread and a short vertical put spread. Put another way, it's a short strangle where you buy "wings" (OTM options) to cap your downside.
If you're unfamiliar with the dictionary full of the lingo we options traders use, an Iron Condor involves shorting an out-of-the-money (OTM) put and call and buying a further OTM put and call.
These extra OTM options we buy are used to cap our downside. Because shorting options comes with an unlimited downside, the Iron Condor has the benefits of shorting options with the added benefit of limiting our downside.
An iron condor is an option spread that involves using options to profit from a stock staying within a certain price range. Put simply, the iron condor enables traders to make profits even when a stock doesn’t move at all.
The iron condor is composed of four options, a long put and call, and a short put and call. Here’s an example of an iron condor spread:
BUY (1) 394 PUT SELL (1) 400 PUT SELL (1) 420 CALL BUY (1) 426 CALL
As you can see, you’re selling an inner options spread, and protecting the unlimited loss by buying cheap out-of-the-money (OTM) “wings” that backstop the losses if your trade idea is wrong.
Here’s what the payoff diagram for this trade looks like:
The goal of this option spread is for the underlying stock price to remain within the range you define with your short strikes. Because we’re selling a $400 strike put and $420 strike call, we want the stock to trade within that price range. Should it remain inside this range, we make our maximum profit at expiration because the options expire worthless.
However, as you can see, our long OTM options cap our downside, mitigating the biggest risk of selling options: the unlimited losses. Of course, because there’s no free lunch, this costs us money because we have to buy options that we hope ultimately expire worthless.
Characteristics of the Iron Condor
The Iron Condor is Market Neutral
The iron condor is market neutral, meaning it doesn’t take a directional price view, and instead profits from the lack of directional price movement. Traders often refer to this characteristic as “short volatility” because you’re betting that the stock price will move less than the options market is pricing in.
You would use an iron condor when you expect the underlying stock to stay within a tight trading range and not bounce around a lot.
The Iron Condor is a Theta Decay Strategy
Because iron condors collect a net credit and are hence net short options, it is a positive theta strategy, meaning it benefits from the passage of time.
Iron Condor Payoff and P&L Characteristics
Iron condors have limited maximum profit potential as well as a limited maximum loss.
The maximum profit is equivalent to the net credit collected from initiating the trade. You can easily calculate this by subtracting the cost of your long OTM wings from your short options.
Let’s use our previous example:
BUY (1) 394 PUT @ 2.28 SELL (1) 400 PUT @ 3.20 SELL (1) 420 CALL @ 3.45 BUY (1) 426 CALL @ 1.47
First, let’s sum the prices of our short options.
Our 400 put costs $3.20 and our $420 call costs $3.45, meaning we collect $6.65 for selling these two options.
Then, we simply add together the price of our long options, giving us a debit outlay of $1.47 + $2.28 = $3.75.
Now we just subtract the debit from our credit to find our net credit, $6.65 - $3.75 = $2.90. Our maximum profit is $2.90
The maximum loss of an iron condor is simply the “wing width” minus the net credit received. Wing width refers to the distance between the strike prices two calls or two puts. In this case, we’d just subtract the 426 call from the 420 call, giving us a wing width for $6. Now we just subtract our net credit of $2.90 giving us a max loss of $3.10.
Iron Condor Pros and Cons
Pro: Low Capital Requirements
Because the iron condor is a limited risk strategy, you can execute it with significantly less margin than selling the equivalent short strangle (which is the same trade, except without the long OTM options capping your losses). This makes it a very popular way for undercapitalized traders to harvest premium.
Pro: Structure Trades With High Probability of Profit and No Huge Downside
Many option traders approach the market with a systematically short-volatility positioning. They’re constantly selling options and rolling them out further if the trade goes against them. This is a strategy that can print money for a long time until you’re on the wrong side of a volatility event. Many traders, like James Cordier of OptionSellers.com have blown up as a result.
For this reason, some traders take a similar approach using iron condors, avoiding catastrophic losses. However, this strategy has significant drawbacks as you’re harvesting significantly less premium because you’re buying the OTM options and reducing your net credit.
Con: High Commission Costs
The iron condor requires four options per spread, making it twice as expensive to trade compared to most two-option spreads like straddles, strangles, and vertical spreads. Unlike the stock market, where commissions are zero across all retail brokers, option commissions still leave a dent in your P&L, with the standard introductory rate being $0.60/contract, which you have to pay to both open and close, bringing it to $1.20 per contract.
So even for a one-lot, you’re paying $4.80 to open and close an iron condor, which is typically structured with a low maximum profit, meaning that your commissions can be a hefty percentage of your P&L when trading iron condors.
Con: Less Liquidity
The combination of requiring simultaneous execution of four different option contacts usually means it takes longer to get filled on these trades, making active trading more difficult.
What is an Iron Butterfly?
The Iron Butterfly is like an Iron Condo with a higher reward/risk ratio but a lower probability of profit.
The primary difference is the short strikes. In choosing your strikes in an Iron Condor or Iron Butterfly trade, you’re defining the range you expect the underlying to remain within.
Iron Condors are more forgiving, as that range is much wider. Iron Butterflies, on the other hand, short puts and calls at the same strike, making your defined range narrower and making it less likely that you'll profit on the trade. You will, however make more money if you're right on the trade.
Iron butterflies and iron condors are sisters. They express very similar market views and are structured similarly. The primary difference in practice is that the iron butterfly is a far more precise strategy. It’s harder to be right, but if you are right, you make much more money.
The iron butterfly is composed of four options: two long options and two short options at the same strike. Here’s an example:
BUY (1) 404 Put SELL (1) 412 put SELL (1) 412 call BUY (1) 420 call And here’s what the payoff diagram for this trade looks like:
As you can see, the character of the trade is quite similar to the iron condor except for the fact that it has a more narrow opportunity to make profit. However, when the trade is in-the-money, the profits are much higher.
So while most iron condors have relatively low reward/risk ratios and high win rates, iron butterflies are the opposite. They have a lower chance of success with a much higher reward/risk ratio.
In this way, you can have the same view (the market will stay within a relatively tight range) and structure dramatically different trades around it. The iron condor will probably work out and net you a small profit, while the iron butterfly is a more confident approach giving you the chance for fatter profits.
