The word scares people, especially when put next to the words, retirement, savings, or life’s earnings. When I talk about options trading with people who dabble in online investments, I usually hear a story about how they were screwed by an options speculation and will never trade options again. My first experience with options was exactly the same. I bought something I didn’t know much about because of the high yield and an over confident ability to predict the market’s direction. I got burned. After that, I thought I was done with options, but climbed back on the horse and learned. I am not a professional trader and I am not claiming to be a master; however, I have learned a lot since then and I would like to share it with you. I encourage you to test my conclusions and numbers. I hope that this article will help understand the flexibility and investment value of options strategies for risk adverse investors.
Running away from options? Understandable.
Options are complex, they require sophisticated math to analyze and follow a completely different set of rules than equities. An option represents an obligation to buy or sell an underlying asset at a set price, for a set amount of time. Subsequently, an option’s market price will change because of a change in these variables. That is a broadly stated explanation of the Greek symbols which accompany options trading platforms. By gaining a better understanding of how these variables work in conjunction, you increase the chances of making an informed and profitable trade. The final goal is to create a trading system that acts upon similar conditions and has a repeatable and predictable result. After all, a perpetuity is simply a repeatable and consistent result of a business investment.
Now for the good stuff.
The point of this article is to show you how to set up an options strategy which creates a perpetuity. The golden goose bankers everywhere, but wait, there’s more, the strategy even comes with a capital gains tax break (http://en.wikipedia.org/wiki/1256_Contract, its true!). As long as you buy broad index funds such as, the SPY or IWM, your capital gains are taxed at a reduced rate.
The strategy is called an Iron Condor.
The objective is to create boundaries around the price of the index fund that will not be surpassed by the asset price for a set amount of time. Believe me, it is harder than it sounds. The first and most difficult aspect to understand about the strategy, is that you cannot win every time. The Iron Condor strategy is comparable to becoming “the house” in sports betting. Much like a Las Vegas casino, the name of the game is risk management. If done correctly the strategy should win 9/10 times, or 90%. From what I have seen, the return on risk is around 11%. Anytime you see a strategy that has a payout (11%) larger than its losing odds (10%) you should take it, because when repeated over and over, it will become profitable.
The set up.
To initiate an Iron Condor strategy that has the maximum potential for success you need to pick a broad index fund. One because of the inherent diversification imbedding into a broad index fund and two because of the aforementioned capital gains tax break. IWM, SPY or SPX are all potential candidates that will allow you to take advantage of the 60/40 tax rule.
After an appropriate index fund has been selected, start number crunching. Number crunching is what separates the winning trades from the losing trades. If your numbers are off from the beginning, then you will never give yourself a chance to succeed.
The Iron Condor strategy is a 4-leg option strategy. Buy a very low put, sell a put just above that, buy a really high call, and sell a call just below that. As you can see, the strategy is a credit spread strategy, so you make money when the purchased call and put expire worthless. If the asset ends up higher than your upper and lower bounds, your risk is limited to the gap between your sold option and your purchased option. I try to make that gap as small as possible, but this also limits the gains. The trick is figuring out where to sell the put and the call.
Statistics, it’s actually useful.
Now comes the number crunching. Remember, with the Iron Condor strategy you do not need to know whether the stock is going to increase or decrease in value. You simply need to know the maximum potential of increase or decrease for a set amount of time. Get comfortable calculating metrics such as average true range, exponential moving averages and standard deviation. Also consider the amount of time you want to hold these options. As a writer or seller of options, I advise a shorter time frame. Time decay is your best friend, and positions with high theta are preferable. Time decay has the highest impact on the price of options with 45 days or less until expiration. I suggest using the 45-days-or-less rule as a strong guideline for where to construct your positions.
Stop. Do not trade until you are ready.
The strategy has its dangers. If a large global event that shakes the market occurs, your position will likely be a loser due to the uncommon increase in volatility of the markets. Luckily you have a maximum loss with the Iron Condor strategy, but each loss is costly. The perfect time to implement an Iron Condor strategy is after a large global event when perceived volatility is high, but trading has leveled out. These large events are an Iron Condor trader’s greatest enemy and represent the largest threat to your profitability. These events usually happen in clusters. So if you one of your trades becomes a loser due to a global concern in the market, it is prudent to wait a while until the market settles down. The easiest and most predictable time to activate the Iron Condor Strategy is during times which the market is in a defined horizontal trading zone.
Here is a simple example of how an Iron Condor works:
Russell 2000 Index Fund (IWM) – Current Price $82.09
Jan 12 Contracts
Target: 90% chance of winning trade
From here, you need to make a starting point decision:
use the current price as the starting point of analysis
use a type of average as the starting point
Whichever you choose, make sure to be up to date on any relevant market information.
Once you have a starting point, calculate the standard deviation of IWM’s price. Another choice you need to consider is how much look back time do you want to use when calculating your standard deviation? Longer time frames will likely have larger standard deviation results, will not be as timely and will have lower returns. Shorter time frames offer higher returns, but also give a smaller margin of safety. So like all investments there is a trade-off between profit and safety when setting your boundaries. For the sake of a simple example, I will use the current price of IWM as my starting point.
The graph below shows the relationship between standard deviation result, or Z-score and the likelihood of additional data being within your selected boundaries.
Current Price – 82.09
1.65 St. Dev = 90% accuracy (approximately)
1 Standard Deviation- 7.43
1.65 St. Dev = 12.26
High Boundary – 94.34
Low Boundary – 69.83
Since there is no corresponding options listed at these prices you will have to adjust your targets up or down depending on the closest option strikes.
Sell Long Call @ 94
Buy Long Call @ 96
Sell Long Put @ 70
Buy Long Put @ 68
Reward = 21.00
Risk = 185.00
Return on Risk = 11.3%
If done correctly, this trade should be profitable over time. Think about it this way, one miss will cost you $185, but 9 wins will gain you $189. So strategy has a value of $4. Initially this does not seem like much of a win (just 4 dollars for all that work!), but our analysis has not considered the added power of compound interest. Additionally this is the least risky and most basic way to run a sustainable Iron Condor strategy. If you are more risky than I am, you could always increase the risk and reward by decreasing the range between your sold put and sold call.
As previously stated, this article is an introduction to the Iron Condor options strategy. People who are seriously interested in using this technique should develop personalized metrics which track the increase or decrease of current market volatility risk. There are many financial and statistical techniques that will allow you to track the likelihood of a winning trade. As a start, look into different time frames for standard deviation calculations, divergence and convergence metrics and commodity channel calculations. If you are seriously interested in the subject and have questions, comments, or simply wish to know more, please contact me via email.
Remember, insight is the father of foresight,
By. Calder H. Lamb