Condor Options

The liquidity issue is absolutely important, no matter whether you’re working with a small personal account or a massive hedge fund. There’s a sense in which most – maybe even all – of the financial crises in modern history were caused by illiquid positions and portfolios. While the failure of Long Term Capital Management, for example, was triggered by the Russian default, the liquidity issues the firm faced meant that any number of other surprises or scenarios could have triggered a similar crisis had Russia not been the circumstantial catalyst. The situation with CDOs and sub-prime debt in the US is a similar case: even if borrower default had started later or had been less intense, the fact that these positions are so hard to unwind meant that any substantial change in sentiment would inevitably cause a downward spiral in which people looking to exit would be forced to accept ever lower prices, causing more bag-holders to look for exits, driving prices even lower, etc.

The same thing happens all the time during options expiration – that’s why gamma risk is so deceptive, and why you never really notice it until it smacks you in the face. We’ve heard some stories lately about people who were stampeding out of crowded put strikes having trouble finding buyers. This kind of thing can get really nasty if you’re with some trading service or other and they stick you with a position that doesn’t have enough volume to make a timely exit possible. Even if you’re working with index ETF options – some of the most liquid derivatives on the planet – you can still have some trouble if you get marooned at a lonely strike somewhere with mere hours until expiration. We won’t name any names, but it seems that more than one other iron condor service had just these kinds of problems last month.

A couple people asked if we were prone to those same risks, which is a totally fair question. Here’s what we do to keep things nice and liquid:

1. We only use index ETF options. Sure, you could technically trade condors or credit spreads on anything that has listed options. But check the volume on both the underlying and the options themselves – if it’s not really heavy, expect some liquidity hassles. The vast majority of the time, the options on the major ETF indexes (SPY, DIA, QQQQ, IWM) are more liquid than a tourist during Oktoberfest.
2. No rolling. We never roll positions from month to month: if we don’t like a set of strikes near expiration, chances are we won’t like them by next expiration either. (Newbies: rolling refers to the practice of simultaneously closing one positinon while opening another; you can roll up or down within the same month, roll to an identical strike forward in time, or roll up or down forward in time.) More importantly, while rolling can save you a bit on slippage sometimes, if you’re trying to exit in a hurry, it just makes your order that much more complex, and that slows things down.
3. We’re on a permanent diet. That is to say: we limit the number of subscribers we’ll accept at any one time, and we only increase that limit when we’re confident that our member base is still small enough that we can all stay liquid.

Remember, it doesn’t matter how much money is at stake, what kind of strategy you’re using, or what your positions look like – if your positions aren’t liquid, they’re not worth having.

[tags] liquidity, options, LTCM, sub-prime, CDO, trading, iron condor, credit spread, rolling, ETF [/tags]