Condor Options Explained

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Trade Iron Condors Like Never Before

Iron Condors have gained a lot of popularity among professional money managers and retail investors. It is a market neutral strategy that allows you to profit when the underlying price moves sideways. Iron Condors usually have a limited risk and a high probability of success.

Introduction to Iron Condors

The Iron Condor is a combination of a bull put spread and a bear call spread. The basic construction is:

  • Sell 1 OTM Put
  • Buy 1 OTM Put (Lower Strike)
  • Sell 1 OTM Call
  • Buy 1 OTM Call (Higher Strike)

All options expire at the same month. The distance is usually the same between the short and the long legs of the calls and the puts.

A typical P/L chart looks like this:

The Iron Condor option strategy is a theta positive gamma negative and vega negative strategy. That means that it benefit from time decay, but suffers if the underlying moves too much and/or Implied Volatility increases.

One approach that can maximize credit received and the profit range of the iron condor, is to leg into the position. “Legging in” refers to creating the put spread and the call spread at times that when market makers are inflating the prices of either the sold call or put. However, most experts agree that this approach hardly justifies the risk.

Iron Condor Trading Parameters

So before you start trading with the Iron Condor option strategy, there are two most important things you need to decide about:

  • How far in time to go (expiration).
  • How far OTM to go (strikes).

The time can vary between one week and three months. Those are the extremes, most people go for 3-10 weeks.

Going with close expiration will give you larger theta per day. So you might earn 5% in one week or 10% in month or 15% in two months. Obviously 5% every week is better than 10% every month. But there is a catch. Less time to expiration equals larger negative gamma. That means that a sharp move of the underlying will cause much larger loss.

If the underlying doesn’t move, then theta will kick off and you will just earn make money with every passing day. But if it does move, the loss will become very large very quickly. Another disadvantage of close expiration is that in order to get decent credit, you will have to choose strikes much closer to the underlying.

Based on my experience and personal preference, I like to open the IC trade 6-8 weeks before expiration. It works for me, it doesn’t necessarily mean it will work the best for you. In any case, the absolute minimum time that I would recommend is 3-4 weeks.

Another advantage of going further out in time and getting decent credit is the fact that you can close the trade early and remove the risk. I never hold till expiration, trying to close around 10-14 days before expiration. When only 20-25 cents is left, it’s not worth the risk to continue holding. You kept most of the credit, leave the last few cents to someone else.

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This brings us to the choice of strikes. The delta of the options gives you an approximate estimate of the probability to expire ITM. If you open IC with short calls and puts having delta of 15, that means that the trade has probability of

70% to end between the strikes. There is always a trade-off between risk/reward and probability of success. The better the risk/reward, the lower probability of success.

Iron Condor Profit/Loss and Exit strategies

One of the more difficult aspects of options trading is knowing when to take a profit. The profit on the Iron Condor option strategy is calculated as return on margin. Margin on iron condors is the difference between the strikes. For example, if you trade 2100/2110 call spread, the margin will be $1,000. The capital requirement is the margin less the credit. In case you got $200 credit, the capital requirement is $800. So if you sell the IC for 2.00 credit and closed it for 1.00 debit, the gain is 100/800=12.5%

I usually manage the put and the call credit spreads separably. I will place a GTC order to close the spreads at 0.25 debit each, which is around 20-25% of the credit received. The last 25 cents are not worth the risk.

As a rule of thumb, you should aim to limit the losses to 1.5 times the average monthly earnings. For example, if your average monthly return is 10%, you should aim to lose no more than 15% in losing months. There is no point to make 8-10% for few months and lose 50% in one month.

Typical issues with Iron Condors

“I would have had a great year if it wasn’t for one or two months”. If you trade condors without a detailed risk management plan you will eventually experience large losses.

