231 lines
40 KiB
Plaintext
231 lines
40 KiB
Plaintext
CHAPTER 10
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Wing Spreads
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Condors and Butterflies
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The “wing spread” family is a set of option strategies that is very popular, particularly among experienced traders. These strategies make it possible for speculators to accomplish something they could not possibly do by just trading stocks: They provide a means to profit from a truly neutral market in a security. Stocks that don’t move one iota can earn profits month after month for income-generating traders who trade these strategies.
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These types of spreads have a lot of moving parts and can be intimidating to newcomers. At their heart, though, they are rather straightforward break-even analysis trades that require little complex math to maintain. A simple at-expiration diagram reveals in black and white the range in which the underlying stock must remain in order to have a profitable position. However, applying the greeks and some of the mathematics discussed in previous chapters can help a trader understand these strategies on a deeper level and maximize the chance of success. This chapter will discuss condors and butterflies and how to put them into action most effectively.
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Taking Flight
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There are four primary wing spreads: the condor, the iron condor, the butterfly, and the iron butterfly. Each of these spreads involves trading multiple options with three or four strikes prices. We can take these spreads at face value, we can consider each option as an individual component of the spread, or we can view the spreads as being made up of two vertical spreads.
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Condor
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A condor is a four-legged option strategy that enables a trader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors.
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Long Condor
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Long one call (put) with strike A; short one call (put) with a higher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price A and B is equal to the distance between strike C and strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts.
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Long Condor Example
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Buy 1 XYZ November 70 call (A)
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Sell 1 XYZ November 75 call (B)
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Sell 1 XYZ November 90 call (C)
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Buy 1 XYZ November 95 call (D)
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Short Condor
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Short one call (put) with strike A; long one call (put) with a higher strike, B; long one call (put) with a strike, C, that is higher than B; and short one call (put) with a strike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices A and B and the strike prices of the vertical spread of strikes C and D are equal.
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Short Condor Example
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Sell 1 XYZ November 70 call (A)
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Buy 1 XYZ November 75 call (B)
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Buy 1 XYZ November 90 call (C)
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Sell 1 XYZ November 95 call (D)
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Iron Condor
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An iron condor is similar to a condor, but with a mix of both calls and puts. Essentially, the condor and iron condor are synthetically the same.
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Short Iron Condor
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Long one put with strike A; short one put with a higher strike, B; short one call with an even higher strike, C; and long one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread.
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Short Iron Condor Example
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Buy 1 XYZ November 70 put (A)
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Sell 1 XYZ November 75 put (B)
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Sell 1 XYZ November 90 call (C)
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Buy 1 XYZ November 95 call (D)
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Long Iron Condor
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Short one put with strike A; long one put with a higher strike, B; long one call with an even higher strike, C; and short one call with a still higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes A and B) has the same distance between the strike prices as the call debit spread (strikes C and D).
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Long Iron Condor Example
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Sell 1 XYZ November 70 put (A)
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Buy 1 XYZ November 75 put (B)
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Buy 1 XYZ November 90 call (C)
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Sell 1 XYZ November 95 call (D)
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Butterflies
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Butterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four.
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Long Butterfly
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Long one call (put) with strike A; short two calls (puts) with a higher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes A and B equals that between strikes B and C.
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Long Butterfly Example
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Buy 1 XYZ December 50 call (A)
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Sell 2 XYZ December 60 call (B)
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Buy 1 XYZ December 70 call (C)
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Short Butterfly
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Short one call (put) with strike A; long two calls (puts) with a higher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike A and strike B has the same distance between the strike prices of the vertical spread made up of the options with strike B and strike C.
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Short Butterfly Example
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Sell 1 XYZ December 50 call
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Buy 2 XYZ December 60 call
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Sell 1 XYZ December 70 call
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Iron Butterflies
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Much like the relationship of the condor to the iron condor, a butterfly has its synthetic equal as well: the iron butterfly.
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Short Iron Butterfly
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Long one put with strike A; short one put with a higher strike, B; short one call with strike B; long one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal.
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Short Iron Butterfly Example
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Buy 1 XYZ December 50 put (A)
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Sell 1 XYZ December 60 put (B)
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Sell 1 XYZ December 60 call (B)
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Buy 1 XYZ December 70 call (C)
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Long Iron Butterfly
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Short one put with strike A; long one put with a higher strike, B; long one call with strike B; short one call with a strike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. The put debit spread has the same distance between the strike prices as the call debit spread.
