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November 26, 2013

The Fundamentals of Iron Condors

Have you ever noticed a professional athlete warming up before a game or match? What are they doing? They are stretching, running, throwing and catching just to name a few for example. What they are really doing is working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career no matter what your career is.

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 similar 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. Doing this on every potential trade can only improve your odds.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

March 14, 2013

Six-Year Low in the VIX? What’s It Mean to YOUR Options Trading?

The VIX, or CBOE’s Implied Volatility Index, hit a six-year low this week. What’s that mean to options trading? Lots!

Options trading is greatly affected by implied volatility. At its most basic level, when the VIX is low, it tends to mean lousy options trading.

Option traders are not incented to trade when the VIX is low. Traders generally don’t want to sell options when premiums are so low. There is no reward and still there is always the specter of the risk of an unexpected market shock. And, option traders don’t want to buy options either. Why? Because when the VIX is low, the VIX low is for a reason: Because market volatility is low. Why would traders want to buy options (and endure time decay) is the market isn’t moving?

And so, as always, the devil is in the details. Right now, there actually exists a somewhat atypical pattern in many stock options. Many stocks have their implied volatility trading decidedly below historical volatility levels. Though this volatility set up can be seen here and there at any given time, it is more common than usual. That means cheap volatility trades (i.e., underpriced options) are more abundant.

Stocks like CRM, C, GE, F, and even the almighty AAPL all have implied volatility below their historical volatility.

That means that even though overall stock volatility (as measured by historical volatility) is low, the options are priced at an even lower level. That means time decay is very cheap per the level of price action in these stocks. And, implied volatility in these stocks (and probably the VIX as well) is likely to rise to catch up to historical volatility levels—assuming the current price action continues as it is.

So, traders should be careful not to sell too many option spreads (i.e., credit spreads) at these fire-sale levels. Instead, traders should look to positive vega spreads (i.e., debit spreads), at least until implied volatility rises offering worthy premiums to option sellers.

Dan Passarelli

CEO

Market Taker Mentoring

February 14, 2013

Baseball, Buying a Car and Iron Condors

With spring training right around the corner, traders should ask themselves this question; have you ever noticed 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.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 6, 2012

Butterflies and Weekly Options

The weekly options have been the topic of our blog many times before. Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of option strategies. If you need to find out more about weekly options or other option strategies, feel free to visit the options education section on our website.

As an example, consider the case of a frequently traded spread vehicle, the butterfly. For those first encountering this strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price. It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy. Functional characteristics include: negative vega, variable delta and accelerating gamma and theta during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle. Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the changes begin to occur literally over the extent of a few hours. As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

August 18, 2011

If I’d Meant That, I’d Have Said That

To the new option trader, it often seems as if he has entered into the terra incognita of the derivatives world through Alice’s looking glass. Engaging the natives in conversation quickly results in encountering colorful characters who appear not to recognize the same reality from which the traveler has arrived. For those who have chosen to enter this new world, Alice’s conversation with Humpty Dumpty seems particularly familiar wherein he declares: `WhenIuse a word,’ Humpty Dumpty said, in rather a scornful tone, `it means just what I choose it to mean — neither more nor less.’

The nomenclature of options is boundlessly confusing. While the casual visitor may only notice the broad categories of puts and calls, the serious student soon will come to realize that the detailed nomenclature is confusing and results from the inescapable fact that options have more moving parts than do stocks. When initiating a stock position, the choices are two: buy or sell the issue. When initiating an options position, the choices are numerous and not mutually exclusive. The selection of the particular series to trade and the anatomic structure in which to place it is often nuanced.

An individual option’s value is a function of three main factors: price of the underlying, time to expiration, and implied volatility. Furthermore the individual options can be combined into complex spreads composed of multiple positions in an almost limitless variety. It is from this abundance of choice that the word salad of option terminology arises.

I find the terminology paradoxically to find its maximum point of obfuscation when used to describe one of the basic building blocks of options, the vertical spread. Verticals represent a two-legged category of spreads in which one option is bought and an option of a different strike is sold; both positions are taken in the same series month and in the same type, either puts or calls. Strike selection determines the directional bias of the trade as well as the credit or debit status. Bullish and bearish trades are easily constructed in both puts and calls.

This simple spread results in a chaotic and confusing panoply of names including: bull call spread, call debit spread, bear call spread, call credit spread, bear put spread, put credit spread, bull put spread, bull call vertical, bear call vertical, bull put vertical, and bear put vertical. As if this collection of a dozen names describing four basic trades were not sufficiently opaque, many traders use an implied shorthand description. For example, they may refer to opening a call credit spread as “selling a call vertical”; conversely opening a call debit spread is often referenced as “buying a call vertical”. The directional bias of the trade is apparent to those having been shown the “secret handshake” by the spread type, call or put, used and the credit or debit status of the opening cash flow.

Unfortunately there is no easy resolution to this nomenclature nightmare. Various traders use the terms inconsistently and variably for no apparent logical reason. Such is everyday life in the world of options.

July 14, 2011

The Family of Wing Spreads

The Butterfly and Condor Clans
We have previously introduced the large and diverse option family of the range bound structures and visited in some detail two of the less frequently discussed trades, the double calendar and the double diagonal. Since attracting attention to the lesser known brethren of the family, the branch representing the wing spreads has made its impatience for the spotlight to be known and is demanding its usual disproportionate quota of attention. So it shall be.