Like everything in options trading, it’s all about tradeoffs.
Characteristics of the Iron Butterfly
The Iron Butterfly is Market Neutral
Just like the iron condor, short strangle, and short straddle, the iron butterfly has no directional price bias. It doesn’t care which direction the underlying stock moves. Instead, the iron butterfly is concerned with the magnitude of the price move. It profits when the underlying stock stays within a narrow range and doesn’t make any significant price moves.
Due to the iron butterfly using just one short strike, the underlying stock must stay in a much more narrow range than with the iron condor. Whereas the iron condor has the freedom to define a wide range using a short put and call, the iron butterfly is short only one strike, leading to the cone-shaped payoff diagram.
For this reason, the maximum profit is much higher with the caveat that the probability of reaching the maximum profit is far lower than that of the iron condor.
In this way, the iron butterfly enables you to express a market-neutral and short-volatility market outlook with a high reward/risk ratio that would usually be a trait of a net debit strategy.
The Iron Butterfly is a Theta Decay Strategy
The goal of the iron butterfly strategy is for the short option to expire worthless, or at least with less value than you initially sold it for.
As with any short options strategy, much of the profit comes from the stock price not moving, resulting in the option rapidly losing time value due to theta decay.
Iron condors capitalize on the same phenomenon but with a different trade structure.
The Iron Butterfly Has Limited Profit and Risk Potential
The max profit and loss math for the iron butterfly is quite similar to that of the iron butterfly.
The max profit is the net credit received when opening the position
The max loss math works similarly to simply shorting a call or put. The further away the stock is from the strike price, the more the losses build until your long option hedges kick in and cap the losses.
Iron Butterfly Pros and Cons
Pro: Short Volatility With High Reward/Risk Ratio
In general, market-neutral strategies that capitalize on theta decay tend to have poor reward/risk ratios, only making up for this drawback with a high win rate. The iron butterfly turns this on its head and instead has a much lower win rate than traditional short-volatility strategies with a higher reward/risk ratio, giving you the potential for asymmetric profits.
Pro: Selling Options With Limited Risk
For many traders who lean towards selling premium, the potential for unlimited, catastrophic losses keeps them up at night. Despite the low probability of an extreme price move, black swans seem to creep up more than anyone expects.
The iron butterfly allows traders to mimic the payoff structure of simply selling a put or call while capping losses with long options on either side of their short option strike.
Con: Narrow Range of Profitability
An iron butterfly has a narrow range of profitability compared to the iron condor because there is only one short strike. This means there’s a far greater margin of error for strike selection, whereas the iron condor allows you to choose two strikes and define as wide of a range as you’d like.
Summary
Iron Condors are made up of both a short vertical spread and a short vertical put spread.
Iron Butterflies are made up of two short options at the same strike and two long "wings" that protect your downside.
Remember that option spreads are trade constructions, not trade strategies. There's no inherent edge in trading Iron Condors or Iron Butterflies. They're just tools to apply to market dynamics where its more likely for markets to stay range-bound.
Related articles
Trading An Iron Condor: The Basics Butterfly Spread Strategy - The Basics 4 Low Risk Butterfly Trades For Any Market Environment Using Directional Butterfly Spread Options Trading Greeks: Gamma For Speed Options Trading Greeks: Vega For Volatility Why You Should Not Ignore Negative Gamma Iron Condor Vs. Iron Butterfly
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By Pat Crawley
It's a core tenant of how options are priced, and it's often the trader with the most accurate volatility forecast who wins in the long term.
Whether you like it or not, you're taking an inherent view on volatility anytime you buy or sell an option. By purchasing an option, you're saying that volatility (or how much the options market thinks the underlying will move until expiration) is cheap, and vice versa.
With volatility as a cornerstone, some traders prefer to do away with forecasting price directionality entirely and instead trade based on the ebbs and flows of volatility in a market-neutral fashion.
Several option spreads enable such market-neutral trading, with strangles and straddles being the building blocks of volatility trading.
But even though straddles and strangles are the standards, they sometimes leave something to be desired for traders who want to express a more nuanced market view or limit their exposure.
For this reason, spreads like iron condors and butterflies exist, letting traders bet on changes in options market volatility with modified risk parameters.
Today, we’ll be talking about the iron condor, one of the most misunderstood options spreads, and the situations where a trader may want to use an iron condor in favor of the short strangle.
What is a Short Strangle?
Before we expand on the iron condor and what makes it tick, let's start by going over the short strangle, a short-volatility strategy that many view as the building blocks for an iron condor. An iron condor is essentially just a hedged short strangle, so it's worth understanding them.
A strangle comprises an out-of-the-money put and an OTM call, both in the same expiration. A long strangle involves buying these two options, while a short strangle involves selling them. The goal of the trade is to make a bet on changes in volatility without taking an outright view on price direction.
As said, strangles and straddles are the building blocks for options volatility trading. More complex spreads are constructed using a combination of strangles, straddles, and "wings," which we'll explore later in the article.
Here’s an example of a textbook short strangle:
The goal for this trade is for the underlying to trade within the 395-405 range. Should this occur, both options expire worthless, and you pocket the entire credit you collected when you opened the trade.
However, as you can see, you begin to rack up losses as the market strays outside of that shaded gray area. You can easily calculate your break-even level by adding the credit of the trade to each of your strikes.
In this case, you collect $10.46 for opening this trade, so your break-even levels are 415.46 and 384.54.
But here's where the potential issue arises. As you can see, the possible loss in this trade is undefined. Should the underlying go haywire, there's no telling where it could be by expiration. And you'd be on the hook for all of those losses.
For this reason, some traders look to spreads like the iron condor, which lets you bet on volatility in a market-neutral fashion while defining your maximum risk on the trade.
Iron Condors Are Strangles With “Wings”
Iron condors are market-neutral options spreads used to bet on changes in volatility. A key advantage of iron condors is their defined-risk property compared with strangles or straddles. The unlimited risk of selling strangles or straddles is
Iron condors are excellent alternatives for traders who don't have the temperament or margin to sell straddles or strangles.