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Long Iron Butterfly Example
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Sell 1 XYZ December 50 put
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Buy 1 XYZ December 60 put
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Buy 1 XYZ December 60 call
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Sell 1 XYZ December 70 call
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These spreads were defined in terms of both long and short for each strategy. Whether the spread is classified as long or short depends on whether it was established at a credit or a debit. Debit condors or butterflies are considered long spreads. And credit condors or butterflies are considered short spreads.
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The words long and short mean little, though in terms of the spread as a whole. The important thing is which strikes have long options and which have short options. A call debit spread is synthetically equal to a put credit spread on the same security, with the same expiration month and strike prices. That means a long condor is synthetically equal to a short iron condor, and a long butterfly is synthetically equal to a short iron butterfly, when the same strikes are used. Whichever position is constructed, the best-case scenario is to have debit spreads expire with both options in-the-money (ITM) and credit spreads expire with both options out-of-the-money (OTM).
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Many retail traders prefer trading these spreads for the purpose of generating income. In this case, a trader would sell the guts, or middle strikes, and buy the wings, or outer strikes. When a trader is short the guts, low realized volatility is usually the objective. For long butterflies and short iron butterflies, the stock needs to be right at the middle strike for the maximum payout. For long condors and short iron condors, the stock needs to be between the short strikes at expiration for maximum payout. In both instances, the wings are bought to limit potential losses of the otherwise naked options.
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Long Butterfly Example
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A trader, Kathleen, has been studying United Parcel Service (UPS), which is trading at around $70.65. She believes UPS will trade sideways until July expiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She executes the following legs:
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Kathleen looks at her trade as two vertical spreads, the 65–70 bull (debit) call spread and the 70–75 bear (credit) call spread. Intuitively, she would want UPS to be at or above $70 at expiration for her bull call spread to have maximum value. But she has the seemingly conflicting goal of also wanting UPS to be at or below $70 to get the most from her 70–75 bear call spread. The ideal price for the stock to be trading at expiration in this example is right at $70 per share—the best of both worlds. The at-expiration diagram,
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Exhibit 10.1
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, shows the profit or loss of all possible outcomes at expiration.
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EXHIBIT 10.1
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UPS 65–70–75 butterfly.
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If the price of UPS shares declines below $65 at expiration, all these calls will expire. The entire 2.00 spent on the trade will be lost. If UPS is above $65 at expiration, the 65 call will be ITM and will be exercised. The call will profit like a long position in 100 shares of the underlying. The maximum profit is reached if UPS is at $70 at expiration. Kathleen makes a 5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00 initially for the spread, her net profit at $70 is just 3.00. If UPS is above $70 a share at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create a short position in the underlying. That short position loses as UPS moves higher up to $75 a share, eating away at the 3.00 profit. If UPS is above $75 at expiration, the 75 call can be exercised to buy back the short stock position that resulted from the 70’s being assigned. The loss on the short stock between $70 and $75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her a net loss of 2.00 to boot. End result? Above $75 at expiration, she has no position in the underlying and loses 2.00.
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A butterfly is a
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break-even analysis trade
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. This name refers to the idea that the most important considerations in this strategy are the breakeven points. The at-expiration diagram,
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Exhibit 10.2
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, shows the break-even prices for this trade.
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EXHIBIT 10.2
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UPS 65–70–75 butterfly breakevens.
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If the position is held until expiration and UPS is between $65 and $70 at that time, the 65 calls are exercised, resulting in long stock. The effective purchase price of that stock is $67. That’s the strike price plus the cost of the spread; that’s the lower break-even price. The other break-even is at $73. The net short position of 100 shares resulting from assignment of the 70 call loses more as the stock rises between $70 and $75. The entire 3.00 profit realized at the $70 share price is eroded when the stock reaches $73. Above $73, the trade produces a loss.
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Kathleen’s trading objective is to profit from UPS trading between $67 and $73 at expiration. The best-case scenario is that it declines only slightly from its price of $70.65 when the trade is established, to $70 per share.
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Alternatives
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Kathleen had other alternative positions she could have traded to meet her goals. An iron butterfly with the same strike prices would have shown about the same risk/reward picture, because the two positions are synthetically equivalent. But there may, in some cases, be a slight advantage to trading the iron butterfly over the long butterfly. The iron butterfly uses OTM put options instead of ITM calls, meaning the bid-ask spreads may be tighter. This means giving up less edge to the liquidity providers.
