Stock Option Trading | Options Trading Strategies

This section specifically plans how to monetize the Greeks and Probability of Touching strikes criteria unique to each spread type for Entry, Staying In-Play and Exiting, to take Profits and limit Losses.

 

There is plenty of web-available information on the construction of the well-known spreads discussed below.  I won’t unnecessarily repeat their definitions. Here, it is about emphasizing the criteria for controlling the risks.

 

Design each trade template specific to the chosen strategy, planning that chosen set of Greeks that adds to Profit; versus, which Greeks runs the Risks of incurring Losses.  Reconcile the planned versus actual Greeks-based P/L criteria to determine the set up of Entries and Exits, for that particular spread traded.

 

Long Calendar (Debit Spread) Plan: Theta & Vega Affects Profit, Delta & Gamma Impacts the Loss.

Both option legs in a Calendar share the same strike, making the intrinsic value in a common strike the same, for the 2 legs.  Effectively, this cancels out the intrinsic value with the Short option leg paired against the Long option leg, at the same strike. 

❑  With intrinsic value removed, only the extrinsic/time value of Theta and Vega remains in the Calendar to make it profitable.  This is why the term “Time Spreads” is used to describe Calendars.

Characteristically of Index products, in comparing Call Calendars versus Put Calendars, the Volatility Skews favours Puts, more so if the market drifts or trends down with a low Volatility climate (i.e. VIX between 10-15). Unlike the current situation with the VIX trading near 40 and above. Typical of the trait of Indices is for their OTM Puts to carry higher Implied Volatilities compared to their corresponding OTM Calls on the upside. The market crashes down. There is no “crash up”.   This allows higher premium to be sold at the Short strike of the ATM Put Calendar making it relatively cheaper than Call Calendars. With more embedded premium that can be sold at the outset, Put Calendars can and do expand more in value to lower the initial Debit than Call Calendars. As the Calendar starts of initially as a Debit spread, it just makes sense to give the position better odds in the first place of collecting more Credit on the Short leg to finance the Long leg.  That’s why it makes sense to use Put Calendars for Downside protection; but, for the Upside use Call Diagonals (which is a Short Vertical to finance a Debit Calendar). From here on the term “Calendar” assumes the construction using Puts.

 

Greeks Profile: –Delta (~0.00), –Gamma, +Vega and +Theta

❑  Profit from selling Theta to collect increasing amounts of premium to fund a rising Vega (IV needs to increase from a lower range to a higher range). 

❑  Loss arises from sizeable Delta (and Gamma = “Delta” of the Delta) increasing.

You want Delta and Gamma to remain as small numbers, meaning limited directional speed and slow price movement signalling restricted range bound behaviour. You do not want these 2 Greeks to become larger numbers.

❑  Theta is the highest when it is ATM (Delta 0.50). A Calendar is worth the most money when it closes exactly on the ATM strike, at expiration of the Front Month Short leg.

– This is when the Front Month Short leg expires without any time value left (Theta ~0) and the Back Month Long leg is ATM with one full month (or more) remaining.

– The “Roll value” of a Calendar, gets its highest value when the product’s price is ATM producing the greatest amount of Theta to sell the Front Month option again.

 

Entry

Strike width intervals. A Calendar strategy, by definition needs the product’s price to drift or inch up/down within a tightly confined range.  So, choosing a product with strike increments of $1 at minimum and $2.50 at maximum between strikes, in the first place, avoids the risk of using a product that has strike intervals that are too far apart (e.g. $5–$10 intervals). 

 

As there is no Profit to be made using intrinsic value, it’s not sensible to choose Calendars using a product with wider strike increments.  Typically, widening a Calendar from a $1 width to a $2 width is adequate. The need to widen a $1 width Calendar to $3 is rare (i.e. 2 strikes away from the strike the Calendar is initiated from, typically ATM) and that would be the maximum width.  Else, it would be inviting more Delta & Gamma risk than is necessary to construct a viable Reward : Risk Roll Value. In turn, destabilizing Theta & Vega and diluting the Roll Value.

 

❑  If an exact ATM strike with Delta – 0.50 is not available, Near The Money strikes (Delta – 0.45 to – 0.55) may make sense, depending on the Reward : Risk Ratio of the Theoretical Prices at the NTM strikes. Deltas used here are negative, as the chosen construction is using Puts.

 

❑  If the Delta of a product fails to have an ATM/Near the Money Delta between –0.45 to –0.55; but, instead has an OTM Delta of –0.40 (or less) jumping to an ITM Delta of –0.60 (or more), trying to construct an “ATM” Calendar is pointless. Same rule if the Delta jumps from ITM into OTM, skipping the ATM/Near-the-Money range, reject the product as a non-directional Calendar candidate. A directional spread for a product with such fast Delta characteristics is more relevant.

 

As Delta denotes directional speed, look at the spatial differences between the Delta of the ATM strike and the Deltas of the subsequent OTM and ITM strikes moving away from the ATM strike.

❑  If the increments of 3-4 strikes towards the furthest OTM/ITM strike become increasingly bigger per strike up/down, the product has “faster” Deltas. There is more directional speed in each strike the closer it gets to OTM/ITM.

❑  If the increments of 3-4 strikes towards the furthest OTM/ITM strikes become increasingly smaller per strike up/down, the product has “slower” Deltas. There is less directional speed in each strike the closer it gets to OTM/ITM.