The spread is made up of four contracts; two calls and two puts. To simplify, let's create a hypothetical. Our underlying SPY is at 400. Perhaps we think implied volatility is too high and want to sell some options to take advantage of this.
We can start by constructing a 0.30 delta straddle for this underlying. Let's use the same example: selling the 412 calls and the 388 puts. We're presented with the same payoff diagram as above. We like that we're collecting some hefty premiums, but we don't like that undefined risk.
Without putting labels on anything, what would be the easiest way to cap the risk of this straddle? A put and a call that is both deeper out-of-the-money than our straddle. That's pretty easy. We can just buy further out-of-the-money options. This is all an iron condor is, a straddle with "wings."
Another way of looking at iron condors is that you’re constructing two vertical credit spreads. After all, if we cut the payoff diagram of an iron condor in half, it’s identical to a vertical spread:
Here’s what a standard iron condor might look like when the underlying price is at 400:
● BUY 375 put
● SELL 388 put
● SELL 412 call
● BUY 425 call
The payoff diagram looks like this:
The Decision To Use Iron Condors vs. Short Strangles
Ever wonder why the majority of professional options traders tend to be net sellers of options, even when on the face of things, it looks like you can make huge home runs buying options?
Many natural customers in the options market use them to hedge the downside in their portfolios, whether that involves buying puts or calls.
They essentially use options as a form of insurance, just like a homeowner in Florida buys hurricane insurance not because it's a profitable bet but because they're willing to overpay a bit for the peace of mind that their life won't be turned upside down by a hurricane.
Many option buyers (not all!) operate similarly. They buy puts on the S&P 500 to protect their equity portfolio, and they hope the puts expire worthless, just as the Florida homeowner prays they never have actually to use their hurricane insurance.
This behavioral bias in the options market results from a market anomaly known as the volatility risk premium. All that means is implied volatility tends to be higher than realized volatility. And hence, net sellers of options can strategically make trades to exploit and profit from this anomaly.
There's a caveat, however. Any source of returns that exists has some drawback, a return profile that perhaps isn't ideal in exchange for earning a return over your benchmark. With selling options, the risk profile scares people away from harvesting these returns.
As you know, selling options has theoretically unlimited risk. It's critical to remember that when selling a call, you're selling someone else the right to buy the underlying stock at the strike price. A stock can go up to infinity, and you're on the hook to fulfill your side of the deal no matter how high it goes.
So while there can be a positive expected value way to trade from the short side, many aren’t willing to take that massive, undefined risk.
And that's where spreads like the Iron Condor come in. The additional out-of-the-money puts and calls, often referred to as 'wings,' cap your losses, allowing you to short volatility without the potential for catastrophe.
But it's not a free lunch. You're sacrificing potential profits to assure safety from catastrophic loss by purchasing those two OTM options. And for many traders, this is too high a cost to harvest the VRP.
In nearly any, backtest or simulation, short strangles come up as the clear winner because hedging is generally -EV. For instance, take this CBOE index that tracks the performance of a portfolio of one-month .15/.05 delta iron condors on SPX since 1986:
Furthermore, there's the consideration of commissions. Iron condors are made up of four contracts, two puts, and two calls. This means that iron condor commissions are double that of short strangles under most options trading commission models.
With the entry-rate retail options trading commission hovering around $0.60/per contract, that’s $4.80 to open and close an iron condor.
This is quite an obstacle, as most iron condors have pretty low max profits, meaning that commissions can often exceed 5% of max profit, which has a big effect on your bottom line expected value.
Ultimately, it costs you in terms of expected value and additional commissions to put on iron condors. So you should have a compelling reason to trade iron condors in favor of short strangles.
Bottom Line
Too many traders get stuck in the mindset of "I'm an iron condor income trader" when the market is far too chaotic and dynamic for such a static approach. The reality is that there's an ideal strategy for risk tolerance at a given time, in a given underlying.
Sometimes the overall market regime calls for a short-volatility strategy, while others call for more nuanced approaches like a calendar spread.
There are times when it makes sense to trade iron condors when implied volatility is extremely high, for instance. High enough that any short-vol strategy will print money, but too high to be naked short options. Likewise, there are times when iron condors are far from the ideal spread to trade.
Another comparison is Iron Condor Vs. Iron Butterfly
Like this article? Visit our Options Education Center and Options Trading Blog for more.
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Selling Naked Strangles: The Math Selling Short Strangles And Straddles - Does It Work? Trading An Iron Condor: The Basics Low Premium Iron Condors Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Comparing Iron Condor And Iron Butterfly Butterfly Spread Strategy - The Basics Iron Condor Vs. Iron Butterfly
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By cwelsh
Such lawsuits are common and typically lack merit because offering documents are properly drafted to protect the companies involved and disclose the risk.
I find it unlikely that the documents were not properly drafted. For instance, in one of the few actual UBS documents I could find on UBS’s yield enhancement strategies provided “yield enhancement strategy products are designed for investors with moderate risk tolerance who want to enhance the low to moderate return typically generated in a ‘flat’ or ‘sideways’ market.” That’s a great description for trading iron condors.
So, if the documents were fine (most likely, but you never know), what was the issue?Most likely overzealous brokers pushed the strategy without really understanding the risk profile.
My takeaway from reading about this is two part. First, investors typically don’t understand options, and the media certainly does not. Most advisors do not either. For instance, the media has called the strategy used by UBS a “leveraged, esoteric options strategy.” Iron condors are neither esotericor typically leveraged. They are the definition of a defined risk option strategy. A profit/loss graph of an iron condor looks like:
There is a maximum loss on any single trade that can be controlled based on the strikes and premiums received. UBS’s strategy purportedly used iron condors on the S&P 500 index, the NASDAQ, and other “primary” market indexes – so volume should not have been an issue.
Other writers have demonstrated their ignorance of the strategy. One popular critique of the UBS strategy reads:
“The problems with YES began in 2018 with violent fluctuations in the S&P 500…The most volatile period was between October and December 2018, during which time the market declined 20%--then followed by a rebound of 12% through January 2019. The violent swings caused the premiums of both the put and call side of the iron condor strategy to spike, leading to losses on both sides of the trade.”