This more visible portion of the clan retains the characteristic defining points of family identity: a variably large range of profitability with regard to price of the underlying and the theta positive blood type. In addition, this branch has additional characteristics of being vega negative and having the individual option positions selected from a single expiration date. To review, lest they feel slighted by not being introduced once again, the specific names of the individual family members of this branch are: butterfly, iron butterfly, condor and iron condor.

Butterfly, Iron Butterfly, Condor and Iron Condor
The nomenclature of the family is more complicated than necessary; the positions are more similar in make up than the individual family members would like to admit. The fundamental defining structure of this group is to be found in the butterfly . It is from this basic structure that the individual members of the wing-spread-family of option strategies have evolved.

Butterflies and Iron Butterflies

Butterflies
Butterflies in their classic form, whether in puts or calls, are constructed with the anatomy of 1/-2/1. The concise description is to “sell the body and buy the wings”. This structure finds its evolution from the combination of a bull and bear vertical spread. It is in the butterfly that this branch of the family generally finds both its most profitable trades based on percentage returns and its narrowest zones of profitability.

Iron Butterflies
The butterfly can be constructed in puts, calls, or both puts and calls. When constructed in both puts in calls, the appellation “iron butterfly” is used. This general organizational structure applies throughout this branch of the family; structures composed of both puts and calls are termed iron. Put and call butterflies are debit transactions while the iron butterfly is a credit trade.

Unconventional Butterflies
The remaining members of this branch of the family can be most easily viewed from an organizational standpoint as butterflies with cosmetic surgery of varying degrees. The first step in the gradual transmogrification is to separate the two short strikes of a classic butterfly from the 1/-2/1 anatomy to the 1/-1/-1/1 framework. This produces the entity of a split-strike butterfly. Some would consider this newly modified entity to be a condor, the result of the next to be described modification in our collection of wing spreads.

The Split-Strike Butterfly
As compared with a butterfly structure, the split-strike butterfly has the primary effect of broadening the price range of the underlying over which the position is profitable. As in life in general, increases in yin are irrevocably linked to decreases in yang. Benefits accruing to the trade from this modification and widening of the zone of profitability are accompanied by reduction in the maximum potential extent of profitability.

Condors and Iron Condors
The final step in our structural manipulation of the butterfly is the condor and its most frequently encountered variation, the iron condor. In the shorthand in which we have described the anatomy, the condor could be written as 1/-1/-/-/-/-/-1/1. The iron condor could be designated as 1/-1/-/- (put segment) and -/-/-1/1 (call segment).

Condors vs. Iron Condors
The condor is a debit transaction and the iron condor is a credit trade. This final step in the modification has the major effect of broadening yet again the profitable range of prices over which the underlying can oscillate and remain profitable. The broadening of the profitability range is once again accompanied by reduction in the maximum achievable percentage profit.

Each of the condor family members has certain important characteristics arising from the specific components and the manner in which they are combined within the complete position. The trader must be aware of these specific points of distinction.

There will be more discussion to follow on the specifics. Each of these spreads is the subject for extensive and detailed discussion.

February 4, 2010

COST Short Iron Condor

Filed under: Uncategorized — Tags: , , , , — Dan Passarelli @ 10:30 am

In last week’s edition of the Market Taker Edge newsletter, we took a look at a short iron condor on Costco Wholesale (COST) [Which is proving to be a nice little trade, BTW]. One of the rationales behind selling the March 50/52.50/60/62.50 iron condor was that COST’s implied volatility (implied volatility is – simply defined – the volatility component of an option price) were inflated to roughly 22% (meaning the implied volatility has pushed the option price higher) , which lifts the premium values for option sellers. In addition, the profitable range on the short iron condor is $51.90 to $60.60.

Before we delve any further into the trade, let’s take a look at the strategy. A short condor occurs when a trader combines a bear call spread and a bull put spread. The trade is executed by buying a lower-strike out-of-the-money put and selling an out-of-the-money put with a higher strike. Then the trader sells an out-of-the-money call with a higher strike and buys another out-of-the-money call with an even higher strike.

A short iron condor consists of four legs and results in a net credit received.  As for profit potential, the maximum potential profit is the initial credit received upon entering the trade. This profit will occur if the underlying stock price, on expiration date, is between the two middle (short) strikes. As noted before, the max potential profit for the COST trade would occur it the stock was trading between $52.50 and $60 by expiration.

One of the benefits of a short iron condor (and potentially options in general) is limited risk. For short condors, the maximum loss comes when the underlying stock price drops below the lowest strike or above the highest strike. If you want an equation for max loss, think of it as the difference in strike prices of the two lower-strike options (or the two higher-strike options) less the initial credit for entering the trade. In the case of COST, the max potential loss was limited to $1.90. Not bad, right?

Well, we now have to look at the stock and the aforementioned rationale to the trade. COST is a warehouse retailer, allowing customers to pay for membership and then purchase any of their daily needs (and sometimes wants) at a bulk discount. Retail has struggled thanks to the recession and all, but COST has traded in a range between $51.90 and $60.60 (the aforementioned profitable range on this trade) since September. With the market kicking sideways, expect COST to do the same – making this trade strategy ideal for the current market.

It’s best to take profits when able on this short iron condor, mainly because the company posts earnings on March 4. This date would be ideal to exit the trade by because this event has a chance of pushing the COST out of its range. Again, we suggested this trade in our newsletter, the Market Taker Edge, because COST has such a wide profit range and a potential return on risk of roughly 32%. The short iron condor is a logical way to play COST in this scenario.

(Try a one-month free trial of the Market Taker Edge on us http://markettaker.com/market_taker_edge/)