❑  Increments in an ideal Calendar would maintain near equally spaced Deltas apart as it moves 3-4 strikes away from the ATM strike towards the OTM/ITM. In absence of equally spaced Deltas, slow Deltas may be an acceptable alternative for a non-directional Calendar. But, if the product shows fast Deltas, choose another product to assess Calendar candidates.

❑  There is no need to test the spatial increments of Deltas beyond 4 strikes up/down, as a non-directional Calendar has limited Profit potential, when the product moves 4 strikes away from the ATM strike. Why? Because the extrinsic value  to sell for collecting Theta as premium diminishes, as strikes move away from the ATM strike towards OTM/ITM, given the ATM strike is highest in extrinsic value.

 

❑  Theoretical Price. Peculiar to a multi-month Calendar’s construction, the Short Front Month leg will always have a different expiry cycle from the Long Back Month leg (until the last month).  This distinct difference gives the Calendar it’s “Roll” value, which is not present in Vertical Spreads – as both legs expire in the same month. 

 

Separately measure the IV differences in Theoretical Price between the Front Month to the first Back Month, to estimate the Calendar’s payout ratio.  Arguably, Theoretical Price will at best always be an estimate.  Still, specific to the Calendar, as both legs expire at different months, it is critical to evaluate the Theoretical Price of the first Roll separately. Then, repeat the test for the Long leg’s subsequent Back Months remaining as Rolls before the last month, which may not have any economic value left to Roll with the onset of accelerating Theta decay in the last 30 days.

❑  This is the key tool to gearing the payout ratio of Reward to Risk in the Calendar.

 

The trading platform of your existing broker should already have an in-built Theoretical Price function in it for free.

 

IV. The lower the Back Month’s IV is to the Front Month’s IV, the cheaper the initial Debit of the Calendar. Remember, the Calendar’s Short /”Sell” leg is the Front Month option and the Long/”Buy” leg is the Back Month option.

❑  For the Short/”Sell” leg, choose an option about 3-7 weeks away from expiration.

❑  For the Long/”Buy” leg, choose between 2-3 months (1 Roll at minimum, 2 rolls at maximum) away from expiration, to see which Back Month yields the lowest initial Debit.

 

Index products are ideal to trade Calendars, as their Back Month options typically have an IV about the same, if not marginally lower/higher (within –/+ 5%), than their Front Month options’ IV.

 

An iVolatility IV forecast in the lower ranges (0.20–0.30 deciles; or, 0.60–0.80) moving up by +0.10 deciles representing an increase of +10% in IV is an ideal opportunity. IV forecasting tools from iVolatility.com have been blended into the Home Options Trading techniques.

 

❑  Select a $1.5 Reward at minimum (ideally $2) to $1 Risk Ratio.

In a Calendar, the Reward is the Theoretical Price’s estimate of the payout. And the Maximum Risk is limited to the Initial Debit.

 

So, to determine how many Back Months to embed into the Long option, assess the number of months that will yield the biggest difference between the Initial Debit and Theoretical Price. For example, compare a Calendar with

❑  3 months apart, e.g. Apr-Jun with 2 rolls in it: Initial Debit is $0.70 and Theoretical Price payout is $1.05. So this is a $1.5 Reward : $1 Risk opportunity; versus,

❑  3 months apart, e.g. May-Sep with 2 rolls in it: Initial Debit is $0.90 and Theoretical Price payout is $1.58. So, this is a $1.75 Reward :  $1 risk opportunity.

 

Choose the Calendar with the higher payout of Reward. You do not need to use all the Rolls, especially if you have met the Roll Target of halving the initial Debit with the first Roll. How do you work out the exact Theoretical Price to target the first roll of the Calendar? Click here.

 

As it is the Long leg that generates the Profits, whereas the Short leg finances the Long leg, take the effort to evaluate the Long leg separately to make sense of the payout.

 

❑  Remember to value the Long Calendar for its Theoretical Price, to buy this as a Debit spread below the market value. See Price Scout: Work the Entry Hard.

 

Open Interest. 

❑  For the Front Month Short leg, the Open Interest should be at minimum 10–20 times the number of Calendar contracts you plan to fill. (e.g. If you plan to do 4 ATM Put Calendars, the Open Interest number for the ATM Put strike needs be above 40). Same rule applies when rolling – the strike in the following Front Month that the Short option is being rolled to must have at least 10–20 times Open Interest.

❑  Same for the Back Month Long leg, check that Open Interest is between 10–20 times the number of Calendar contracts you plan to fill at that same strike.

 

Exit (versus Stay In-Play)

For a Calendar Exit always test 

❑  How much of a +/– change in Price will cause zero change in the Calendar’s Theoretical Price, i.e. Reward = Risk, a point of no Profit but also no Loss.  Plan below/above this price, as an Exit/Roll.

 

❑  How much of a +/– % change in IV (rush & crush) will cause zero change in the Calendar’s Theoretical Price, i.e. Reward = Risk, a point of no Profit but also no Loss. Plan below/above this IV%, as an Exit/Roll.

– Specifically for IV, you must stress test the % change in IV of the Short leg separate of the % change in Long leg.  Why? Breakdown the construction of the Calendar.  The Short leg needs to make money from the Credit collected (premium from Theta sold), as well as IV falling. IV rising in the Short leg wipes out the Theta collected as premium.  The Long leg only makes money as IV rises while suffering the Loss of Theta decay. But as the Short leg’s IV falls, at the same time, the Long leg’s IV will also fall; but, at different rates. The analysis is flawed if you assume IV’s fall on the Short leg shares the same trajectory as a rise in IV on the Long leg, simply because both legs share the same strike. Remember the Short leg is in a Front Month while the Long leg has multiple Back Months built into it.