But this is practically impossible. An investor can’t experience losses on BOTH sides of the graph (in effect doubling the losses), unless the traders are idiots. The only way to have that happen is to close out one half of the trade for a loss, in the hopes that the profits on the other side will increase, but then the market whipsaws back, thus causing losses on both sides.
Of course, at this point, the strategy is no longer an iron condor. It’s a simple vertical spread:
The odd thing about this critique is that even vertical spreads have loss limits. Let’s say the UBS traders had a maximum loss rate of ten percent. A structured iron condor can have a max loss of ten percent the same as a vertical spread.
If the traders are trading to profit from time decay across multiple indexes, risk could be further controlled through the use of reverse iron condors that have a profit and loss graph of:
In the event of a large move, such a position could help offset losses. (There are other ways to protect against such a move as well – anything from simply buying long dated out of the money puts and calls to trading volatility instruments).
The problem with a normal iron condor in a low volatility market is that traders do not receive a very high premium for the risk they take. In order to get a 1% or 2% return per month, UBS traders would have to be taking risks that were outside of the “moderate” or “low” range. Traders probably started taking chances they shouldn’t have.
Much of the media has commented that the UBS traders “compounded” their results by trying to “make up” for losses after blowing up trades. (Who of us hasn’t done that?) Traders make trade adjustments or open new trades on the prediction that either (a) the price will return to the mean or (b) the price will continue moving. It appears the UBS traders made the bet that the price would continue moving, and instead it reverted to the mean.
Of course,when traders do that, they are no longer trading risk defined iron condors. They are making directional market bets – bets that if wrong, make the situation worse.
What can we, as option traders, learn from this?
Trading is as much psychological, as it is methodical, even for supposed professionals. Losses will occur and decisions will be made trying to “make up” for losses rather than staying within stated trading guidelines. This is a mistake. Plan trades, plan for what happens when the trades go wrong, and when they do go wrong, stick to the plan. Sure you might occasionally “fix” what went wrong, but more often than not, you’ll likely make the situation worse; The general public views option as “high risk” investments. They are not, when handled properly. In fact, as option traders know, options can be used to mitigate risk. Try to combat the disinformation when you can; Don’t trust plaintiff class action lawyers.
I personally do not understand all of the class type legal advertising that exists because of the strategy. By all accounts, all UBS agreements require FINRA arbitration of individual claims. This greatly decreases the profit potential for attorneys, unless the client lost hundreds of thousands of dollars (in which case the client is probably not calling Saul from the internet for the case). Strangely, that is what can currently be seen.
Christopher Welsh is a licensed investment advisor and president of LorintineCapital, LP. He provides investment advice to clients all over the United States and around the world. Christopher has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™. Working with a CFP® professional represents the highest standard of financial planning advice. Christopher has a J.D. from the SMU Dedman School of Law, a Bachelor of Science in Computer Science, and a Bachelor of Science in Economics. Christopher is a regular contributor to the Steady Options Anchor Trades and Lorintine CapitalBlog.
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By Mark Wolfinger
Timing
Some investors believe they have a ‘feel’ for the market, or individual stocks and ‘know’ when that stock is going to make a large move. If you are one of them, then don’t open an iron condor position unless you believe the stock is NOT going to make such a move before the options expire. As an alternative you can have an iron condor position with a bullish or bearish bias. You do that by choosing appropriate strike prices for the options spreads you choose.
Many investors (that includes me) cannot predict the future and are willing to own positions that profit when the market holds steady, trades within a range that’s not too wide, or if the market does move significantly in one direction, does so at a slow and steady pace.
Underlying
It’s generally safer to trade iron condors on indexes because you never have to be concerned with a single stock issuing unexpected news that results in a gap of 20% or more. True that can happen with an index if there is world-shattering news – but it’s a much less likely event.
Most indexes in the U.S. are European style vs. American style. That means they cannot be exercised before expiration – and that’s to your advantage. We’ll discuss the differences between these option ‘styles’ another day.
Expiration Month
Most iron condor traders prefer to have positions that expire in the front month (options with the least time remaining before they expire). These options have the most rapid time decay, and when you are a seller of option premium (when you collect cash for your positions as opposed to paying cash), the passage of time is your ally and rapid time decay is a positive attribute for your position.
However, there are negative factors associated with front-month options:
With less time remaining, iron condor positions are worth less than if there were more time remaining. Thus, you collect less cash when you open the position. If the index undergoes a substantial price change, the rate at which money is lost is significantly greater when you have a front-month option position. It’s too early in your education to discuss why this is true in detail, but it’s because they gain or lose value more rapidly than options with longer lifetimes. This is effect of gamma, one of the ‘Greeks’ used to quantify risk when trading options. Because there are so many topics to discuss, I will not be getting to the Greeks for quite awhile. When you sell options that expire in the 2nd or 3rd month, you collect higher cash premiums (good), have positions that lose less when something bad happens (good), but there is more time for something bad to happen (bad). When you have iron condor positions, you don’t want to see something bad (and that’s a big market move). The more time remaining before the options expire, the greater the chance that something bad happens. That’s why traders who sell* iron condors are willing to pay you a higher price for them.
Strike Prices and Premium Collected
Choosing the strike prices for your iron condor position – and deciding how much cash credit you are willing to accept for taking on the risk involved – are irrevocably linked. Thus, I’ll discuss them together.
Assume the call spread and put spread are each 10-points wide.
For example: (RUT is the (Russell 2000 index)
Sell 10 RUT Sep 620 put Buy 10 RUT Sep 610 put Sell 10 RUT Sep 760 call Buy 10 RUT Sep 770 call
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Market bias
Most of the time that you open an iron condor, you have a neutral opinion, i.e., you have no expectation that the stock is going to move in one direction as opposed to the other. As a result, you tend to choose a call spread and a put spread that are equally out of the money. To put it simply – the call and put you sell will each be approximately the same number of points away from the price of the underlying security. In our example above, If RUT is trading near 690, the 620 put and the 760 call are each 70 points out of the money, and the position is ‘distance neutral.’
There are other methods you can use to have a position that is ‘neutral.’ Instead of equally far out of the money, you may choose to sell spreads that bring in the same amount of cash. This is ‘dollar neutral,’ a method seldom used.
