Tactics II – Volatility & Time Iron Condors

Sideways and Volatility Strategies Iron Condors Butterflies

The Basics An Option is the Right to Buy (or Sell) a Stock at a specific price over a set period of time A buyer pays (debit) for this right and the seller receives the money (credit) All options in the market are created by a transaction between a buyer and a seller, the total number of contracts at any one time is called Open Interest Calls are the right to Buy a Stock at a Specific Price Puts are the Right to Sell a Stock at a Specific Price

The Basics The Strike is the price of the Stock that the Buyer will pay if they Choose to exercise the Option In the case of a Call Option with a strike of 35 the buyer has the right to buy that stock from the seller for $35 If the price of the stock has gone above $35 it makes sense for the Option holder to exercise his right and get the stock for a cheaper price than the current market The same goes for Puts, just in the opposite direction

What makes up the Price of an Option – Part 1 Intrinsic Value – If the stock is currently trading above (or below) the strike price then the difference between the strike and the current price is called intrinsic value Time Value – The seller needs to get something for his commitment to this contract for a period of time. The time value is normally calculated from the return on a risk free trade for the same period as the options life. Rule of Thumb – The closer you get to Expiration the smaller the Time Value left in the trade. This is called Theta Decay.

Implied Volatility What makes up the Price of an Option – Part 2 Risk – Every Seller of Options wants to make money and to protect themselves against Risk. A Risk Premium is added to the price of the Option based on the sellers analysis of the chance that the Stock will go past the Strike before the expiration of the Option If the stock moves a lot then the Risk is High and the Option Price goes up If the stock does not move much then the Price of the Option will be lower Upcoming events such as Earnings or a FDA announcement will increase the Risks and the Price of an Option This is referred to as Implied Volatility

Implied Volatility can be High or Low Implied Volatility can be over priced or under priced Option Writers may have written too many options and are not interested in selling any more There may be rumors or other vague risks in the market driving IV up Large funds may be taking protective positions driving Options prices higher Sometimes Options Traders just want to reduce their positions, driving the prices down Understanding Implied Volatility gives you an Edge

A note on Time Decay Time Decay (Theta Erosion) increases dramatically as you approach the expiration date of the Option The last 30 days of an Option’s life sees the Time Value of an Option decay to almost nothing

Iron Condors as an Income Strategy So What Do We Do? Iron Condors as an Income Strategy

Iron Condor Basics Why do we trade Iron Condors? We expect a Stock Price to stay within a specific Range We are looking to take advantage of High IV and Premium to capture profits Iron Condors give us specific limits to our Risks We are taking advantage of Options’ natural tendency to be overpriced Iron Condors are High Probability and Consistent Trades

What is an Iron Condor What is an Iron Condor The Basic Trade Sell a Call Option at a Strike above the current price of the stock (Out of the Money) Protect ourselves from a large loss by buying a Call Option at a higher Strike price Sell a Put Option at a Strike that is lower than the current price of the Stock (Out of the Money) Protect ourselves from a large loss by buying a Put Option at a lower Strike price

Targeting a Stock Look for Options with a high IV relative to their normal price movement Make sure there are no risky events coming up If the difference in IV and Historical Volatility is extreme find out why – too good to be true?

Finding the Strikes I use a Delta Neutral approach and Short Term Options Look for an options series that expires between 20 – 40 days out (rule of thumb) Find the first Call Option with a Delta between .10 and .15 This is you Short Call for the Iron Condor Use the next Strike up for your Long Protective Call Find the first Put option with a Delta similar to the Call’s Delta This is your Short Put Option Use the next Strike down as your Protective Put Option There are lots of variations on this, but it is a good place to start

Analyze the Trade I have a spreadsheet to specifically analyze Iron Condors Enter the Information on Current Price of Stock, Strike Prices, Expiration of Options and Costs of the trade Estimate the Forecast Volatility of the Stock Forecast Volatility is one of the most important aspects of this analysis It is a prediction of how much the stock price is likely to move between the trade entry and the expiration of the options This estimate drives the Expectancy calculation for the trade Expectancy tells you if you have an edge in the trade

Look for the Following Expectancy needs to be positive – this means you have an edge in this trade I look for a % Daily Expectancy to be above .5% Higher is better, but beware of ones that are too high Above 3% daily expectancy is likely to be too good to be true, find out why Look for a Max Return Probability to be as high as possible Better than 75% at least (rule of thumb) High 80’s to 90’s is good This is your probability that the trade is going to make the max profit

Placing the Iron Condor Trade Try to get filled at the midpoint price Have patience Have a minimum amount you are willing to take and do not go below that. The odds get worse quickly when you don’t get the credit you expect

Goal is for the Options to all expire worthless You keep your full credit These need to be watched and adjusted periodically