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She could have also bought a condor or sold an iron condor. With condor-family spreads, there is a lower maximum profit potential but a wider range in which that maximum payout takes place. For example, Kathleen could have executed the following legs to establish an iron condor:
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Essentially, Kathleen would be selling two credit spreads: the July 60–65 put spread for 0.30 and the July 75–80 call spread for 0.35.
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Exhibit 10.3
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shows the payout at expiration of the UPS July 60–65–75–80 iron condor.
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EXHIBIT 10.3
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UPS 60–65–75–80 iron condor.
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Although the forecast and trading objectives may be similar to those for the butterfly, the payout diagram reveals some important differences. First, the maximum loss is significantly higher with a condor or iron condor. In this case, the maximum loss is 4.35. This unfortunate situation would occur if UPS were to drop to below $60 or rise above $80 by expiration. Below $60, the call spread expires, netting 0.35. But the put spread is ITM. Kathleen would lose a net of 4.70 on the put spread. The gain on the call spread combined with the loss on the put spread makes the trade a loser of 4.35 if the stock is below $60 at expiration. Above $80, the put spread is worthless, earning 0.30, but the call spread is a loser by 4.65. The gain on the put spread plus the loss on the call spread is a net loser of 4.35. Between $65 and $75, all options expire and the 0.65 credit is all profit.
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So far, this looks like a pretty lousy alternative to the butterfly. You can lose 4.35 but only make 0.65! Could there be any good reason for making this trade? Maybe. The difference is wiggle room. The breakevens are 2.65 wider in each direction with the iron condor.
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Exhibit 10.4
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shows these prices on the graph.
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EXHIBIT 10.4
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UPS 60–65–75–80 iron condor breakevens.
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The lower threshold for profit occurs at $64.35 and the upper at $75.65. With condor/iron condors, there can be a greater chance of producing a winning trade because the range is wider than that of the butterfly. This benefit, however, has a trade-off of lower potential profit. There is
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always
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a parallel relationship of risk and reward. When risk increases so does reward, and vice versa. This way of thinking should now be ingrained in your DNA. The risk of failure is less, so the payout is less. Because the odds of winning are higher, a trader will accept lower payouts on the trade.
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Keys to Success
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No matter which trade is more suitable to Kathleen’s risk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found a stock on which to trade her spread, she will have sifted through myriad stocks to find those that she expects to trade in a range. She has a few tools in her trading toolbox to help her find good butterfly and condor candidates.
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First, Kathleen can use technical analysis as a guide. This is a rather straightforward litmus test: does the stock chart show a trending, volatile stock or a flat, nonvolatile stock? For the condor, a quick glance at the past few months will reveal whether the stock traded between $65 and $75. If it did, it might be a good iron condor candidate. Although this very simplistic approach is often enough for many traders, those who like lots of graphs and numbers can use their favorite analyses to confirm that the stock is trading in a range. Drawing trendlines can help traders to visualize the channel in which a stock has been trading. Knowing support and resistance is also beneficial. The average directional movement index (ADX) or moving average converging/diverging (MACD) indicator can help to show if there is a trend present. If there is, the stock may not be a good candidate.
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Second, Kathleen can use fundamentals. Kathleen wants stocks with nothing on their agendas. She wants to avoid stocks that have pending events that could cause their share price to move too much. Events to avoid are earnings releases and other major announcements that could have an impact on the stock price. For example, a drug stock that has been trading in a range because it is awaiting Food and Drug Administration (FDA) approval, which is expected to occur over the next month, is not a good candidate for this sort of trade.
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The last thing to consider is whether the numbers make sense. Kathleen’s iron condor risks 4.35 to make 0.65. Whether this sounds like a good trade depends on Kathleen’s risk tolerance and the general environment of UPS, the industry, and the market as a whole. In some environments, the 0.65/4.35 payout-to-risk ratio makes a lot of sense. For other people, other stocks, and other environments, it doesn’t.
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Greeks and Wing Spreads
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Much of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades.
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The vegas on these types of spreads are smaller than they are on many other types of strategies. For a typical nonprofessional trader, it’s hard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads.
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The true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is a winner if it is on the correct side of the break-even price. Wing spreads, however, are a combination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be a winner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners.
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Consider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect a double credit, but only one of the credit spreads can be a loser at expiration. The trader, however, does have to worry about both directions independently.
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There are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade a directional spread. The other uses implied volatility in strike selection decisions.