There are few serious issues with “traditional” iron condors:

  • If the market makes a move up after trade launch you will start to lose money immediately even with declining implied volatility typically helping your short Vega position.
  • Markets tend to rise over time, so most of the cycles you are fighting the Iron Condor on up moves.
  • “Rolling” adjustments isn’t really an immediate risk reducing technique if the market continues to fall and implied volatility continues to rise.
  • As you move from the center of an Iron Condor, gamma kicks in and makes the T+0 curve “bend” and change relatively quickly so you tend to adjust fairly soon.

How to address those issues?

To address the issues with “traditional” iron condors, we developed a very unique version of the iron condor strategy. We call it Steady Condors. Steady Condors is a market neutral, income generating, manage by the Greeks strategy.

Here are the highlights:

  • For downside protection, we use long puts and debit spreads at trade setup and as adjustments instead of rolling our threatened options. This helps reduce the Vega and Gamma so as price moves down and volatility moves up.
  • To flatten the T+0 curve on the up side, we sell fewer call credit spreads. We normally only use enough call credit spreads to balance our setup. This limits upside risk from the beginning of the trade and it’s easy to manage.
  • If the market is moving up, we take the calls off at predefined adjustment points.It doesn’t hurt the profit potential too much and also eliminates the upside risk.
  • We would typically open the trades 6-8 weeks before expiration and close them 2-3 weeks before expiration, in order to reduce the negative gamma risk.

Those steps help to keep the drawdowns reasonable relative to realized and expected returns.

This is a typical P/L chart of our Steady Condors setup:

You can see the relatively flat T+0 line and limited upside risk.

To get an idea how this Iron Condor option strategy would perform in a down market, we presented a case study from August 2020 cycle. The trade began on July 6, 2020 with RUT at 844. On Aug 4 with RUT at 752 the trade was taken off for target profit of 5%. Frankly I’m not familiar with another variation of Iron Condor that can actually make a gain after the index declines by 11%+.

Conclusion

Steady Condors is a strategy that maximizes returns in a sideways market and can therefore add diversification to more traditional portfolios. Selling options and iron condors can add value to your portfolio. The strategy produced 46.7% non compounded return in 2020 (56.5% compounded return) and 17.8% CAGR (Compounded Annual Growth Rate) since inception, with 14.6% annual volatility, resulting 1.27 Sharpe Ratio. Our reported results are net of commissions and are on the entire account.

Does it mean you should stop trading “traditional” iron condors? Not at all. They should still work well – as long as you implement prudent risk management. Steady Condors just provides you a viable alternative and addresses some of the issues traders face when trading this strategy.

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Gamma Risk Explained

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Gamma is the ugly step child of option greeks. You know, the one that gets left in the corner and no one pays any attention to it? The problem is, that step child is going to cause you some real headaches unless you give it the attention it deserves and take the time to understand it.

Gamma is the driving force behind changes in an options delta . It represents the rate of change of an option’s delta . An option with a gamma of +0.05 will see its delta increase by 0.05 for every 1 point move in the underlying. Likewise, an option with a gamma of -0.05 will see its delta decrease by 0.05 for every 1 point move in the underlying.

KEY POINTS REGARDING GAMMA

Gamma will be higher for shorter dated options. For this reason, the last week of an options life is referred to as “gamma week”. Most professional traders do not want to be short gamma during the last week of an options life.

Gamma is at its highest with at-the-money options.

Net sellers of options will be short gamma and net buyers of options will be long gamma. This makes sense because most sellers of options do not want the stock to move far, while buyers of options benefit from large movements.

A larger gamma (positive or negative) leads to a larger change in delta when your stock moves.

Low gamma positions display a flatter risk graph, reflecting less fluctuation in P&L.

High-gamma positions display a steeper risk graph, reflecting high fluctuation in P&L.

HOW GAMMA WORKS – RELATIONSHIP WITH DELTA

To get an idea of how gamma and delta work together, we will compare an at-the-money and an out-of-the-money call option. In the picture below you can see that a 10 lot at-the-money call position has a positive delta of 524 and a gamma of positive 62. The 185 call position has a delta of 86 and a gamma of 29. The gamma for the at-the-money position is significantly higher.