If you understand the term delta (we’ll get to it eventually) you may choose to sell spreads with equal delta. I don’t recommend this method for iron condors, although ‘delta neutral’ trading has a great deal to recommend it under different circumstances.
If you are bullish, you can choose to sell put spreads that bring in more cash, attempting to profit if the stock or index does move higher, per your expectation. If you are bearish, you can choose to sell call spreads that bring in more cash, attempting to profit if the stock or index does move lower, per your expectation.
How far out of the money
Most investors believe that the further out of the money the options they sell, the ‘safer’ their position and the less risk they have. That's one way to look at ‘safety.’
Probability vs. Maximum loss. If you sell the RUT 580/590 put spread instead of the 610/620 put spread, there is a higher probability that the options you sell will expire worthless, allowing you to earn the maximum profit that trading this iron condor allows.
I believe that is intuitively obvious, but for those who don’t see it, consider this (and for the purposes of this discussion, assume you hold this position until the options expire): Most of the time the options expire worthless, but part of the time, RUT moves far enough below 620, resulting in a loss. Part of the time that RUT is below 620 at expiration, it is also below 590. But, the probability that it’s below 590 must be less than the probability that it’s below 620 because part of the time RUT is going to be between 590 and 620. Thus, you lose money less often, when you sell options that are further out of the money. That fits the first definition of ‘safer’.
But, you can also look at it this way. When you sell the 580/590 put spread, you collect less cash than when you sell the 610/620 put spread. This is always true: the more distant the options are from the market price of the underlying stock or index, the less premium you collect when selling single options or option spreads.
This is why it’s so important to find your comfort zone when choosing the options that make up your iron condor.
You can trade options that are very far out of the money. These positions have a very small chance of losing money. You can easily find iron condors with a 90% (or even higher) probability of being winners. However, the cash you collect may be too little to make the trade worthwhile. Some investors are willing to sell iron condors and collect between $0.25 and $0.50 for each spread, netting them $50 to $100 per iron condor. If that makes you comfortable, then it’s okay for you to trade this way. For my taste, the monetary reward is too small. NOTE: Selling a spread for $0.40 translates into $40 cash, and the possibility of losing $960. Remember that the maximum loss is very high, and one giant loss can wipe out years of gains. The maximum loss is $950 per iron condor, when you only collect $50 to initiate the trade.
You can trade options that are far out of the money, but not so far that the premium you collect is too small. You still have a high probability of owning a winning position. You have the potential to earn more money because you collected more cash upfront. The maximum loss is reduced, and some consider this position ‘safer.’ That fits the second definition of safety.
You can sell options that are closer to the money. This reduces your chances of having a comfortable ride through expiration, and increases the chances of losing money. In return for that reduced probability of success, potential profits are significantly higher. You may decide to collect $400 or $500 per iron condor. The maximum loss is much smaller, and again, that fits the second definition of owning a safer position. Your goal should be to find iron condors that places you well within your comfort zone. And if you are unsure of how your comfort zone is defined, use a paper trading account to practice trading iron condors (or any other strategy). I know that real money is not at risk, but if take the positions seriously, you can determine which iron condors leave you a bit uneasy and which ‘feel’ ok. Advice: Don’t make the decisions about comfort based on which trades are profitable. Base the decision on which iron condors make you nervous about potential losses both when you open the position and as the risk changes over time.
It’s easy to randomly open positions and hope they work. But it’s better to open positions that fall within your comfort zone.
Summary
Here’s a statement I am going to make repeatedly when giving stock option advice: There is no ‘right’ choice. As an investor, you want to hold positions that are comfortable for you. The best way to discover your comfort zone is to trade. But, please use a practice account and do not use real money until you truly understand how iron condors (or any other strategy) work. Some traders always trade the near-term (front-month) options, while others (myself included) prefer options that expire in two, three, or even four months.
Another comparison is Iron Condor Vs. Iron Butterfly
Related Articles:
Trade Iron Condors Like Never Before Why Iron Condors are NOT an ATM machine Why You Should Not Ignore Negative Gamma Can you double your account every six months? Can you really make 10% per month with Iron Condors? Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Is Your Iron Condor Really Protected? Trade Size: Taming The 800-Pound Gorilla
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By Kim
Iron Condor Description
Iron Condor is a vega negative gamma negative trade. Choosing the strike prices for your iron condor position – and deciding how much cash credit you are willing to accept for taking on the risk involved – are irrevocably linked. If your strike has lower deltas, you will get less credit, but also higher probability. As we know, Risk/reward and Probability of Success have reverse relationship.
Construction:
Buy one out-of-the-money put with a strike price below the current price.
Sell one out-of-the-money put with a strike price closer to the current price.
Sell one out-of-the-money call having a strike price above the current price.
Buy one out-of-the-money call with a strike price further above the current price.
Lets take a look at typical Iron Condor trade using SPX and 15 deltas for the short options.
As we can see, we are risking ~$750 to make ~$250 (around 33% gain), but we have a fairly high probability of success (~78%). We can select tighter strikes, for higher credit and better risk/reward, but we will be sacrificing the probability of success.
Iron Butterfly Description
Iron Butterfly spread is basically a subset of an Iron Condor strategy using the same strike for the short options.
Construction:
Buy one out-of-the-money put with a strike price below the current price.
Sell one at-the-money put.
Sell one at-the-money call.
Buy one out-of-the-money call with a strike price above the current price.
Lets take a look at Iron Butterfly trade using SPX:
As we can see, we are risking ~$880 to make ~$4,120 (around 455% gain), but we have a fairly low probability of success (~30%). We can select further OTM long strikes, for lower credit and higher probability of success. But generally speaking, Iron Butterfly will usually have a better risk/reward but lower probability of success than Iron Butterfly.
Which one is better?
As you can see, there are tradeoffs to each strategy. Both strategies benefit from range bound markets and decrease in Implied Volatility. The Iron Butterfly has more narrow structure than the Iron Condor, and has a better risk-to-reward, but also lower probability of success. If the underlying stays close to the sold strike, the iron Butterfly trade will produce much higher returns.
Both strategies require that the underlying price stay inside of a range for the trade to be profitable. The Iron Condor gives you more room, but the profit potential is usually much less.