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Directional Butterflies
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Trading a butterfly can be an excellent way to establish a low-cost, relatively low-risk directional trade when a trader has a specific price target in mind. For example, a trader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys a butterfly consisting of all OTM January calls with 31 days until expiration.
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He executes the following legs:
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As a directional trade alternative, Ross could have bought just the January 35 call for 1.15. As a cheaper alternative, he could have also bought the 35–36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only a dime. The benefit of lower cost, however, comes with trade-offs.
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Exhibit 10.5
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compares the bull call spread with a bullish butterfly.
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EXHIBIT 10.5
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Bull call spread vs. bull butterfly (Walgreen Co. at $33.50).
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The butterfly has lower nominal risk—only 0.10 compared with 0.35 for the call spread. The maximum reward is higher in nominal terms, too—0.90 versus 0.65. The trade-off is what is given up. With both strategies, the goal is to have Walgreen Co. at $36 around expiration. But the bull call spread has more room for error to the upside. If the stock trades a lot higher than expected, the butterfly can end up being a losing trade.
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Given Ross’s expectations in this example, this might be a risk he is willing to take. He doesn’t expect Walgreen Co. to close right at $36 on the expiration date. It could happen, but it’s unlikely. However, he’d have to be wildly wrong to have the trade be a loser on the upside. It would be a much larger move than expected for the stock to rise significantly above $36. If Ross strongly believes Walgreen Co. can be around $36 at expiration, the cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As a general rule, directional butterflies work well in trending, low-volatility stocks.
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When Ross monitors his butterfly, he will want to see the greeks for this position as well.
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Exhibit 10.6
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shows the trade’s analytics with Walgreen Co. at $33.50.
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EXHIBIT 10.6
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Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50, 31 days to expiration).
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Delta
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+0.008
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Gamma
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−0.004
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Theta
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+0.001
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Vega
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−0.001
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When the trade is first put on, the delta is small—only +0.008. Gamma is slightly negative and theta is very slightly positive. This is important information if Walgreen Co.’s ascent happens sooner than Ross planned. The trade will show just a small profit if the stock jumps to $36 per share right away. Ross’s theoretical gain will be almost unnoticeable. At $36 per share, the position will have its highest theta, which will increase as expiration approaches. Ross will have to wait for time to pass to see the trade reach its full potential.
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This example shows the interrelation between delta and theta. We know from an at-expiration analysis that if Walgreen Co. moves from $33.50 to $36, the butterfly’s profit will be 0.90 (the spread of $1 minus the 0.10 initial debit). If we distribute the 0.90 profit over the 2.50 move from $33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen Co. (0.90/(36 − 33.50). This implies a delta of about 0.36.
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But the delta, with 31 days until expiration and Walgreen Co. at $33.50, is only 0.008, and because of negative gamma this delta will get even smaller as Walgreen Co. rises. Butterflies, like the vertical spreads of which they are composed, can profit from direction but are never purely directional trades. Time is always a factor. It is theta, working in tandem with delta, that contributes to profit or peril.
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A bearish butterfly can be constructed as well. One would execute the trade with all OTM puts or all ITM calls. The concept is the same: sell the guts at the strike at which the stock is expected to be trading at expiration, and buy the wings for protection.
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Constructing Trades to Maximize Profit
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Many traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why? Diversification. Because indexes are made up of many stocks, they usually don’t have big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’s not just selecting the right underlying to trade that is the challenge. A trader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well.
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Three Looks at the Condor
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Strike selection is essential for a successful condor. If strikes are too close together or two far apart, the trade can become much less attractive.
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Strikes Too Close
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The QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They have strikes in $1 increments, giving traders a lot to choose from. With QQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In this example, with 31 days until expiration, the following legs can be executed:
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In this trade, the maximum profit is 0.63. The maximum risk is 0.37. This isn’t a bad profit-to-loss ratio. The break-even price on the downside is $54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for a mover like the QQQ to occupy in a month. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes a loser. No one needs any fancy math to show that this is likely a losing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.
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Strikes Too Far
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Strikes too far apart can make for impractical trades as well.
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Exhibit 10.7
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shows an options chain for the Dow Jones Industrial Average Index (DJX). These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example, DJX is around $135.20 and there are 51 days until expiration.
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EXHIBIT 10.7
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Options chain for DJIA.