 

❑  Forward the date to each expiration cycle (1 or 2 rolls) to note the dates before expiration of when Theta’s premium contribution of the Short leg fails to compensate the Long leg’s accelerating Theta decay, especially in the final expiration month of the Calendar. Take note of the date/specific week when Reward = Risk, when no Profit but also no Loss is made.  Plan the week(s) of these dates to watch for an Exit/Roll.

 

Plan each Exit scenario independently. Then, keep the worst case scenario of the Price change, add the worst case scenario of the IV% change and combine the remaining days discounted with forward dates for a complete and robust stress test of the Calendar’s Exit plan.

 

Any change that adds to Profits, re-evaluate the Roll value. Any change that incurs Losses, consider an Exit.  A Roll may or may not be 10 days from expiration.  It may be sooner. Though, never Roll a Calendar inside expiration week, as it leaves the Long leg unhedged in that week itself.  Always, give priority to Theoretical Price to guide you on timing the date or the week for an Exit/Roll.

 

❑  Base the Break Even Exits of the Calendar on the strikes above/below where the Calendar is initiated (typically ATM) and Theoretical Price conditions. 

– Increase/decrease the product’s price up/down to a point where the Theoretical Price of the Calendar is not making Profit or incurring a Loss. These are the specific points where the Calendar can move up/down to with zero Roll value remaining – points where the Calendar loses its ability to generate a Profit.

 

As IV changes, this impacts the value of the Back Month(s) option. Subsequently, affecting the Calendar’s Theoretical Price Payout, which makes it mandatory to re-assess the trend of the Probability of Touching the Break Even strikes on a weekly basis.

 

❑  Remain in trade, to Roll the Front Month Short option, if the $1.50 Reward : $1 Risk ratio holds up and is Supported by an increasing/progressively modest rise in IV.

– About 5 days before the 10 days to the Short option’s expiry, look for highest/higher Roll values as product’s price drifts between Deltas of –0.45 to –0.55. At these Delta ranges, Theta produces higher/the highest time value to sell the Roll for. Once within the 10 day period before expiry, you are unlikely to get higher Credit premiums to sell, mechanically Roll the Calendar if the Roll can at least lower the initial Debit by 10%–15% for the minimum economic justification to proceed onto the second roll. Otherwise, exit entirely.

– The higher the Front Month Short option’s IV is compared to the Back Month Long option’s IV, the higher the Credit you will receive for selling the Short month, to lower the cost of the initial Debit more than you would otherwise get.

 

❑  Monitor the Calendar more vigilantly if the $1.50 Reward drops down to a $1.25 Reward : $1 Risk ratio, with an increasing/mild rising trend in the Probability of Touching the Break Even points.

 

❑  Exit the entire Calendar if the ratio drops below $1.25 Reward : $1 Risk, with a rising trend in the Probability of Touching the Break Even Points and a flat IV trend.  Do not wait to lose 50%-100% of the Initial Debit before exiting entirely. Losing 100% of the Initial Debit is the Maximum Loss.

 

❑  Use Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os. Take the Longest column of Xs and Longest column of Os (widest trading ranges) as the worst-case test for a price move in either direction in evaluating a non-directional Calendar’s Probability staying ATM/Near The Money.

 

An Exit at Maximum Profit is obvious. Maximum Profit occurs when the product’s price remains at the strike of the Short leg at expiration. The Front Month’s Short option expires worthless, while the Back Month retains the highest Theta (extrinsic time value) as it remained ATM.

❑  If the product’s price fails at expiration to stay precisely at the strike of the Short leg, there is zero intrinsic value left.  Remember, the Short leg and Long leg share a common strike, eliminating any intrinsic value.

❑  An ATM Calendar is worth approximately the same, if price closes an equal distance ITM or OTM from the ATM strike.

 

❑  Close out the Calendar entirely, once you have rolled to the final month before expiration of the Short option. Else, all that is left is a Long naked option exposed to Delta and Gamma risk, plus accelerating Theta decay.

 

Back Ratio Spread (Credit, Even Money or Debit Spread) Plan:
Delta, Gamma & Vega affects Profit, Theta Impacts the Loss.

A Back Ratio Spread is essentially a Short Vertical Spread, plus buying 1–2 more options at the Long strike. Hence, the ratio of 1 Short option: 2 Long options or 1 Short option : 3 Long options. Regardless of the ratio, the position is always Net Long options. Remember you need to be Net Long for the directional bias you have forecasted: Calls being Bullish and Puts are for a Bearish outlook.

❑  Due to the embedded Vertical, you need a sizeable movement in the expected price direction (Delta & Gamma) and IV to rise as forecasted – these are the Greeks to plan for to generate Profits.  Remember, the entire position has to fight against the extra Long options’ increasing Theta decay.  The Short Vertical (choose ATM to ITM strikes) is embedded deliberately to subsidize the purchase of the Long options (which shares the same strike of the Long leg of the Short Vertical). Being Net Long options, requires IV to take the central role in increasing the value of the Long legs. Hence, the Back Ratio Spread is often called a “Volatility” spread.