Generally speaking, Iron Condor is a High(er) Probability trade and Iron Butterfly is a Low(er) Probability trade. However, those probabilities refer to holding both trades till expiration. In reality, we rarely hold them till expiration. We usually set realistic profit targets and exit at least 2-3 weeks before expiration, to reduce the negative gamma risk.
The bottom line is that the strategies are pretty similar because they profit from the same conditions. The major difference is the maximum profit zone, for a condor is much wider than that for a butterfly, although the tradeoff is a lower profit potential.
Related articles
Trading An Iron Condor: The Basics Butterfly Spread Strategy - The Basics 4 Low Risk Butterfly Trades For Any Market Environment Using Directional Butterfly Spread Options Trading Greeks: Gamma For Speed Options Trading Greeks: Vega For Volatility Why You Should Not Ignore Negative Gamma
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By Jesse
Why Steady Condors is different?
Can you make 10% per month with Iron Condors? Yes, you can - but this is a wrong question to ask. The right question is how much you lose when the market goes against you?
Steady Condors at its core is managed by the Greeks but mostly resembles a variation of iron condors. Anyone who has traded more than a handful of non-directional iron condors knows they can be extremely challenging in a trending market potentially causing a lot of stress, large drawdowns, and significant losses.
Our manage by the Greeks philosophy is designed to take advantage of the volatility skew that naturally exists in index options like RUT and SPX and to deal with the inherent flaws this creates for traditional condors. We all know that the market “takes the stairs up and the elevator down” and this is built into index options pricing. For condors this means that you will be able to sell much farther OTM puts than calls for the equivalent premium. This causes a traditional iron condor to naturally set up short Delta (bearish). If the market makes a move up after trade launch you will start to lose money immediately even with declining implied volatility typically helping your short Vega position.
August 2011 Case Study
We certainly saw plenty of upside in the recent years. But as we all know, the market tends to take the stairs up and the elevator down. Steady Condors is short Vega, and I thought it would be a good example to show the backtested example of the Steady Condors trade during the August 2011 correction/crash.
The trade began like normal on July 6, 2011. 44 DTE. Note that RUT was at 844.
No adjustments were necessary until 8 days into the trade when RUT was at 832. Interesting though was RUT had first moved up to nearly 860 before starting its descent. The short leg of the put debit spread was rolled down 20 points. Business as usual.
On July 18, 32 DTE and 12 DIT, another debit spread was added (one other had also been added a few days prior) and the call credit spreads were taken off for 20 cents. RUT at 816, down about 1 standard deviation since entering the trade. Being down 1 standard deviation in 12 days isn't necessarily concerning, but RUT has declined over 40 points from its high. PnL is in good shape, up about 1%.
On July 27, 21 DIT, RUT is at 806 and another debit spread is added (rolling down the 800 short to 780). At this point the move down is still reasonable (around 1 standard deviation after 21 days). PnL is in good shape up about 2% at this point. The debit spread adjustments are causing the trade to look more like a bearish butterfly than a condor. No additional long puts have been necessary yet at this point.
Skipping ahead to Aug 2, 27 DIT and 17 DTE, RUT is now at 783. A few more debit spreads have been added at this point. The idea is to simply keep managing position delta as RUT moves further down. PnL is in great shape, closing in on target profit, up close to 4%. In situations like this I will consider going for more profit because it's possible to make significantly higher returns when the trade finishes under the "wing". One or two months per year we can usually get 5%+ out of the MIC.
Later in the day on Aug 2 position delta reached the adjustment target again so at this point a long put was added. Rational for the long put (compared to yet another debit spread) was as follows...1. There is more than enough potential profit and theta in the trade 2. This was the second adjustment in the same day with the daily move over 1.5 SD 3. RUT has moved down 66 points since trade launch and 82 points since the high. 4. The short leg of the put credit spreads are now carrying a delta of 30 increasing the short gamma of the position.
One day later on Aug 3 another long put was needed. It would certainly be reasonable to take profits at this point, the key is to keep the t+0 line as flat as possible while maintaining as much theta as possible. Note how flat the t+0 line is, and also how it curves up if a serious crash would occur. Translation: minimal fear of additional downside.
One day later on Aug 4 with RUT at 752 the trade was taken off for target profit of 5% and because RUT touched the short put strike, and theta was now negative. IV had increased 56% in the 29 DIT and the total move represented over 2 standard deviations. Max margin at the beginning of the trade was just over $26,000, and by the end of the trade margin was down to less than $17,000.
Just to show the power of risk management, the next picture is the original trade with no adjustments. Although the setup is important, it's the adjustments that make the difference. Without them, the trade would have been down 22% at the point it was taken off for target profit.
One last interesting point...On Monday Aug 8 RUT closed down 64 points at 650. If you wouldn't have taken the trade off on the 4th the trade would actually have been up 67% at the end of the day on the 8th.
Frankly I'm not familiar with another variation of Iron Condor that can actually make a gain after the index declines by 11%+.
Note: our current setup is slightly different, but the general principle is very similar.
Related articles:
Steady Condors 2015 Report: 46.7% Return Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustments: How And When Iron Condor Adjustment: Can I "Roll" It Forever? Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Is Your Iron Condor Really Protected?
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By Jesse
What I began to realize over the years was that the risk I was taking with iron condors was excessive, so the thought of selling a “naked” strangle was unimaginable. This risk was due to ridiculously large position size, or leverage, and over time I began to understand this reality better.
An iron condor is simply a short strangle with long options that are further out of the money than the short options. Some traders refer to the long options as “wings”. Because an iron condor creates a maximum potential loss equivalent to the width of the spread, traders make the mistake of often trading their account up to or near the maximum number of contracts that would wipe out most of their account if that max loss occurred, which during periods of low market volatility may be as minor as a 10-15% drop in the market.The average intra-year drawdown for the S&P 500 has been about 14% since 1980, so this is something that occurs almost every year.
This is of course why you hear so many stories of retail traders and credit spread/iron condor newsletters blowing up. As is almost always the case, the risk isn’t really the strategy…but instead the position size of the strategy! There’s no strategy so good that enough leverage can’t make it a blow up waiting to happen. Due to the nature of out of the money option selling, the negatively skewed return stream can take a while to materialize when there are long periods of relatively calm market conditions.
