We talk a lot about why adjusting iron condors is rarely, if ever, a good idea, and adjustment decidedly is not a part of the Condor Options strategy. So you’re probably wondering, why all these Calendar Options posts about adjustments? The answer is simple—calendar spreads are not like iron condors.

A quick review: As we explained in Part I of this series, our decision to adjust calendar spreads is based on the same criteria as our decision not to adjust iron condors—probability. When we open an iron condor, we typically have nearly a 70% chance of expiring out of the money. And as long as we’re out of the money, we can keep most of our initial credit when we close the trade. Our winning trades have an average return of 23%, and a few have returned more than 30%.

A typical calendar spread, on the other hand, has only a 30% to 50% probability of being profitable when the short option expires. If we’re lucky enough to be near the money when expiration week rolls around, we could have a 50% or 60% return; but if the stock is as little as half a standard deviation away from our strike, every dollar it continues to move against us can slice 10 percentage points off that return. If we expect to get high monthly returns from calendar spreads, month after month, we have to do something to tip the odds in our favor. One thing we can do is open a trade as a double-calendar, but even a double-calendar has only a 50% to 60% probability of profit if left as-is.

That’s where adjustments come in. Calendar spreads provide ways to adjust our trades that extend our range of profitability if the underlying moves too far in one direction or the other. Read the rest of this entry »

On a day like this, you really need to start off any post with some good news.  Apparently, one of the greatest television shows of our time might be made into a movie: we’re talking about Arrested Development.  So you see, there is hope for this country after all.  (Nevermind that we’re all so scared of the boogeyman that the government will be warrantlessly watching the movie over our shoulders; that’s a matter for another day.)

Okay, now to the issue at hand.  Markets gapped down at the open and never looked back, closing at the lows on higher volume.  Severe technical damage has been done to the indexes on a short and long term basis.  Key support levels from March 07, January 08, and March 08 should have held the selling in check, but the bears blew right through those lows.  This was a high volume, high intensity day in which no buyers ever really stepped up.  We kept hearing things throughout the day like, “Where are all the value investors?”  Off acting like Milford men, that’s where.

Before the open this morning, we sent a note to subscribers describing why we were still in full bearish mode:

Our opinion is still that we are in the midst of a bear market and that any rallies will be short-lived and indecisive.  Some market commentators (especially in the rah-rah corporate media) have been calling for another rally like the one we saw off the March lows.  The primary reason we reject this view is that the sectors that provided leadership during the March rally (tech, transports, energy) now appear overextended - or at least weakened - and we haven’t seen any new leaders emerge…

More importantly, we said that this was as good a time as any to tighten up those allocations and double-check your risk tolerance:

One other important point here is that this is a good time to double-check the allocations you’re working with.  This applies not just to our newsletter trades, but to your whole portfolio.  Revisit each open position, and ask yourself whether you would be comfortable if you ended up exiting that individual position for a 50% or even a 100% loss.  If the answer is no, then dial down your allocation.

Today was a perfect example of why we prefer to trade spreads on ETF options instead of the traditional big index products.  SPY quoted contracts a few pennies apart today, which is typical, while you could catch similar SPX strikes at a dollar and a half wide or more.  Good luck getting a fast and fair exit in the SPX pit on a day like today.

Where do we go from here?

The first thing to say is that action like this is not to be blown off - even if we bounce up 200 Dow points over the next couple trading days, that wouldn’t negate the horrible market internals and total lack of support we’re seeing now.  That said, here are some factors that may favor a snapback sooner rather than later:

• $SPXA50R - the percentage of S&P 500 stocks above their 50 day moving average has been a helpful tool in the past for discerning market tops and bottoms.  Over the past four years, on the five occasions when this indicator has been at 20 or below, the S&P 500 has been significantly higher in the weeks following.  Now that it is fashionable once again to disparage technical analysis, we’ll note that this particular indicator is actually quasi-fundamental: when too many high quality stocks are irrationally sold off, value-chasing buyers invariably step in to snap them up, and that tide lifts even the less seaworthy boats.  Click on the chart for a full view.
• RSI(14) - this is the old standby, the 14 period Relative Strength Index.  Going back to 1999, there are only about 15 occasions when the RSI(14) has fallen to 30 on the SPX daily chart.  When that happens, the index is almost invariably higher the following week(s).  One interesting, if unsettling caveat is the fact even a slow-moving indicator like this can get oversold and stay oversold through a pretty nasty fall, as happened twice in 2001 and once in 2002.  Even so, unless we’re in the middle of a slow motion market crash, the odds still seem to favor some moderation in the near future.
• $VIX - normally, this is the part where we comment on some beautiful VIX spike and how investor fear has gotten really overblown. But the story here is actually the relative complacency in implied volatility.  Not sure exactly what’s going on there, expect that in all likelihood the smart money has been putting on robust hedges for weeks now.  This is also a data point in favor of not using VIX options as a proxy for regular index price movement - there’s absolutely no guarantee of any 1:1 relationship.  But anyway, what do we make of the conventional wisdom that you can’t get a market bottom without a VIX spike?  Who knows?  (Well, our future selves of 3-4 weeks from now know, that’s who.)

One last thing.  If your portfolio got hammered today and you’re looking to rebalance, don’t kill all of the positive theta trades you have going by throwing in the towel and loading up on expensive puts.  If you want to get in on this trend, sell some OTM index call spreads; if you’re an uber-contrarian, sell some not-so-OTM put spreads.

