To this end, we focus on creating the greatest odds for our success using one of the best methods available to the modern investor which is selling options.
Previously, you learned that option selling strategies are called credit type strategies. These strategies derive their profit from selling or shorting options which produces a payment called a credit. This is often referred to as “premium selling” and it’s a key part of Profit Effect’s investment philosophy. This is because of the higher probability for success compared to buying stock outright. Option selling or credit strategies can be used to create bullish, bearish or neutral positions.
Short option strategies do carry an increased probability for profit and their success is pushed to an even higher degree when limiting their use to high volatility situations only. This is due to the fact that the human emotions of fear & greed impact option prices by forcing them higher.To be fair, greed is just another side of fear. Greed is fear of missing out. In either case, whether it’s fear of losing or fear of missing out, the higher this fear, the more options for the market will cost. This value is displayed as Implied Volatility.
Implied volatility is a function of an option’s price. It shows what the market expects in terms of future price movement in the particular security. A larger expected move will increase the implied volatility.
When it comes to using this measure, our concern is what the current level of volatility is compared to its historical range. The implied volatility level on it’s own does not give us useful information when it comes to aligning the correct option strategy with the given volatility environment. In order to do that we need to compare volatility to itself and give the current state of volatility a relative value when compared to its historical range. This value is often referred as “IV Percentile” or “IV Rank”.
IV Percentile (IVP) is a function of human emotion and there are two important characteristics that option sellers can exploit when it comes to these emotions:
The first important fact about emotions is they normalize over time. This means, that no matter how fearful or greedy people become, this heightened emotion does not last forever. Emotions display a mean reverting quality that greatly surpasses any found among asset prices themselves. The simple fact is they normalize over time.
The second reason is that emotions almost always over state the reality or eventual outcome which trigger the emotion. This fact of human nature is evident in the option pricing.
For these reasons, credit strategies are utilized during high volatility situations only.
In addition you learned that when it comes to selling options, the disadvantage lies in the reward to risk ratio. The reward side of the ratio is limited to the credit received from selling the option.
Because of this, option sellers need to control the risk side of the equation to succeed long term.
Fortunately, we have many tools at our disposal to do this, including the option itself.
Reward to Risk
The reward to risk ratio refers to how much potential gain compared to how much potential loss the investment holds. This ratio is arguably the most important metric in all of investing. You determine the ratio by dividing the reward by the risk. This tells you how much you are risking to how much you can gain.
If you are risking $100 for the chance to make $200, you have a 2:1 reward to risk ratio, if risking $100 to make $100 you have a 1:1 ratio and if risking $100 to make $50 your ratio is .5:1.
Typically speaking, investors prefer a high reward to risk ratio and consider a ratio less than 1:1 a very poor ratio. But, this is not necessarily the case. The probability for achieving the profit needs to be considered.
If an investment is risking $100 to make $50 but carries an 80% probability for profit, that means out of 100 trades 80 of them will make $50 each for a profit of $4,000 and 20 of them will lose $100 each for a loss of $2,000. If you then subtract the total loss amount of $2,000 from the total profit amount of $4,000, you end up with a total profit from the investing activity of $2,000. This example shows how important the risk to reward ratio relative to the probability for profit is when it comes to successful trading or investing.
In this week’s strategy focus we center our attention on the short Iron Condor. As mentioned at the beginning, there is no such thing as a crystal ball and we can’t rely on hunches to guide our investment decisions. The truth is, no one can say for sure what the market will do next. We can ignore this fact or choose to embrace it and find ways to profit in spite of this uncertainty.
Trading options gives you the ability to profit when a stock price remains within a range over a specified period of time. This can be accomplished through a variety of options strategies. One way is by using an Iron Condor. Specifically, we’ll look at the credit style or “short” Iron Condor.
This variety takes full advantage of the positive attributes associated with selling options as outlined in the previous issue of Profit Talk.. In addition, the Iron Condor addresses the reward to risk issue as well because it carries defined risk. This allows the user to limit the risk side of the equation.
The short Iron Condor is constructed through the combination of buying and selling options. The short Iron Condor version, which we are covering here, means that the profit is derived from the sold (short) options. The purchased (long) options are used to hedge the position and define the risk.
Selling the Iron Condor results in a credit. This means you get paid for placing the trade. That makes the short Iron Condor a credit style option trade. Specifically, it’s a credit spread, because it utilizes long options to limit (hedge) the risk. The money you receive is called a credit and you get that payment no matter what happens.