Today, I think of a strangle as a cash secured put along with an out of the money short call. Thinking about the trade this way transforms a short strangle from seemingly risky into a rather conservative trade, due to the position sizing rule. For example, with SPX currently trading at about $3,000, a strangle would be sized at about 1 contract per $300,000. Compare this to selling 10-point wide put and call credit spreads to create an iron condor, and many newsletters might suggest that you sell something like 275 contracts per $300,000 of capital! Think about that for a moment…technically the iron condor has “defined risk” of $275,000 (ignoring the credit received), while the strangle has “undefined” risk because the short call is naked and prices can theoretically rise forever.
Yet the risk is immensely different for the two trades due to the number of contracts involved. The strangle has a positive expected return and will very likely survive and succeed over the long-term due to the well documented Volatility Risk Premium (VRP), while the iron condor will cause an eventual blowup. When someone says they prefer iron condors over strangles because the risk is “defined” with an iron condor, they probably haven’t spent a lot of time thinking about position sizing. This should be the biggest lesson from this article…risk is defined by your position size to a much greater degree than it is by the strategy. Yet it’s a topic that is not well understood or appreciated by most traders.
I think about an iron condor similar to how I’d think about owning 100 shares of a stock and then buying a protective put. A strangle is like owning just those 100 shares, while an iron condor is like owning those 100 shares along with an out of the money protective put. That put will reduce your downside during extreme selloffs that are greater than the market already baked into prices, but at a substantial cost over the long run (again, due to the VRP). To illustrate this, I backtested SPY strangles and iron condors using the ORATS wheel. Selling 30 delta strangles on SPY since 2007 has produced an average annual return of 5.34% (volatility of 8.36%, Sharpe Ratio 0.64), while a 30 delta iron condor with wings set at 20 delta returned only 0.15% (volatility of 3.08%, Sharpe Ratio of 0.05). I ran the test a few times just to make sure I was getting consistent results. The additional transaction costs and performance drag of the long options is so significant that almost the entire return generated from the short options disappears.
Another comparison is Iron Condor Vs. Iron Butterfly
Conclusion
On your journey as an options trader you’ll hear a lot of conventional wisdom repeated over and over that simply isn’t true or provides incomplete information. One of those myths is how selling strangles is risky and instead a trader should sell an iron condor. This statement tells us nothing about position sizing. If you read this article and are still resisting the information I’m sharing, ask yourself this question: Is the reason you still want to use an iron condor over a strangle due to how you might look at the expected return of the strangle as I’ve laid it out and feel a little underwhelmed? Perhaps this article is also what you need to hear instead of what you want to hear, because I know I was in that camp at one time.
You might consider that the 5% return of the SPY strangle since 2007 is similar to the long-term global equity risk premium, which serves as the benchmark for virtually everything since so few investments have been proven to be able to reliably exceed it over the long term.Until someone shows you an independently audited decade plus long track record of a fund or newsletter selling iron condors with the “X% per month” average returns that are often fantasized about and marketed to new traders, use the position sizing algorithm presented in this article instead as your baseline. Think in terms of notional risk instead of margin requirements, and you’ll substantially reduce the risk of an unrecoverable negative surprise on your trading journey.
Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He provides investment advice to clients all over the United States and around the world. Jesse has been in financial services since 2008 and is a CERTIFIED FINANCIAL PLANNER™ professional. Working with a CFP® professional represents the highest standard of financial planning advice. Jesse has a Bachelor of Science in Finance from Oral Roberts University. Jesse manages the Steady Momentum service, and regularly incorporates options into client portfolios.
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By Mark Wolfinger
Some adjustments are made because we anticipate a specific event in the market (buy vega in anticipation of a increase in implied volatility). Others are made because we fear a big rally or decline. However, most of the time adjusters seek to find a trade that reduces risk for as many different market conditions as possible.
Traders tend to find that one specific adjustment type is their favorite because it has brought satisfactory result sin the past. Some adjustment techniques are well-suited to a specific strategy and the pair go well together. [Rolling down when trading CTM iron condors]
The trap
Some adjustment methods are so attractive because they offer a very reassuring risk graph. The problem with that adjustment type is that the graph may be deceiving. This is the topic of today’s post.
Readers who are familiar with my philosophy concerning the purchase of individual calls or puts as insurance for an iron condor trade know this: I recommend NEVER buying any option for protection when that option is farther OTM than the option (or spread) being protected. There are situations when ignoring that advice brings excellent results. However, much of the time the trader can get trapped and loses even more money than would have been lost without the adjustment.
That is a situation that has to be avoided. So let’s make this one basic premise for all iron condor adjustments:
No iron condor adjustment is acceptable when losses may become higher than that of the original trade with no adjustment
Translation: An adjustment must never add to losses. An adjustment must earn a profit (if it were a standalone trade) at any time that the position being protected loses more money that it is losing when the adjustment is made. In my opinion, there are no exceptions unless you are sophisticated enough to recognize the extreme danger and will get out of the trade early enough to prevent a disaster. Here is an example:
Example:
Let’s say you are short the 750/760 call spread for some unspecified index. Wanting protection against a big rally, you buy one or more extra 760 calls. When looking at the risk graph, all we tend to notice is the large potential profit when the index rises to 800, 850, 900 etc.
However, the crucial part of the trade gets ignored (by those who have not thought this through well enough). As time passes, those extra calls lose much of their power. Sure, the graph still looks good and the position performs well when the market moves a lot higher. But that is not the scenario for which we bought protection. The adjustment trade must reduce losses when the index creeps higher and approaches the short strike.
We should not be concerned with risk when the index rallies to 850. That is an unlikely scenario. The trader has to worry about the market moving to 740, 745, 750 – especially as expiration nears. [One of my tenets is that we should not be holding positions in this very risky situation, but some traders hold anyway]. When your ‘protection’ is owning extra 760 calls, and time is getting short, those calls do not help when the rally continues slowly as the days pass. In fact, they could easily expire worthless while your short spread finishes in the money by as many as ten points.
That would be a double disaster: losing a lot of money on the original position and seeing the adjustment trade expire worthless.
The problem occurs because the trader bought calls with a higher strike than her short calls. The situation is identical when you buy puts that are farther OTM than the short puts being protected.