 

Greeks Profile for a Back Ratio Call: +Delta, +Gamma, +Vega and –Theta

Greeks Profile for a Back Ratio Put: –Delta, +Gamma, +Vega and –Theta

 

❑  Profit from increasing +/–Delta, +Gamma and +Vega (IV needs to increase from a lower range to a higher range). The Net Long position depends on increases in these 3 Greeks to make money.

❑  Loss arises from Theta decay. The Short ITM option’s Credit is used to finance the decay of the Long ITM/ATM or Near The Money (NTM) leg. While Theta is highest ATM – where the sale of the Short leg here collects the highest possible Credit – practically speaking this may not be the logical strike to construct the Short leg. As price will need to move pas 1 Standard Deviation for the Back Ratio to begin breaking even and closer to 2 Standard Deviations to generate a Profit. This overburdens Delta & Gamma to make such a huge move, effectively lowering the odds of making Profit. It makes more sense to sell the Short leg deep ITM to collect adequate credit to almost offset the cost of buying the Long leg’s ITM/ATM or NTM options.

 

❑  A positive Vega means IV must rise as forecasted from a lower range to a higher range, for the Long leg’s ITM/ATM or NTM options to increase in value.

 

Entry

❑  Choose a ratio of 1 ITM Short option: 2 ITM/ATM/NTM Long options at a minimum; and, 1 ITM Short option: 3 ITM/ATM/NTM Long options at maximum. Select the ratio that buys you the most Long OTM options, with the total cost of the entire position near zero (or a small debit below $0.75).

❑  The way to look at the Credit of the Short ITM option in subsidizing the Long options, is to ask how many Long ITM/ATM/NTM options can the Short ITM option finance – is it 2 or 3?; before, it becomes an outright Debit spread where you would typically pay up to 1/3 for the strike width of a Debit Vertical?  Choose the combination (2 or 3) that is closest to placing the entire Back Ratio Spread for ~$0.00 (even money).  Typically, it is unlikely that the one Short option’s Credit can subsidize completely the purchase of more than 2–3 Long options.

❑  If the construction allows for a Credit, at maximum, leave $0.01 to $0.10 Credit in the position. Use up as much of the Short option’s Credit to finance the Long options, as it is the Long legs of the Back Ratio that generates the Profits. The Short leg merely acts as a subsidy for the Theta decay working against the Delta and Gamma of the Long legs that are fighting against the decay to increase in value, as IV rises.

 

❑  While price may move in the direction forecasted, the size of the move may lack sufficient Delta and Gamma to adequately increase the value of the Long ITM/ATM/NTM option(s) – as the Long options are further away from the product’s price –  compared to the Short leg being deep ITM which is more likely to increase in value, being closer to the product’s price. As all options are in the same expiry month, the nearer it is to expiration, there is more pressure on the size and directional speed of Delta and Gamma’s velocity to move the Long option(s), as the Short ITM option’s Gamma becomes smaller.

❑  The Back Ratio spread’s risk is characterized by its “Valley of Loss”. It is the size of Delta plus Gamma’s move that needs to overcome the Valley’s width. And the Valley’s depth is a battle between how much Profit a positive and increasing Vega can contribute against how much Loss a negative and increasing Theta takes away with each day of decay. This is why it makes sense to construct the position to fill at near even money or a small Credit to begin with to make the Valley of Loss as shallow as possible from the first day of entry.

❑  Vega must rise to supplement the inadequacies of Delta & Gamma’s move. The positive Vega in a Back Ratio Spread means IV must increase for the position to become profitable.

 

❑  As the position will always be Net Long more naked options, it is not prudent to place a Back Ratio Spread for an large Debit at the start. Do not give up the opportunity to subsidize the Long naked option(s) with as much credit as you can sell in the Short leg.  If you are absolutely certain of the product’s price direction, get a Long straight ITM call/put option and pay the Debit. At the same time, do not lower the number of Long options just to get a Credit, as it is the Long legs that are responsible for generating the Profit.

 

Given the Net Long feature of these spreads, construct a

❑  Back Ratio Call spread to be Net Long at the ITM/ATM/NTM Higher Call strike, for $0.00 or a Credit between $0.01–$0.10.

–  At minimum, the Probability of the Call Back Ratio spread Touching its Higher strike should be 30%–50% more than the spread Touching its Lower strike.  More than 60%, you may well consider a straight ITM call.

 

❑  Back Ratio Put spread to be Net Long at the ITM/ATM/NTM Lower Put strike, for $0.00 or a Credit between $0.01-$0.10.

–  At minimum, the Probability of the Put Back Ratio spread Touching its Lower strike should be 30%-50% more than the spread Touching its Higher strike.  More than 60%, you may well consider a straight ITM put.

 

❑  In both scenarios, if you are unable price the spread at $0.00 or a minimum Credit between $0.01–$0.10; and, the preferred range of the Probability of Touching the 1 Standard Deviation’s boundary towards the profitable strike fails to be met, reject the Back Ratio opportunity and evaluate another product.

 

Strike width intervals. In constructing the Back Ratio Spread for a minimal Credit/even money ($0.00), you will have to widen out the strikes. Effectively, stretching the horizontal width of the Valley of Loss. 

❑  Choose a product with strike increments of $1 at minimum and $2.50 at maximum between strikes. Choose products with tighter strike intervals in the first place, as you will need to widen the strikes apart to price the spread at near $0.00 or a Credit. 

❑  Avoid a product with strike intervals of $5–$10, as you will end up with a Valley of Loss as wide as $30 (or more) apart between the lower and higher strikes to price the position near $0.00. This places over–reliance on Delta and Gamma to move violently in your forecasted price direction, to bridge such a large gap before the position can even start to break even, let alone become profitable.