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If the goal is to choose strikes that are far enough apart to be unlikely to come into play, a trader might be tempted to trade the 120–123–142–145 iron condor. With this wingspan, there is certainly a good chance of staying between those strikes—you could drive a proverbial truck through that range.
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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.
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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.
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Strikes with High Probabilities of Success
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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.
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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.
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1
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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 condor’s expiring profitable, but there are a few adjustments that need to be made.
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First, because with an iron condor the idea is to profit from net short option premium, it usually makes more sense to sell shorter-term options to profit from higher rates of time decay. This entails trading condors composed of one- or two-month options. The IV needs to be deannualized and converted to represent the standard deviation of the underlying at expiration.
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The first step is to compute the one-day standard deviation. This is found by dividing the implied volatility by the square root of the number of trading days in a year, then multiplying by the square root of the number of trading days until expiration. The result is the standard deviation (σ) at the time of expiration stated as a percent. Next, multiply that percentage by the price of the underlying to get the standard deviation in absolute terms.
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The formula
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2
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for calculating the shorter-term standard deviation is as follows:
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This value will be added to or subtracted from the price of the underlying to get the price points at which the approximate standard deviations fall.
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Consider an example using options on the Standard & Poor’s 500 Index (SPX). With 50 days until expiration, the SPX is at 1241 and the implied volatility is 23.2 percent. To find strike prices that are one standard deviation away from the current index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate which strikes to sell.
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The lower standard deviation is 1134.55 (1241 − 106.45) and the upper is 1347.45 (1241 + 106.45). This means there would be about a 68 percent chance of SPX ending up between 1134.55 and 1347.45 at expiration. In this example, to have about a two-thirds chance of success, one would sell the 1135 puts and the 1350 calls as part of the iron condor.
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Being Selective
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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.
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||
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.
|
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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.
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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 technical analysis, fundamental analysis, volatility analysis, feel, and subjectivity.
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A Safe Landing for an Iron Condor
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Although traders can’t control what the market does, they can control how they react to the market. Assume a trader has done due diligence in studying a stock and feels it is a qualified candidate for a neutral strategy. With the stock at $90, a 16.5 percent implied volatility, and 41 days until expiration, the standard deviation is about 5. The trader sells the following iron condor:
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With the stock at $90, directly between the two short strikes, the trade is direction neutral. The maximum profit is equal to the total premium taken in, which in this case is $800. The maximum loss is $4,200. There is about a two-thirds chance of retaining the $800 at expiration.
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After one week, the overall market begins trending higher on unexpected bullish economic news. This stock follows suit and is now trading at $93, and concern is mounting that the rally will continue. The value of the spread now is about 1.10 per contract (we ignore slippage from trading on the bid-ask spreads of the four legs of the spread). This means the trade has lost $300 because it would cost $1,100 to buy back what the trader sold for a total of $800.
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One strategy for managing this trade looking forward is inaction. The philosophy is that sometimes these trades just don’t work out and you take your lumps. The philosophy is that the winners should outweigh the losers over the long term. For some of the more talented and successful traders with a proven track record, this may be a viable strategy, but there are more active options as well. A trader can either close the spread or adjust it.
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The two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade.
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||
Exhibit 10.8
|
||
shows the new data with the stock at $93.
|
||
EXHIBIT 10.8
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||
Greeks for iron condor with stock at $93.
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The trade is no longer neutral, as it was when the underlying was at $90. It now has a delta of −2.54, which is like being short 254 shares of the underlying. Although the more time that passes the better—as indicated by the +0.230 theta—delta is of the utmost concern. The trader has now found himself short a market that he thinks may rally.
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||
Closing the entire position is one alternative. To be sure, if you don’t have an opinion on the underlying, you shouldn’t have a position. It’s like making a bet on a sporting event when you don’t really know who you think will win. The spread can also be dismantled piecemeal. First, the 85 puts are valued at $0.07 each. Buying these back is a no-brainer. In the event the stock does retrace, why have the positive delta of that leg working against you when you can eliminate the risk inexpensively now?