Choosing an Iron Condor Candidate
When it comes to choosing a prospective security to use an Iron Condor strategy on, the most important factor lies in the current relative state of implied volatility. Matching the correct option strategy with the current state of implied volatility is significant to successful option trading. The subject of implied volatility bears some lengthy discussion which will be tackled in future Profit Talk issues. For now, let me provide a quick overview of implied volatility and its role in the option strategy selection process.
Implied volatility is a function of an option’s price. It shows what the market expects in terms of future price movement in the particular security. The security is referred to as the underlying asset or just “underlying” for short. The current price movement and the expected future price movement of the underlying directly affects the price of the option. A larger expected move will increase the implied volatility. When it comes to using this measure, our concern is what the current level of volatility is compared to its historical range.
The implied volatility level on it’s own does not give us useful information when it comes to aligning the correct option strategy with the given volatility environment. In order to do that we need to compare volatility to itself and give the current state of volatility a relative value when compared to its historical range. This value is often referred as “IV Percentile” or “IV Rank”.
All credit based option strategies, which includes Iron Condors, enjoy better success rates if placed when the IV Percentile (IVP) is high. Ideally, we’re looking for the IVP to be 60% or higher. But, the market can experience long periods of low volatility which makes finding suitable candidates based on this criteria difficult. Under these circumstances, I may choose to employ a few credit strategies at a lower IV Percentile than 60% but never when it’s below 50%. There are other strategies that are best utilized under those conditions which you’ll learn in future issues.
Now that we know what to look for in terms of IV Percentile we can use our platform tools to filter prospective candidates. Here is the list of stocks to use as our underlying asset that trade options and have the highest amount of volume. The watchlist window can be customized to display your desired criteria. This column here shows the current IV Percentile. (Figure 1) At this point in time, there are three symbols that display a higher than 60% IVP. You’ve got TBT which relates to US Treasuries. Also, FXE which is the Euro dollar ETF and GDXJ which is the junior gold miners ETF. (Figure 2)
The vetting process consists of simulating an Iron Condor trade on the prospective markets and using the risk graph to determine the best choice.
This first step in constructing an option position is to choose which expiration contracts to use.
The expiration of the options used for all credit style strategies should be within 60 days or less. The sweet spot is around 45 days until expiration, but anything less than 60 days is good. Another consideration when choosing an expiration is volume in the market. In general, it’s best to go with the regular monthly expiration which occurs the 3rd Friday of every month. This expiration is displayed in white text on this platform. The weekly expirations are displayed in yellow text.
The reason for using the monthly expiration is it has the highest number of participants, or the highest volume. This leads to better pricing and overall lower risk compared to low volume markets.
You cans see, at this time, the monthly expirations available that have less than 60 days to expire are either 18 days away or 53 days away. (Figure 3) We are looking for 60 days or less. Experience tells me that 18 days, though within the credit strategy rules of less than 60 days, probably doesn’t contain enough option premium to pass the risk/reward test we’re about to perform. So, let’s look at the 53 day expiration cycle first. We’ll let the risk graph determine whether or not the any of these trades are worth taking.
In order to analyze the trade we need to simulate it in action and view it on the risk graph. Construction of a short Iron Condor consists of selling 1 Put option at the bottom of the bottom of the range and buying 1 Put further out and selling 1 Call option at the top of the range and buying 1 Call further out. This creates a credit spread with 4 “legs” which include both a long and short Put option. Plus, a long and short Call option. These 4 legs equal 1 spread.
The strike choices can be determined with technical analysis (chart reading) or by using the option greeks. The process involves selling the closer in options and buying the further out options. When using the greeks for strike selection I like to start with selling options closest to the 16 delta value.
Then, start with buying options around $2 away then check how the risk looks. This will typically create a well balanced Iron Condor. In addition, by selling the 16 delta options, the short strikes should fall just outside the range that price is expected to close in on the option expiration.
The first consideration when analyzing an Iron Condor is total the credit received for the trade. Since this is a spread with 4 legs involved it’s a bit commision intensive. So, it’s important to collect enough credit to make the trade worthwhile. In general, make sure you receive at least 50 cents for the trade spread at the minimum. That’s the first hurdle to cross.
The amount of credit received can be adjusted by moving the strike locations. The long options can be moved further away to increase the credit. The credit increase because the cost of the long options are cheaper the further away they are from current price, which leaves you more credit. However, the distance between the short strikes and the long strikes is what determines the maximum risk in the trade. This is because the loss amount is capped at location of the long strikes. The most that can be lost on the trade is determined by the distance between the short and long strikes. This means that although moving the long strike location further away increases the credit received, which is positive for our reward to risk ratio, doing this also increases the the risk in the trade which is negative for our reward to risk ratio. This can be a bit of a “catch 22”. It’s a tradeoff that must be analyzed to determine how best to construct the Iron Condor and ultimately, whether or not to place the trade at all.