❑  The Valley’s depth is determined by how many more Long options there are than the one Short option. The more Long options there are, the deeper the Valley. Always, choose a ratio that keeps the Valley’s depth shallow to limit the risk. Work on the width of the Valley first.  Then, if needed, adjust the ratio of Long options to the Short option to change the depth of the Valley.

 

As Delta denotes directional speed, look at the spatial differences between the Delta of the Short ITM strike and the Deltas of the Long NTM strikes moving away from the ATM strike.

❑  If the increments between strikes towards the NTM strike becomes increasingly bigger per strike, the product has “faster” Deltas. There is more directional speed in each strike moving towards the furthest OTM strike.  Fast Deltas moving to the Long NTM strike is favourable for the Back Ratio Spread signalling more directional speed towards the Break Even Point and the outer boundary of 1SD. What is not favourable is fast Deltas towards the Maximum Risk point, when price moves in the opposite direction it was forecasted to move.

❑  If the increments between strikes towards the NTM strike becomes increasingly smaller per strike, the product has “slower” Deltas. There is less directional speed in each strike moving towards the furthest OTM strike. Slow Deltas moving to the Long NTM strike is not favourable for the Back Ratio Spread signalling lack of directional speed towards the Break Even Point and the outer boundary of 1SD. What is favourable is slow Deltas towards the Maximum Risk point, when price moves in the opposite direction it was forecasted to move.

 

IV. Placing a Back Ratio spread at lower IV levels helps price it closer to $0.00/near even–money. At lower IV levels, the ITM Credit received from the sale of the Short option to fund the purchase of more Long options is lower than if IV were in the mid-levels; but, the IV of Long options has less to rise if they have already risen to the mid-levels. This is the trade-off.

❑  An iVolatility IV forecast in the lower ranges (0.20–0.30 deciles; or, 0.60–0.80) moving up by +0.10 deciles representing an increase of +10% in IV is an ideal opportunity. IV forecasting tools from iVolatility.com have been blended into the Home Options Trading techniques.

 

Currency ETFs/UltraShort Pro Shares & Commodity Indexes are suited for Back Ratio spreads, as their IV characteristically behaves in an explosive manner.

 

❑  Target a $1.5 Reward to $1 Risk Ratio, at minimum.

The Maximum Risk is the width of the Back Ratio spread (difference between Long and Short strike), minus the Credit received; or, plus the Debit paid.

 

Work the entry hard, it makes sense to value the spread for its Theoretical Price, to fill it slightly above market value if the Back Ratio is to be done for a credit; or marginally below market value if the Back Ratio is to be done for debit. See Price Scout: Work the Entry Hard.

 

Evaluate the Reward in context of 1 Standard Deviation (+1σ, –1σ).  For a

❑  Back Ratio Call spread, the Probability of Touching the Upside Exit within +1σ from the live price needs to be 60% or more. This leaves a 50+% Probability of Price reaching the Upside boundary of +1σ.

❑  Back Ratio Put spread, the Probability of Touching the Downside Exit within –1σ from the live price needs to be 60% or more. This leaves a 50+% Probability of price reaching the Downside boundary of –1σ.

❑  Determine at what price, after +1σ or –1σ is passed that a Reward of 1.5 times the risk incurred can be made. Then, test if the Probability of Touching this price point is at least 40%.  Also, raise Volatility by +10% to see how much more the Probability increases.  Reject any opportunity that fails to yield a 40% Probability of Touching the price point at which a $1.5 Reward per $1 Risk is generated.

 

❑  Likewise, evaluate the Risk in context of 1 Standard Deviation (+1σ, –1σ).  Take note of the price at the lowest point in the “V” shape of the Valley’s bottom – evaluate the Probability of Touching this price point – it is where the Maximum Risk of the spread occurs.

 

Within +1σ or  –1σ, for a

❑  Back Ratio Call, compare the Probability of Touching the Maximum Risk point against the Probability of Touching the Upside Exit.

❑  Back Ratio Put, compare the Probability of Touching the Maximum Risk point against the Probability of Touching the Downside Exit.

– In both cases, the Probability of Touching the Upside/Downside Exits should be at minimum 10% (ideally 20%) more than the Probability of Touching the point of the Maximum Risk.  If there is no material edge in the Upside/Downside Exits having obviously higher odds than the Maximum Risk point of being touched, consider a Strangle/Straddle instead.

 

❑   Remember to value the Back Ratio Spread for its Theoretical Price, to fill it close to near even money or as a Credit spread between $0.01 to $0.10 above the market value. See Price Scout: Work the Entry Hard.

 

Open Interest & Days to Expiry

❑  For both the Short and Long legs, choose strikes with Open Interest between 10-20 times the number of Back Ratio spread contracts you plan to fill.  This ensures adequate liquidity, especially when its time to exit the trade.

❑  Look to fill the spread between 80-90 days at minimum to 100-120 days at maximum before expiration.

 

Exit Criteria for Profit/Loss (versus Stay In-Play)

❑  Maximum Profit is finite – the product can drop to zero, in a Back Ratio Put. A Call Back Ratio Call Spread’s Profit is “unlimited” (in theory).

❑  The guideline to exit the Call or Put Back Ratio spread is when the Profit is 1.5-2.0 times the original Risk (which could have been a small Credit or $0.00).

