Prudent option traders love to sell options/spreads based on various criteria and goals to generate additional revenue. This can be done as new speculative trades or deployed around existing positions as a way to generate additional yield and reduce the cost basis of longer-term holdings.
We advocate both approaches. Our approach focuses on selling overpriced premium after having a directional bias of the underlying or in situations where we believe the technical pattern on the time frame being traded has made a short term top or bottom. Seasoned option sellers have been “crying the blues” for the past few months (except for the short-term volatility spikes during broader market sell offs or with earnings plays when implied volatility increases into earnings and other binary events where the stock is expected to make a big move on the news announcement). When the $VIX is low (currently at 11.87 which is the lower end of his historical range), that depresses option premium so that the option seller receives less premium (i.e., potential profit) for the risk taken as opposed to when the $VIX is high. There are obviously numerous other option strategies that can be used in low volatility environments when you have a directional bias of the underlying (e.g., buying in-the-money (ITM) credit spreads).
I am m a regular reader of Barron’s for educational articles in addition to generating trade ideas. In this issue of Option Trader, I decided to review a trade discussed in this weekend’s Barron’s, Striking Price column, entitled Iron Condor Helps Returns Fly High (page M11, 8/1/16), and provide additional analysis and observation without commenting on the underlying merits of the trade.
Author Mr. Solaka discussed a hypothetical short iron condor play on SPY as a means to generate additional income in the current low interest rate environment. Selling an iron condor means selling both an out-the-money (OTM) call credit spread an OTM put credit spread. This strategy is generally used with the trader believes that the underlying will remain range-bound within the expiry date of the options sold. The maximum profit is the net credit received (times the number of contracts sold); the maximum risk is the difference in strike prices (of the spread which the SPY closes through at expiry) less the net credit received.
Let’s review the trade mentioned. Mr. Solaka reviewed the following iron condor: sell the Sep 2 weekly 222/227 call spread and sell the Sep 2 weekly 206/195 put spread for a net credit of $1.10/share.
Iron Condor: Trade Rationale
The following is the daily chart of SPY as of last Friday’s close.
As mentioned, selling an iron condor is done when the trader expects the underlying to stay fairly range bound and believes the premium received warrants the risk assumed. The strike price selection should be consistent with your expectations of possible movements. SPY has been trading in a 2-point range ($215.50 – $217.50) for over two weeks now. Greg Capra has discussed numerous times in his Free Trading Newsletter the incredible bullish move of SPY since the post-Brexit June low. Although the weekly and monthly charts of SPY are overbought, and some market internals flashing bearish warning signs, nobody can dispute that the SPY move and two-week consolidation is extremely bullish. Although not to be discussed herein, another variation to this trade is to “leg into” the iron condor (e.g., wait for a breakout and sell the put spread first, or wait for a break down and only sell the call spread first) or even just focus on one side after a decisive break.
Iron Condor: Maximum Gain
NOTE: The following order blotter on my Think or Swim (TOS) option trading software shows a “mid-point net credit” of $.96 for this trade; thus, for the remainder of this article, I will analyze the $.96 premium received versus the $1.10 mentioned in the article. The difference is that the article assumed SPY was $216, but it closed at $217.12 last Friday. I will also assume for this analysis that a trader sold a 10-lot (which represents 1,000 shares since 1 contract represents 100 shares of the underlying).
Assuming a trader sold a 10-lot, the trader would receive $1,100 (if filled) in exchange for the risk assumed. The maximum gain of $1,100 would be obtained if SPY closed between $206 and $222 (the short option strike prices) on Sep 2nd expiry.
Iron Condor: Maximum Loss
The maximum loss occurs if SPY closes beyond the long strike prices (i.e., over $227 or under $195 on Sep 2nd expiry. If SPY closed over $227, the loss on the trade would be the difference in strike prices of $5,000 ($227 – $222, times 1,000 shares) less the net credit received of $960 = ($4,040), less commissions. If SPY closed below $195, the loss on the trade would be the difference in strike prices of $11,000 ($206 – $195, times 1,000 shares) less the net credit received of $960 = ($10,040), less commissions.
Iron Condor: Risk Profile
The following Risk Profile graph (available on the TOS Analyze tab) visually shows how the profit and loss of the iron condor discussed as SPY moves towards expiry, as well as the maximum gain and loss.
Iron Condor: Implied Volatility
As discussed above, it is best to sell premium when implied volatility (IV) is high. As you can see on the following TOS chart of SPY, it shows the current IV of SPY is only 12, with an IV Rank of a mere 3%. That means that only 3% of the time is IV of SPY less than 12.
Option traders (buyers and sellers) must be cognizant of IV since it can adversely affect the intended trade. The major problem selling options during low volatility environments (low $VIX) or instruments with low IV Rank, is that when volatility does increase, the price of the options should increase. This can cause the spreads to increase in value and cause unrealized losses which is opposite the reason for selling premium (i.e., we sell premium with the goal of making money through theta time decay).
Notice on the SPY chart how volatility/IV increases each time the market has a meaningful selloff. Once confirmed by a bullish bottom, those provide the best opportunity and timing to sell put options and spreads since the premium received will be significantly greater than currently exists with a low IV Rank.
Iron Condor: Risk Management
Although beyond the scope of this article, there are numerous ways to manage option positions, including the iron condor discussed herein. But traders as part of their Trading Plan should have a clear “plan” for both entering, managing, and taking profits before entering any trade.
For the iron condor, some possible ways to manage include:
- Do nothing and manage the position if assigned. The trader will be long 1,000 shares of SPY if the put is assigned, or short 1,000 shares of SPY if the short call is assigned. If SPY closes beyond one of the long strikes, then the clearing firm will close out the trade for you with the trader incurring the maximum loss defined above.
- Close out the losing spread just prior to expiry if the trader does not want to be assigned the position over the weekend.
- Close both positions once achieved a maximum percent of gain (e.g., 50-80% of max gain achieved), particularly if obtained in a relatively quick time.
- Close the losing position only (i.e., the call spread if SPY breaks out, or the put spread if SPY breaks down).
- “Adjust” the trade as it develops (e.g., lessen the losing spread, add more contracts to the winning side, etc.).
- “Roll” the trade up or down as SPY develops to bring in additional premium through time or different strikes.
- Other ways to hedge.
- Just take stop loss on everything if the reasons for entering the trade no longer exist.
I hope the above was helpful. We will be diving into these and many other option trading topics in the future, as well as giving suggested option trading ideas with the underlying rationale.
Happy trading! If you have any questions or comments, please e-mail Dan Gibby at gibbyglobal@gmail.com