On the right side of the picture is a custom scenario. Assuming SPY has risen by 1% and all other factors remain the same (volatility, time to expiry, dividends). The delta for the 177 calls has risen by 107 to 631 whereas the 185 calls have only risen by 65. (Note that on a percentage basis the 185 calls had a bigger rise, but in terms of actual delta exposure, the 177’s had a bigger increase)

We can do the same analysis using long calls with different expiry months. Here you can see that the Dec 177 calls have a delta of 525 and a gamma of 63. The June, 2020 177 calls have a similar delta at 501, but a much lower gamma at 21. Again, assuming a 1% change in price, you can see that the Dec calls have picked up an extra 107 delta and the June calls have only picked up an extra 38 delta.

The above analysis confirms that at-the-money options have higher gamma risk than out-of-the-money options and shorter dated options have higher gamma risk than longer dated options .

HOW GAMMA WORKS – RELATIONSHIP WITH VEGA

The gamma of an option will also be affected by Vega. When implied volatility on a stock is low, the gamma of at-the-money options will be high, while the gamma of deep out-of-the-money options will be near zero. This is because, when volatility is low, deep out-of-the-money options will have very little value as the time premium is so low. However, option prices rise dramatically on a relative basis, as you move back along the option chain towards the at-the-money strikes.

When volatility is high, and option prices are higher across the board, gamma tends to be more stable across the option strike prices. When volatility is high, the time value embedded in the deep out-of-the-money options can be quite high. Therefore as you move from the outer strikes back towards the at-the-money strikes, the increase in time value is less dramatic.

This concept is probably best explained visually. In the table below you can see the gamma of SPY calls when volatility is low (VIX at 12.50) and high (VIX at 25.00). The variation in gamma across the strikes is much smoother when volatility is high. Therefore, you can assume that the gamma risk of at-the-money options is much higher when volatility is low .

Here is the same data represented graphically. You can see when implied volatility is low, the gamma risk is much higher for the at-the-money strikes.

GAMMA AND OPTION STRATEGIES

So far we have only looked at individual options strikes. However, every option combination strategy will also have a gamma exposure. Trades that require you to be a net seller of options, such as iron condors, will have negative gamma, and strategies where you are a net buyer of options will have positive gamma. Below are some of the main options strategies and their gamma exposure:

GAMMA RISK EXPLAINED

In order to better illustrate how gamma works, I’ll look at a couple of different scenarios and compare how they are affected by a -2.0% move in price, with all other factors staying the same. I’ll look at their initial delta and their new delta after the move.

IRON CONDOR GAMMA RISK – COMPARING WEEKLY AND MONTHLY CONDORS

First up we have two iron condors with the short strikes set at delta 10. The weekly condor has a -4 gamma which is twice as high as the monthly condor at -2.

After a -2.0% move in the underlying, the weekly condors gamma has switched to positive and exploded out to 62, while the monthly delta has only moved to 20.

Clearly, the weekly condor has a much higher gamma risk. This is part of the reason why I do not like to trade weekly condors. A small move in the underlying can have a major impact on your position .

BUTTERFLY GAMMA RISK – COMPARING WEEKLY AND MONTHLY BUTTERFLIES

Next we will look at butterfly spreads comparing weekly, monthly, narrow and wide butterflies.

Comparing a weekly and monthly 10 point butterfly, we have an interesting situation, with both trades basically having zero gamma at initiation. This is due to the fact that the short strikes were exactly at-the-money with RUT trading at 1101 at the time.

In any case, we see that with a -2.0% move in RUT, the weekly delta moves from -20 to +3 for a move of 23 points. The monthly delta moves from -4 to +3 for a total move of only 7 points.

Finally, let’s look at a 50 point wide at-the-money butterfly. The weekly butterfly has a whopping 146 point change in delta! The monthly butterfly moves 73 points.

