Being Selective
There is about a two-thirds chance of the underlying staying between the
upper and lower standard deviation points and about a one-third chance it
won’t. Reasonably good odds. But the maximum loss of an iron condor will
be more than the maximum profit potential. In fact, the max-profit-to-max-
loss ratio is usually less than 1 to 3. For every $1 that can be made, often $4
or $5 will be at risk.
The pricing model determines fair value of an option based on the implied
volatility set by the market. Again, many traders consider IV to be the
market’s consensus estimate of future realized volatility. Assuming the
market is generally right and options are efficiently priced, in the long run,
future stock volatility should be about the same as the implied volatility
from options prices. That means that if all of your options trades are
executed at fair value, you are likely to break even in the long run. The
caveat is that whether the options market is efficient or not, retail or
institutional traders cannot generally execute trades at fair value. They have
to sell the bid (sell below theoretical value) and buy the offer (buy above
theoretical value). This gives the trade a statistical disadvantage, called
giving up the edge, from an expected return perspective.
Even though you are more likely to win than to lose with each individual
trade when strikes are sold at the one-standard-deviation point, the edge
given up to the market in conjunction with the higher price tag on losers
makes the trade a statistical loser in the long run. While this means for
certain that the non-market-making trader is at a constant disadvantage,
trading condors and butterflies is no different from any other strategy.
Giving up the edge is the plight of retail and institutional traders. To profit
in the long run, a trader needs to beat the market, which requires careful
planning, selectivity, and risk management.
Savvy traders trade iron condors with strikes one standard deviation away
from the current stock price only when they think there is more than a two-
thirds chance of market neutrality. In other words, if you think the market
will be less volatile than the prices in the options market imply, sell the iron
condor or trade another such premium-selling strategy. As discussed above,
this opinion should reflect sound judgment based on some combination of