Reader S. V. raises an interesting question:

I am working on scenarios to trade the contra-ultra indexes like SDS to take advantage of either a combo spread (selling puts and buying call) or another method to take advantage of price movements while reducing risk.   Any thoughts?

Interesting idea.  These Ultrashort ETFs have really gained in popularity and most of them (like SDS, DXD, QID) now have enough volume to make them decent trading vehicles.  The actual stock, that is.  The options are another story.

1. A big difference here is the lack of volume.  In the case of SDS, the open interest in the July ATM puts is listed in the hundreds - not thousands - of contracts, versus open interest of 18,000 in the SPY ATM calls.  Where this really makes a difference, though, is on the side that anticipates a market sellof (SPY puts; SDS calls).  SPY puts usually have higher open interest, so it stands to reason that on an inverse index, you’ll have a lot more liquidity on the call side (since people typically only think of the inverse products for hedging purposes, whereas it’s natural to turn to a normal index for both long and short purposes).  In the SDS Julys, the call open interest is still only in the 2000-3000 range, which isn’t untradable, but isn’t compelling, either.
2. The spreads on these options are also a bit wider in the inverse products.  Why hassle with 0.15 or 0.20 spreads on these inverses when you can trade the index ETF options and thereby bask in the unrelenting glory that is penny pricing?  One of the lowest circles of market maker hell would have to be an open outcry SPY pit.
3. The inverse products don’t always behave as you might expect.  Adam over at the Daily Options Report did a whole series of good posts on this topic, and the gist is that because these products are designed to track the performance of their index on a daily basis, they’re not going to move in tandem over time.  So if you want to be short technology, buying QID isn’t necessarily going to give you the same outcome as if you just shorted QQQQ.
4. Which bring us to the biggest reason to avoid trading inverse product options: it’s a totally superfluous approach.  We’re kind of burying the lede here, but you can construct the same position with ordinary index ETFs options that you can using the inverse ETFs, and with none of the disadvantages that we’ve outlined above.

Let’s take S. V.’s example.  Say you’re long some stock in SPY as a core portfolio position, and you want to protect your downside.  Collaring your stock is a great way to do that, because each 1-lot position gets you short 100 deltas and carries almost no gamma, so the hedge is easy to size and you don’t have to worry about your hedge losing its potency if the underlying makes a dramatic move.  S.V. wants to put on a combo spread in SDS options, which entails selling puts and buying calls with the same strike prices in a 1:1 ratio.  No matter which strikes you use, that would get you long 100 deltas, which (since this is an inverse of SPY), is like being short 100 SPY deltas.

You can build the same position by selling calls and buying puts (again, with the same strikes, same month, on a 1:1 ratio) in SPY.  The liquidity should be better (making the hedge a touch cheaper), and the value of the position should move in direct inverse correlation to the movement of SPY.  The only reasons we can think of why someone might want to use options on an inverse product instead would be 1) to take advantage of the leverage built into the UltraShort ETFs, or 2) to construct a fancy arb of the disparate movement between the inverse product and its index.  But 2) is difficult and expensive, and not what S.V. was asking about.  And 1) doesn’t hold water here, since options are already leveraged, and it’s a lot easier to just use a few more options contracts than to risk underperformance or mismanagement in a leveraged fund.

It’s Monthly Review time, and we’ll be posting a review of our June Calendar Options trades shortly. But some readers have been having trouble making the returns posted in our Close Trade Alerts add up—and it’s no wonder, because the answer isn’t exactly obvious. How could we open a trade for a net debit of $1.55 and close it for a net credit of $5.75, and come up with a profit of only 7.28%?  It’s not hard to understand once you get a handle on the concept of normalizing to a base position.

The “base position” idea is simple—it’s just the number of contracts given in the Open Trade Alert, which is the minimum number of contracts needed to be able to make any adjustments that might be necessary. But before we get into the normalizing part, let’s try putting our arms around how Calendar Options profit/loss calculations work by figuring out the total cost and the net return for one of our trades in dollar-value terms.

(Warning: This may well be the most tedious post that will ever appear on the Condor Options site—tedious as in “Two trains leave Chattanooga at the same time. . .how many crates of Transylvanian Naked Neck chickens arrive safely in Peoria two days later?”—but if you’re interested in following the Calendar Options strategy, you need to understand what kind of returns we’re actually getting. And to do that, you’ll want to read on. . . Read the rest of this entry »

We’ve actually made this point before, but it bears repeating: iron condors have hard stops already built in. They’re called “long strikes.” So risk management is incredibly easy when you’re trading condors - it’s simply a question of determining how much capital you’re prepared to lose on any one position, and then selecting the appropriate number of contracts for your trade. Then fire and forget.

You don’t need to set some arbitrary mental point at which you’ll exit the trade at a later date; you certainly don’t need to panic the moment the underlying touches the short strike of one side of your position.  Andy Swan makes a similar point about not using stops on his blog, and we would emphasize the fact that the probability of an underlying touching one of your short strikes will always be higher than the probability of that underlying expiring in the money, which means that if you bail out every time your short strikes get violated, you’re just setting yourself up for a lot of churn.

Some people feel uncomfortable with the idea of letting a trade hit its maximum loss point, or with not adjusting a trade that looks like it’s in trouble.  But those are just symptoms of deficient risk management.  If you’re only allocating 1% (or less) of your capital to any given position, then you can afford to let the statistics play themselves out, without worrying much about the final outcome in any one particular case.