We can deduce from the above that weekly trades have a much higher gamma risk. Butterflies have a higher gamma risk than iron condors and wide butterflies have the highest gamma risk of all the strategies. This is summarized below:

Now that we know a bit more about gamma risk, let’s investigate a strategy you may have heard of called gamma scalping.

Gamma scalping is like that hot girl from high school that you were never good enough for. The more you find out about her, the more amazing she sounds, but you don’t really know what makes her tick.

Gamma scalping is not for everyone for a number of reasons. For starters you have to be pretty well capitalized as it can be very capital intensive. Secondly, you need to have a very good understanding of how option greeks work before you even think about trading this way.

Many market makers make their livelihood by gamma scalping, so retail traders are naturally curious about this strategy, so that they can “trade like the pros”. The gamma scalping performed by market makers is an essential component of the efficient functioning of options markets as you will soon learn.

There are a few different ways you can set up a gamma scalp, but let’s look at an example using a long straddle.

IBM GAMMA SCALP USING LONG STRADDLE

Date: November 1, 2020

Current Price: $179.42

Buy 2 IBM Jan 17 th 2020, 180 calls @ $4.35
Buy 2 IBM Jan 17 th 2020, 180 puts @ $5.65

Premium: $2,000 Net Debit

This trade set up gave us a net delta exposure of -13, so to get to delta neutral, we buy 13 shares.

Buy 13 IBM shares @ $179.42

Cost: $2,332.46 Net Debit

Total Cost: $4,332.46

This trade will start out with a delta of zero, but it won’t stay that way. The reason is because of the positive gamma associated with the trade. In this case, the trade has a beginning gamma of +13. As the price of IBM fluctuates, the delta will change because of the gamma exposure. Being a positive gamma trade, price moves will benefit the trade. As IBM moves up, it will gain positive delta, as IBM moves down, the trade will pick up negative delta.

In order to get back to delta neutral each time, we would need to either buy or sell IBM shares. As the stock moves down, we gain negative delta and need to buy shares (buy low). As the stock moves up we sell shares (sell high) to neutralize delta. Notice that we are buying low and selling high. These transactions in the stock generate cash flow and can give rise to a profit providing the straddle does not lose too much value.

THE COST OF SCALPING – THETA DECAY

If the above sounds too good to be true, well it is, there is a catch in the form of Theta decay. We know that long options decay as time passes and this is the issue traders face with gamma scalping. The long calls and puts that make up the straddle will decay by a certain amount each day. If the stock does not move up and down enough, the time decay on the straddle will be greater than the profits from the stock trades.

When gamma scalping, you want a stock that moves a lot during the course of the trade .

Option greeks work together rather than in isolation. Theta and Vega have a distinct relationship. If implied volatility is high, the time value embedded in options will be high. Therefore, options with high implied volatility will have a higher rate of Theta decay. It makes sense that it will be harder to gamma scalp on a stock with high implied volatility, as the stock will need to move much more in order to offset the losses from time decay. It also makes sense that a good time to gamma scalp is when the implied volatility of a stock is at the lower end of it’s 12 month range as the options you are buying will be cheaper and you will need less movement in the stock to cover the Theta decay.

BRINGING IT ALL TOGETHER – GAMMA SCALPING, MARKET MAKERS AND IMPLIED VOLATILITY

Dan Passarelli write a very good article on TheStreet.com which I will quote from here:

Even though you may not be willing or able to engage in gamma scalping, hopefully you now have a little bit more of an understanding of how the options markets works and how the different players all fit together.

You can read a bit more on gamma scalping here on Futuresmag.com and here on the Elite Trader forum.

GAMMA-DELTA NEUTRAL TRADING

Now that we know a bit about gamma scalping and delta neutral trades, the next step would be to learn about neutralizing both delta and gamma. I won’t go into details here as while the theory behind the idea is sound, I’m not convince this would work in practice. If you’re interested in reading an excellent article on the topic, you can do so here.

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