Let’s go through the process of analyzing the reward to risk scenario for each of our candidates and see which, if any, pass the test. The first on our list is GDXJ, this exchange traded fund focuses on junior companies that are in the gold and silver mining business. As mentioned, we’ll analyze an Iron Condor constructed with options that expire in 53 days.
An Iron Condor is constructed by selling a Put and a Call option at the top and bottom of the price range and buying a Put & Call further out in price from the short Put & Call that is sold. I typically start with selling a -.16 delta option and buying one that is $2 away from that option. So, sell 1 -.16 delta Put and buy another Put $2 lower. Then sell 1 .16 delta Call and buy another Call $2 higher. (Figure 4) We start there and then go to the risk graph to analyze how this scenario might play out.
The basic rules regarding a short Iron Condor are:
Implied volatility percentile (IVP) should be in the higher range. 60% IVP or higher is best.
Total credit received must be more than 50 cents per spread
The breakeven point must remain outside of the expected price closing range as outlined by the probability graph
A risk defense point with a loss amount equal to or less than the total credit received (1:1 reward/risk or better) that falls outside of the expected price range must be established, along with an appropriate loss containment strategy. (more detail on coming shortly)
Let’s jump over to the risk profile so i can demonstrate.
The risk graph allows you to simulate the profit and loss scenario of the option position based on the price movement of the underlying security you are analyzing. The light blue line represents the P&L of the position based on the underlying price on the day of expiration. The magenta line represents the P&L of the option position based on the price of the underlying today. Magenta is the option position P&L in real time, light blue is the option position P&L on the day of expiration. The difference between the two price comes from the time value contained in the option which will be gone on the day of expiration.
The lighter gray area displays the range that the underlying price is expected to close within on this date here. (Figure 6)
To analyze the position, set the date to the expiration date of the position you are analyzing.
The red hash marks represent the breakeven point of the position at expiration. (Figure 7) The flat horizontal portion of the blue line, representing the P&L at the time of expiration, extends between the two short strike prices. This is the maximum profit line. It shows that, in this particular case, if the underlying closes at any price from $29 up to $43 the full credit is received.
But, each penny below or above either short strike, eats into the credit received until all the credit is gone, which is our break-even point. Again, as shown by the red hash marks. Subtracting the total credit received from the short Put strike or adding it to the short Call strike gives you the break-even stock price point for the position on the day of expiration. That number is what’s represented by the red marks.
The horizontal “X” axis represents the underlying price. The real time P&L and the expiration day P&L are shown here in this box and colored accordingly. There are a few key attributes we’re looking for here. Let’s review the Iron Condor rules again.
As mentioned, it’s best to meet or exceed a minimum of 50 cents total credit for the spread.
In addition, the break-even point must reside outside of the expected price range as depicted by the light grey area. It would not make sense to put on a trade that has a loss price point that falls within the expected price range. Finally, a risk defense point with a loss amount equal to or less than the total credit received that falls outside of the expected price range must be established, along with an appropriate loss containment strategy. In other words, you must be able to limit the risk to be no larger than the reward, so a 1:1 reward risk minimum, at a point that is outside of the expected range.
As stated previously, when it comes to analyzing an investment, one of the most important metrics to consider is the reward to risk ratio. I also explained that credit style option strategies, like the short Iron Condor, carry a limited amount of possible reward. This fact must be addressed in order to sustain a reasonable reward to risk ratio. We do this by managing the risk side of the equation.
Remember, you learned that credit strategies carry a higher probability for profit. For example, the standard Iron Condor, such as the kind outlined here, has a probability for profit of around 68%. That being the case, if 100 Iron Condor trades were placed, 68 of those trades would be profitable, while 32 of them would be losers. That is great news, but does not tell the whole story. The amount of profit made on the profitable trades and the amount lost on the losing trades is what determines whether this investing activity would bring profit or not. This is the reward to risk ratio.
We know that the reward side of the equation is limited. Our job as a profitable trader must then be to limit the risk side as well. Since this type of strategy carries a higher than 50% probability, if we simply limit the risk amount to not exceed the reward amount, so maintain at least a 1:1 reward to risk ratio, the strategy will be profitable in the end.
Here’s how the math would look if the trades are managed with a 1:1 reward to risk ratio.
Let’s say the total credit received for each spread is 50 cents. The standard option contract represents 100 shares. This means 1 spread that is receiving a 50 cent credit is worth $50.