❑  If price has violently shot past the Long leg’s strike, it is unlikely to move favourably much more.  The price movement would have gone past 1 Standard Deviation and is 1/3rd to half-way towards the boundary of 2 Standard Deviations, which is a rare event. Profit at this level is an obvious signal to close out the entire spread.

❑  Once the Profit Target is met, there is an alternative to closing out the entire spread.  Sell off only the additional Long option(s). Meaning, the Short Vertical Spread remains in play – in losing its maximum Credit premium, you have drained the Credit effectively to finance the Long options.  If price reverses in the opposite direction of the Back Ratio Spread, the Short option of the Vertical remaining in-play becomes even cheaper to buy, increasing its Profit contribution. Mechanically close out the Vertical 7–10 days before expiration.  Do not leave it in–play inside expiration week.  Price may have dropped/risen to a Support/Resistance level within the expiration week.  Do not risk a reversal against the Vertical’s position with limited days to recover, as there is a remaining Short option in the spread with an obligation to settle it.

 

As IV changes, this impacts the value of the additional Long option(s). Remember, in a Back Ratio spread the Long leg has 1–2 more “naked” options which needs a rise in IV to become profitable.  Subsequently, affecting the spread’s value, which makes it mandatory to re–assess the trend of the Probability of Touching the Upside/Downside Exits against the Probability of Touching the Maximum Risk point, on a weekly basis.

 

❑  Stay in play, if the Probability of Touching the Upside/Downside Exits exceeds the Probability of Touching the Maximum Risk by 10% or more.

– A positive trend is when this difference in Probability of Touching the Upside/Downside Exits increases every week –  progressively beyond 10% (without a break across weeks where it falls below 10% for a sustained 2–3 days), in favour of Touching the Upside/Downside Exit. The Probability of Touching the Upside/Downside Exit should increase from the original 50% (which was an entry criteria) towards 60%. Consequently, the Probability of Touching the Maximum Risk point should fall by a near equal %.

 

Exit the trade, if the Probability of Touching the Break Even Exit falls below the Probability of Touching the Maximum Risk by 10% or less.

❑  A negative trend is when this difference of Probability of Touching the Upside/Downside Exits decreases every week –  regressively below 10% (without a break across weeks where it rises above 10% for a sustained 2–3 days), in favour of Touching the Maximum Risk point. The Probability of Touching the Break Even Point itself fails to increase from the original 50% (which was an entry criteria); but, is reduced towards 40%. Consequently, the Probability of Touching the Maximum Risk point rises by a near equal %.  This signals the Probability of price Touching the Upside/Downside Exit has lost its edge to move away from the Maximum Risk point. Do not wait to incur 50+% of the Maximum Loss before exiting entirely.

 

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

❑  Shortest column of Xs (tightest Upside range) as the worst-case test for a favourable price move up of a Bullish Back Ratio Call’s Probability. Use the Longest column of Os (widest Downside range) as the worst-case for price moving in the opposite direction of a Bullish Back Ratio Call’s Probability.

❑  Shortest column of Os (tightest Downside range) as the worst-case test for a favourable price move down of a Bearish Back Ratio Put’s Probability. Use the Longest column of Xs (widest Upside range) as the worst-case for price moving in the opposite direction of a Bearish Back Ratio Put’s Probability.

 

❑  Exit on price drifting with 35–40 days before expiry. With 1–2 weeks before 30 days remaining, if price fails to move past 1 Standard Deviation; but, inches up/down or drifts within the Upside/Downside Exit of the Long strike and the boundary at –1σ and +1σ, exit the position that shows a marginal Profit or Loss.  Close out the entire spread to avoid incurring the Maximum Risk.

❑  With 5–10 days before 30 days to expiry, while the Credit of the Short option is funding the additional Long options, there is not much Delta, Gamma & Vega can do to generate Profit in the Long leg. There is only Theta decaying at the square root of time (days) that is certain, accelerating exponentially with 21–23 days remaining before expiry. This Theta decaying as premium collected only acts as the subsidy for the Long options, it does not generate the Profit.

 

❑  Alternative Exit for directional failure. Price moves in the opposite direction to that originally planned for the Back Ratio Spread: Call = Bullish, Put = Bearish.  Other than closing out the entire spread, buy back only the Short option – if possible, for $0.20 or less; but, leave the additional Long options in play.  The absence of the Short option takes out the Valley in the Maximum Risk, should price reverse back towards the original direction forecasted.

 

Short Iron Condor (Credit Spread) Plan: Vega & Theta affects Profit; Delta & Gamma Impacts the Loss.

The reason behind constructing the 2 Short OTM Verticals (a Call Vertical + a Put Vertical) of a Short OTM Iron Condor equidistant from the product’s price, is to “neutralize” the risk of movement in Delta and Gamma. For entry, do not leg into the position as 2 separate Verticals. Enter into the position as a whole Iron Condor.

❑  While the “wing span” of a typical Iron Condor appears equally balanced in terms of the left and right distance apart from where price is trading, the price dispersion of the product is unlikely to take the form of a normal bell shaped curve –where the left halve is the exact mirror image of the right halve.  The Skew bias in the product – most notably in certain Index products, can flip between being positive and negative, throughout the expiration cycle. 

 

Greeks Profile: –Delta (~0.00), –Gamma, –Vega and +Theta

❑  Profit from increasing amounts of Theta decay and descending Vega  (IV needs to drop from a higher range to a lower range).

