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