100 X 50 cents = $50. For this example, let’s say we sell 10 spreads. That would be worth a total of $500.
Now let’s do the math using a 68% probability for profit and a 1:1 reward/risk ratio.
Out of 100 trades, 68 of them make $500 for a profit of $34,000 and 32 of them lose $500 bringing $16,000 in losses. The result is then $34,000 in profits minus $16,000 in losses for a total remaining profit of $18,000.
You can see how following this rule of maintaining a 1:1 reward to risk minimum that lies outside of the expected price range is so vital to the long term success of this strategy. Armed with this information, let’s go back to the risk graph and continue our analysis of the trade candidates.
Analyze the profit & loss of the prospective trade by moving the cursor along the X axis. You can see the resulting P&L information in the box here. (Figure 8) Again, the magenta color is the P&L information real time and the light blue represents the P&L on the day of expiration. For our purpose here, use the day of expiration information. The purpose is to determine what the loss amount is within the expected price range. In order to maintain the 1:1 reward to risk ratio, the loss amount reached within the expected price range must not exceed the total credit received.
Both the long and short strikes can be moved to adjust the credit received. Just make sure the breakeven point does not fall within the expected price range. That is the light grey area. I always start with moving the long strikes first to see if I can acheive the correct ratio. Again, the farther away the strikes are from current price the lower the cost of the option. This means, moving the long strikes farther away lowers their cost and therefore increased the total credit. But, this widens the distance between the short and long strikes which increases the total risk in the trade and directly affects the P&L scenario. It’s a tradeoff that must be analyzed.
If within the expected range, the loss amount at expiration does not exceed the total credit received, the prospective trade passes the test and is okay to take. I’ve adjusted the strikes and now the GDXJ trade overcomes the hurdles outlined by our Iron Condor trading rules. This is a trade that I’m perfectly okay with taking. I don’t know whether this particular trade will be profitable, but I do know that placing trades that do fall in line with the parameters outlined here and are managed accordingly, will produce profit for me over time. (Figure 9)
The maximum loss we are willing to accept on the particular trade is established as the “risk defense point”. The price of underlying at this point is to be noted and if the trade is taken, risk defense actions must be applied if this price is breached. Doing so will help to maintain the risk to reward ratio. This give us the best chance of being profitable.
When it comes to risk defense there are a few options available for this type of position which includes, closing the trade outright or rolling the trade to a further out expiration date. There is really no right or wrong method. It comes down to personal preferences and/or the particular circumstances involved. The most important point is to limit the total loss amount in order to maintain a proper reward to risk ratio.
Now that you’ve got an idea of the process, let’s go through it on another one of our trade candidates. Next up is FXE, the Euro dollar etf. First construct a simulated position, by selling a Put that closest to -.16 deltas, then buying the further out Put. Then selling a Call closest to .16 deltas and buying one further out. When choosing the further out option to purchase, you can eyeball which one might work based on the credit received for the short option. Look to see if the 50 cents per spread threshold will be met. If you’re unable to get at least 25 cents per side, it probably won’t work. It looks like this one is coming in just shy of the 50 cents. You can adjust the strikes or simply check to see how well it does on the risk graph and then, if everything looks good otherwise, put the trade in at 50 cents and see if you get filled. Is the 1 cent really going to make a difference, perhaps not, but it’s a slippery slope once we start making excepting to our rules. This one looks pretty good on the risk graph, just need to get a bit more credit to give it an official passing grade according to our rules.
So, there you have a great foundation for using short Iron Condors to provide opportunity for profit. This strategy is great for beginners and seasoned investors alike. It offers a way to capture profit from price trading in a range. The Iron Condors is one of the great ways that options allow you to generate profits without having to be 100% right on market direction.
The main takeaways when it comes to using Iron Condors as part of your investing strategy is to:
First of all, only use them in higher IV markets, this increases your odds for success because of increased premium prices.
Second, make sure to get at least 50 cents in credit to make the 4-leg spread worthwhile
Finally, always contain your risk. Doing so will insure long term success.
I hope this was helpful for you. We really just covered the basics when it comes to Iron Condor trading. They can be tweaked in all sorts of ways which make them versatile and fun to use as part of a well balanced investing strategy. We will certainly cover more on the Iron Condor in future Profit Talk issues.
Looking to the next edition of Profit Talk. We’re going flip the cards and cover the process of creating a debit type position using options. This is where the efficient use of capital that options offer really shines. It also gives us a chance to put chart reading skills into action and lean more on directional moves in the market. The payoff is a bigger reward.
Until next time keep trading and investing the Profit Effect way, proven , consistent and stressfree, just the way trading is supposed to be