❑  Loss arises from sizeable Delta (and Gamma = “Delta” of the Delta) increases.  You want Delta and Gamma to remain a small number, meaning limited directional speed and slow price movement signalling restricted range bound behaviour. You do not want these 2 Greeks to become large.

 

While Delta is not exactly equal to an option’s Probability of Expiring ITM, in essence it is more a proxy, Delta is valid to use it as the starting point in constructing the wingspan of the Iron Condor.

❑  As the aim is to retain nearly all of the Credit sold within the 2 Short Verticals on either side, a Credit Iron Condor is typically constructed around where the Delta for Calls is between  +0.20 to +0.30 and the Delta for Puts is between –0.20 to –0.30.

– Selling an Iron Condor within the Delta range of +/– 0.20 to +/– 0.30 gives the Short Verticals on both sides a ~65%-75% Probability of success for the Credit received to expire worthless.  At maximum, tighten the wing span to choose Calls and Puts with a Delta of +/– 0.35 for a 60% Probability of success but no tighter. You want more than 50:50 odds of retaining the credit collected as premium.

 

Entry

Strike width intervals. An Iron Condor strategy, by definition needs the product’s price to drift or inch up/down within a tightly confined range.  So, choosing a product with strike increments of $1 at minimum and $2.50 at maximum between strikes, in the first place, avoids the risk of using a product that has strike intervals that are too far apart (e.g. $5, $10 intervals). An alternative is to widen the $1 strike intervals to $2; or, widen out the $2.50 strike intervals to $5.

 

You can sell $0.25-$0.35 out of $1 strike intervals, just as you can sell $2.50-$3.50 out of $10 strike intervals. Though it’s not identical.

❑  Choosing an Iron Condor from a product with $10 strike intervals does not guarantee that you can collect more Credit in selling the same fraction within the width of the strikes in a product with $1-$2.50 strike intervals.  The reason the strikes are set that far apart in the first place, represents the propensity of the product to move at those intervals, which poses the Delta and Gamma risks that you do not want for a Credit Iron Condor.

❑  Lowering the initial Credit received (i.e. increasing the wing span) raises the probability of retaining the Credit that was sold. The entire wingspan of the Credit Iron Condor should stay within 1 Standard Deviation of where live price is trading, otherwise the Iron Condor is not collecting adequate premium to economically justify the construction in the first place. In other words, do not construct Short Iron Condors spanning 2 Standard Deviations wide.

 

Using a product with $10 strike intervals, invites more Delta and Gamma risk than is necessary for Theta and Vega to cope with, diluting the amount of Profit contributed by these 2 Greeks.

 

Of note, in general because the interest rate component is built into Calls plus the inherent Skew which is typically more pronounced in Index products, the OTM Calls can typically trade 30%-40% higher in Credit premium to sell than the equidistant OTM Puts.  Within a Short period (less than 30 days), the richer premium on the Call side is driven by the inherent +/– Skew of the product and less to do with the interest rate.

❑  With richer premiums on the Call side, it is often easier to get filled on more aggressive mid-price fills by Shorting an Iron Condor when the product is going into a small to moderate rally; but, less so with a sell-off. So, use the Futures to gauge pre-market open trading activity, to see if the major broad-based Indices are opening higher that day to sell the credit at marginally higher prices (up to +0.10 above the Theoretical Price of the Credit Iron Condor) and work the order hard to fill within 60-90 minutes of the markets opening.

 

❑  If the Delta of a product fails to have an ATM/Near the Money Delta between +/– 0.45 to +/–0.55; but, instead has an OTM Delta of +/– 0.40 (or less) jumping to an ITM Delta of +/–0.60 (or more), trying to construct an equidistant Iron Condor with a missing “ATM” strike as the centre that joins the Short Vertical Put together with the Short Vertical Call, as one positions adds Delta risk in price movement.

–  Deltas skipping the ATM/Near The Money strikes represent unstable Delta and Gamma, which is not the required criteria for an Iron Condor.  Same rule if the Delta jumps from ITM into OTM, skipping the ATM/Near-the-Money range, reject the product to construct a non-directional Iron Condor on. An unbalanced/ratioed Iron Condor for a product with such Delta characteristics may be more relevant.

 

Other than directional risk, Delta also denotes directional speed. So, look at the spatial differences between the Delta of the Short ATM/ITM strike and the Deltas of the Long OTM strikes moving away from the ATM strike.

❑  If the increments between strikes towards the OTM strike becomes increasingly bigger per strike, the product has “faster” Deltas. There is more directional speed in each strike the closer it gets to OTM.  Fast Deltas moving to the Long OTM strike is not favourable for the Iron Condor signalling acceleration towards the Upside/Downside Exits and the outer boundary of –1σ and +1σ.

❑  If the increments between strikes towards the OTM strike becomes increasingly smaller per strike, the product has “slower” Deltas. There is less directional speed in each strike the closer it gets to OTM. Slow Deltas moving to the Long OTM strike is favorable for the Iron Condor signalling deceleration towards the Upside/Downside Exits and the outer boundary of –1σ and +1σ.

❑  Increments in an ideal Iron Condor would maintain near equally spaced Deltas apart as it moves 3-4 strikes away from the ATM strike towards the OTM strikes both on the Call and Put side. In absence of equally spaced Deltas, slow Deltas may be an acceptable alternative for a non-directional spread. But, if the product shows fast Deltas, choose another product to construct an Iron Condor on.