Unless you know the adjustment is to be held for a VERY short time and will be replaced, do not buy protection that is farther OTM than the position being protected.
Two of the most difficult aspects of managing risk for negative gamma positions is deciding when to make the adjustment and which specific trade to make as the adjustment.
Today, let’s talk about timing.
If we adjust frequently, we run the risk of buying every rally and selling every dip – exactly what we don’t want to do. If we had done nothing, we’d be holding a winning trade. On the other hand, if the market edges higher (or lower, take your pick) day after day, then these frequent adjustments could save us a pile of money because we would never be too far from delta neutral.
If we adjust in stages or at predetermined levels (price of underlying, delta of short, money lost etc.) we have exactly the same situation as above – but the numbers are all larger. If we adjust and the market reverses direction, we will have spent a decent sum adding protection when it turns out that we would have been better off not to have adjusted. And to make matters worse, we would have locked in a reasonable loss for at least a portion of the position by making that adjustment. On the other hand, if we do not make the adjustment, we own a position that is out of balance, is currently underwater, and has reached a point where we are threatened with ever-increasing additional losses. That is no time for the prudent trader to become stubborn. It is time to do something to reduce risk.
When?
There are two basic approaches:
1) Time adjustments for all trades as consistently as possible. The specific method used is less important than being consistent.
2) Use your best judgment to determine the type of market conditions under which you are trading. Use technical indicators, follow the trend, follow your gut, keep careful records of how much the index is up or down every day, etc.
If it seems as if we are in a trending bull or bear market, then adjust much more often as a safer way of managing risk. You could even initiate the trade with one adjustment built-in. [begin with an unequal iron condor, perhaps 8 calls and 10 puts; or begin with calls (or puts) with a smaller delta than the other side.]
Don’t sit and wait for a reversal that may never arrive. Trade scared and trade with safety in mind. Or don’t trade and wait for better conditions.
If it seems that the market is not trending or that you cannot draw useful conclusions about what you see, then return to your standard risk management technique. Be ready to change course for extra safety.
Bottom line: Whatever it is that you see in the market, the objective is to play it safe. Play it small. Or don’t play at all. There is a ton of money to be made by trading iron condors or selling credit spreads. But that is only true part of the time. When the markets are unfavorable for those methods, we must minimize losses so that we are in good shape to collect when it becomes our turn. And we do not know when our turn will begin or end.
Related articles:
Should You Leg Into Iron Condor? Exiting An Iron Condor Trade Iron Condor Adjustment: Can I "Roll" It Forever? Why Iron Condors Are NOT An ATM Machine Can You Really Make 10% Per Month With Iron Condors? Is Your Iron Condor Really Protected? Want to learn more?
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Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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By Mark Wolfinger
Another choice is to roll the position to one that satisfies all the conditions required for a brand new trade. If rolling is not appropriate, there are other acceptable risk-reducing adjustment choices. The worst choice is to do nothing (after the position reached the point where your trade plan calls for action), and hope that good things will happen.
Example
Let’s assume that you made a trade in which there is a short call spread and the market is rising. Let’s further assume that this position is essentially unhedged (i.e., if it is part of an iron condor, the put spread is not worth enough to provide any reasonable hedge when the market rallies further).
You are short a 10-lot GOOG (price $740) call spread, the Feb 760/770 (or substitute strike prices that place you at the very edge of your comfort zone and where you believe the best move is to cover all or part of that risk). However, you decide to hold for the moment.
The option gods are on your side. A few days pass and GOOG retreats to 730. This feels good and you feel justified in not having acted aggressively. However, expiration is still 32 days away, and this stock can easily run through the 760 strike.
One intelligent plan is to exit now and take advantage of the fact that you did not lose additional money by acting when the stock was moving higher. When I find myself in this situation, I seldom exit. I feel vindicated that the market moved lower, and all exit plans are put on hold. I believe that postponing the exit is the most common choice for traders in this situation. I am now convinced that this is a poor decision.
Another plan is to accept reality: The stock is still near an uncomfortable price level, and the small decline is not necessarily a promise of more decline to come. The conservative trader can covers a portion of the short spread as a compromise between greed and fear. I don’t believe traders make this move either.
The common mindset is to heave a sigh of relief as fear fades away. The mindset is that “the stock is finally slowing down and I no longer feel threatened.”
The Fallacy
This is fallacious reasoning. We feel good. We believe, or at least hope, that the position is once again suitable to hold. However:
It only takes one day’s rally to once again put the position in jeopardy. In only takes a relatively small move for the stock to pass its recent high and threaten to surge higher. It only takes that to force you to exit with a larger loss than you had earlier. Unfortunately, this is not a rare occurrence. It is very likely that the stock is not 100% exhausted and will challenge the recent highs. The problem is that we cannot tolerate holding when that happens. We are already at the edge and cannot take more (rally). When we fail to exit when we get that small reprieve, we need MUCH MORE decline to become comfortable. We need VERY LITTLE upside to force an exit. Isn’t the small rally far more likely than the larger decline? If the market behaves; if another week passes and GOOG declines by 1 or 2%, we are not yet out of trouble. For many traders, the spread will remain too expensive to cove,especially when recent market action has been favorable. The problem is that it still takes only a small rally to threaten the large loss.
The fallacy is believing that a short-lived sell-off or calm market means that all is well. All is not well because it takes a significant passage of time or a decent-sized decline to bring this spread down to where many traders would finally cover.
Being able to get out of the position at a price that is far below the current spread value is far less likely than being forced to exit on the next rally. It is not because the market is bullish. It is because so much more is needed for the trader to earn some money from the position, whereas, it does not take much for the trader to be forced to exit at a price even worse than today.
The fallacy comes in believing that the stock has at least as good a change to move higher (enough to force an exit) or lower (enough to make a voluntary exit).
It can move in either direction. However, the chances of coming out ahead are small. The penalty for being wrong grows quickly while the reward for being correct accumulates slowly.
Thus, the probability of recovering losses is too small to take this risk. The reason for managing risk in the first place is to prevent sitting on bad positions such as this one, and this is not the time to abandon our plans and allow hope to take over as risk manager.
Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.
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