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||
The 80 puts are worthless, offered at 0.05, presumably. There is no point in trying to sell these. If the market does turn around, they may benefit, resulting in an unexpected profit.
|
||
The 80 and 85 puts are the least of his worries, though. The concern is a continuing rally. Clearly, the greater risk is in the 95–100 call spread. Closing the call spread for a loss eliminates the possibility of future losses and may be a wise choice, especially if there is great uncertainty. Taking a small loss now of only around $300 is a better trade than risking a total loss of $4,200 when you think there is a strong chance of that total loss occurring.
|
||
But if the trader is not merely concerned that the stock will rally but truly believes that there is a good chance it will, the most logical action is to position himself for that expected move. Although there are many ways to accomplish this, the simplest way is to buy to close the 95 calls to eliminate the position at that strike. This eliminates the short delta from the 95 calls, leading to a now-positive delta for the position as a whole. The new position after adjusting by buying the 85 puts and the 95 calls is shown in
|
||
Exhibit 10.9
|
||
.
|
||
EXHIBIT 10.9
|
||
Iron condor adjusted to strangle.
|
||
The result is a long strangle: a long call and a long put of the same month with two different strikes. Strangles will be discussed in subsequent chapters. The 80 puts are far enough out-of-the-money to be fairly irrelevant. Effectively, the position is long ten 100-strike calls. This serves the purpose of changing the negative 2.54 delta into a positive 0.96 delta. The trader now has a bullish position in the stock that he thinks will rally—a much smarter position, given that forecast.
|
||
The Retail Trader versus the Pro
|
||
Iron condors are very popular trades among retail traders. These days one can hardly go to a cocktail party and mention the word
|
||
options
|
||
without hearing someone tell a story about an iron condor on which he’s made a bundle of money trading. Strangely, no one ever tells stories about trades in which he has lost a bundle of money.
|
||
Two of the strengths of this strategy that attract retail traders are its limited risk and high probability of success. Another draw of this type of strategy is that the iron condor and the other wing spreads offer something truly unique to the retail trader: a way to profit from stocks that don’t move. In the stock-trading world, the only thing that can be traded is direction—that is, delta. The iron condor is an approachable way for a nonprofessional to dabble in nonlinear trading. The iron condor does a good job in eliminating delta—unless, of course, the stock moves and gamma kicks in. It is efficient in helping income-generating retail traders accomplish their goals. And when a loss occurs, although it can be bigger than the potential profits, it is finite.
|
||
But professional option traders, who have access to lots of capital and have very low commissions and margin requirements, tend to focus their efforts in other directions: they tend to trade volatility. Although iron condors are well equipped for profiting from theta when the stock cooperates, it is also possible to trade implied volatility with this strategy.
|
||
The examples of iron condors, condors, iron butterflies, and butterflies presented in this chapter so far have for the most part been from the perspective of the neutral trader: selling the guts and buying the wings. A trader focusing on vega in any of these strategies may do just the opposite—buy the guts and sell the wings—depending on whether the trader is bullish or bearish on volatility.
|
||
Say a trader, Joe, had a bullish outlook on volatility in
|
||
Salesforce.com
|
||
(CRM). Joe could sell the following condor 100 times.
|
||
In this example, February is 59 days from expiration.
|
||
Exhibit 10.10
|
||
shows the analytics for this trade with CRM at $104.32.
|
||
EXHIBIT 10.10
|
||
Salesforce.com
|
||
condor (
|
||
Salesforce.com
|
||
at $104.32).
|
||
As expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As
|
||
Salesforce.com
|
||
moves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with
|
||
Salesforce.com
|
||
at $104.32, costing $150 a day. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if
|
||
Salesforce.com
|
||
moves through either of the long strikes to, or through, either of the short strikes.
|
||
The prime objective in this example, though, is to profit from a rise in IV. The position has a positive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be a short-term play.
|
||
If Joe were looking for a small rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on a rise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded a strategy like a condor as a vol play, he would likely expect a bigger volatility move than the five points discussed here as well as expecting increased realized volatility.
|
||
A condor bullish vol play works when you expect something to change a stock’s price action in the short term. Examples would be rumors of a new product’s being unveiled, a product recall, a management change, or some other shake-up that leads to greater uncertainty about the company’s future—good or bad. The goal is to profit from a rise in IV, so the trade needs to be put on before the announcement occurs. The motto in option-volatility trading is “Buy the rumor; sell the news.” Usually, by the time the news is out, the increase in IV is already priced into option premiums. As uncertainty decreases, IV decreases as well.
|
||
Notes
|
||
1
|
||
. It is important to note that in the real world, interest and expectations for future stock-price movement come into play. For simplicity’s sake, they’ve been excluded here.
|
||
2
|
||
. This is an approximate formula for estimating standard deviation. Although it is mathematically only an approximation, it is the convention used by many option traders. It is a traders’ short cut. |