This would be a great trade if it weren’t for the prices one would have to
accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts
are 0.25 bid. This means that the put spread would be sold at zero! The
maximum risk is 3.00, and the maximum gain is zero. Not a really good
risk/reward. The 142–145 call spread isn’t much better: it can be sold for a
dime.
At the time, again a low-volatility period, many traders probably felt it
was unlikely that the DJX will rise 5 percent in a 51-day period. Some
traders may have considered trading a similarly priced iron condor (though
of course they’d have to require some small credit for the risk). A little over
a year later the DJX was trading around 50 percent lower. Traders must
always be vigilant of the possibility of volatility, even unexpected volatility
and structure their risk/reward accordingly. Most traders would say the
risk/reward of this trade isn’t worth it. Strikes too far apart have a greater
chance of success, but the payoff just isn’t there.
Strikes with High Probabilities of Success
So how does a trader find the happy medium of strikes close enough
together to provide rich premiums but far enough apart to have a good
chance of success? Certainly, there is something to be said for looking at
the prices at which a trade can be done and having a subjective feel for
whether the underlying is likely to move outside the range of the break-
even prices. A little math, however, can help quantify this likelihood and aid
in the decision-making process.
Recall that IV is read by many traders to be the market’s consensus
estimate of future realized volatility in terms of annualized standard
deviation. While that is a mouthful to say—or in this case, rather, an eyeful
to read—when broken down it is not quite as intimidating as it sounds.
Consider a simplified example in which an underlying security is trading at
$100 a share and the implied volatility of the at-the-money (ATM) options
is 10 percent. That means, from a statistical perspective, that if the expected
return for the stock is unchanged, the one-year standard deviations are at
$90 and $110. 1 In this case, there is about a 68 percent chance of the stock
trading between $90 and $110 one year from now. IV then is useful
information to a trader who wants to quantify the chances of an iron