March 30, 2011

Baseball, Buying a Car and Trading Iron Condors

Have you ever watched a baseball player warming up before a game? Or watched footage of a baseball player at practice? What are they doing? Swinging a bat. Throwing and catching balls. Running bases. Working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career.

Option trading is no different. Even traders who have traded for years, who trade complex strategies return to the fundamentals to make their trading decisions. Take trading iron condors. Trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a P&(L) diagram or through the greeks.

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

March 25, 2011

There’s a Time for Everything: Thoughts on Options Strategies

Filed under: Options Education — Tags: , , , — Dan Passarelli @ 4:56 pm

Do you know how many different types of options strategies there are? A lot: That’s how many! But that’s not really the important question. More importantly: Do you know why there are so many different types of options strategies? Now we have something to discuss.

Different options strategies exist because each one serves a unique purpose for a unique market condition. For example, take bullish traders. Traders who are extremely bullish get more bang for their buck buying short-term out-of-the-money calls. Less bullish traders my buy at- or in-the-money calls. Traders bullish just to a point may buy a limited risk/limited reward bull call spread. If implied volatility is high and the trader is bullish just to a point, the trader might sell a bull put spread, and so on.

The differences in options strategies, no matter how apparently subtle, help traders exploit something slightly different each time. Traders should consider all the nuances that affect the profitability (or potential loss) of an option position and, in turn, structure a position that addresses each nuance. Traders need to consider the following criteria:

  • Directional bias
  • Degree of bullishness or bearishness
  • Conviction
  • Time horizon
  • Risk/reward
  • Implied volatility
  • Bid-ask spreads
  • Commissions
  • And more

Carefully selecting options strategies makes all the difference in a trader’s long-term success. Leaving money on the table with winners, or taking losses bigger than necessary can be unfortunate byproducts of selecting inappropriate options strategies. Be sure to spend time optimizing your options strategies over the next few weeks to build the habit.


March 18, 2011

Learn to Adjust Options Positions

My Online Education Series this month has all been all about helping traders learn to adjust options positions. Adjusting option positions is an essential skill for options traders. Adjusting options positions helps traders repair strategies that have gone wrong (or are beginning to go wrong) and often turn losers into winners. Given that, it’s easy to see why it’s important to learn to adjust options positions.

Adjusting 101

Adjusting options positions is a technique in which a trader simply alters an existing options position to create a fundamentally different position. Traders are motivated to adjust options positions when the market physiology changes and the original trade no longer reflects the trader’s thesis. There is one golden rule of trading: ALWAYS make sure your position reflects your outlook.

This seems like a very obvious rule. And at the onset of any trade, it is. If I’m bullish, I’m going to take a positive delta position. If I think a stock will be range-bound, I’d take a close-to-zero delta trade that has positive theta to profit from sideways movement as time passes. But the problem is gamma. Gamma is the fly in the ointment of option trading.


Gamma—particularly negative gamma—is the cause of the need for adjusting.

Gamma definition: Gamma is the rate of change of an option’s (or option position’s) delta relative to a change in the underling.

Oh, yeah. And, just in case you forgot…

Delta definition: Delta is the rate of change on an option’s (or option position’s) price relative to a change in the underlying.

In the case of negative gamma, trader’s deltas always change the wrong way. When the underlying moves higher, the trader gets shorter delta (and loses money at an increasing rate). When the underlying moves lower, negative gamma makes deltas longer (again, causing the trader to lose money at an increasing rate).

Wrap Up

Therefore, traders must learn to adjust options positions, especially income trades, in order to stave off adverse deltas created by the negative gamma that accompanies income trades.


March 12, 2011

Maximizing Fade Plays

Do you feel like you've seen this movie before? Trouble in the Middle East. People in the streets; panic in the market. Is this recent wave of trouble going to last forever? Not likely. Perhaps there is an opportunity to fade this fall. But how should an option trader play the fade to maximize chances of success and maximize option-trading returns?

The obvious starting point for a trader to fade this fall is to take a positive-delta position. This is fancy options speak for a bullish trade. There are lots of different ways to take a bullish stance given all the various types of option-trading strategies out there. So, the question really is: Which is best?

There are a few major considerations here. First, traders must strive to maximize reward by minimizing risk. In order to do so, option traders must define their expectations. Am I looking for an extreme turn around? A mild retracement? A dead-cat bounce? The more a strategy can be tailored to expectations, the more risk can be controlled and reward can be maximized.

Next traders need to consider implied volatility. This is where option traders can get an edge in their options positions. If implied volatility is high (overpriced), option traders should consider option-selling strategies. If implied volatility is low (underpriced), option traders should consider option-buying strategies.

In the current market scenario we have a situation where if the turmoil in the Middle East subsides, the market should rally somewhat, but it's not likely to go to the moon. Further, with the VIX at its current nose-bleed levels and implied volatility of individual stocks following suit, it's easy to find overpriced options. Any clever fader trader should be looking for put credit spreads to sell. Put credit spreads have positive delta and take a short position on implied volatility. Great candidates for this sort of play are indexes and ETFs like SPX, SPY, DJX, DIA, et. al. Traders are best off staying away from oil stocks and precious metals that might be adversely affected by Middle East stability.