❑  There is no need to test the spatial increments of Deltas beyond 4-5 strikes up/down, as a non-directional Iron Condor has limited Profit potential with price moving 4-5 strikes from the ATM strike, price will almost be Touching the Exits on either side.

 

❑  Never sell options (be it an Iron Condor or Vertical) in the Front Month.  In the last 21-23 days before expiration, the negative Gamma risk outweighs the Theta premium collected.  With 10-15 days to expiry, Gamma explodes at the ATM options.  Even if Delta stays flat (~0.00), the negative Gamma risk (measuring in/stability) expands exponentially at an acute curvature that is in multiples of Theta decaying also exponentially (at the square root of time).  Do not initiate an Iron Condor with less than 20 days before expiry.

 

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

❑  Use the Longest column of Xs and Longest column of Os (widest trading ranges) as the worst-case test for a price move in either direction in evaluating a non-directional Iron Condor’s probability of price staying within the wing span.

 

IV. While at higher IV levels, you get to sell 2 Short Verticals combined as one Iron Condor for more Credit, the risk of IV making a higher high increases. IV forecasting tools from iVolatility.com have been blended into the Home Trading techniques.

❑  An IV forecast in the decile ranges of 0.70–0.80 falling or 0.30–0.40 decreasing by 0.10, i.e. a drop of 10% helps drop the credit further in addition to the Theta collected as premium in a Credit Iron Condor, given it’s –Vega and +Theta profile.

❑  If IV is in the decile range of 0.00–0.10, IV could fail to fall lower and rise instead.  IV increasing raises the Iron Condor’s Credit value, when we want it to fall to buy it back cheaper than when we sold it.

❑  If IV is in the decile range of 0.90–1.00, IV could rise to make a higher high. Again, IV increasing raises the Iron Condor’s Credit value, when we want it to fall to buy it back cheaper than when we sold it.

 

Broad based Indexes (e.g. DIA/DJX, QQQQ/MNX, SPY/XSP) are ideal to trade Iron Condors, because within 50 days their Front Month’s composite IV is often marginally higher than their Back Month’s composite IV.  This gradual decline in IV together with price drifting collecting positive decay, improves the odds of trading Iron Condors. 

❑  Even with an inherent Skew bias unique to specific Index products, its very rare to find more than a 3%-5% difference in the composite IV between the near and far month in most tracking Indexes/ETFs. Do not expose Iron Condors unnecessarily to spikes in an IV rush, hoping to gamble on an IV crush after the rush to make it profitable. Other strategies using other products are better suited for sudden and large changes in IV differences. Within the stipulated time frame to trade Iron Condors, the practical IV testing range of an Iron Condor of most major tracking Indexes for an IV rise/fall is between +/– 5% to +/– 10%. Any more will not be a realistic simulation.

 

The major broad-based and tracking Indexes/ETFs are absent of single event-related news (peculiar to a stock) that spikes the IV within any individual month. Indexes/ETFs are more conducive to trading Iron Condors as they contain Volatility Skews within acceptable limits that do not add Volatility risk.

❑  High IV is not a license to sell it. IV must fall below its high. Neither is Low IV a license to buy it. IV must rise above its low.

❑  The core gauge of the broader market’s propensity to buy/sell 30-day IV is the VIX.  It makes more sense to identify Short Iron Condor opportunities when the VIX is at a higher trading range versus when it is at a lower trading range. The higher the VIX is, the IV levels improves the odds of collecting higher premium. The historical trading ranges of the VIX ranging between 10-20-30 was broken, since October 2008. And a year of trading under the new ranges needs to happen, to comment on what the new ranges would be.

 

The Reward : Risk Ratio of the Iron Condor needs to be analyzed differently.

Sell at minimum 25% up to a maximum of 35%, of the strike width of the Verticals making up the Iron Condor. So, for an Iron Condor with ...

❑  $1 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at  +/– Delta 0.25–0.35 to receive between $0.25 to $0.40 of credit in total.

❑  $2.50 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at  +/– Delta 0.25–0.35, to receive between $0.65 to $1.00 of credit in total.

 

If you have clear reasons to sell higher Call/Put Deltas, stop at +/- 0.35 Deltas as the maximum. Otherwise, the edge in the odds of expiring ITM becomes unfavourable towards the OTM Short strike.

 

Selling these consistent fractions of the width of the Verticals making up the Iron Condor, regardless of the different strike intervals, exposes the edge of Iron Condor’s wings to ~40% (or less) of being touched by price movement. In turn, giving the Iron Condor’s outer wings a minimum of ~60% (or more) probability of price not touching them, for the position to retain the Total Credit received.

❑  At maximum, choose OTM strikes that give the entire Iron Condor a 30% probability of both outer wings being touched by price movement, i.e. 70% probability of not being touched. Lowering the probability beyond 30% is margining capital on a credit spread beyond what is efficient that could have been used for another strategy.

 

Regardless of the strike width chosen, the typical method of constructing an entire Iron Condor position is to contain its entire wing span within 1 Standard Deviation (–1σ to the Downside/left of the Live Price and +1σ to the Upside/right of the Live Price). Outside the range of –1σ and  +1σ makes it difficult to collect sufficient credit premium to justify the return on probabilities of initiating a 4–legged, 2–ways non–directional trade.

 

However, beyond the typical method and unique to trading Iron Condors is the method of staggering the number of contracts allocated for the entire trade, across an increasing number of strikes.

– See pagelet on the right for depiction of staggering contracts within a given % allocation per trade.

 

❑  Remember to value the Short Iron Condor for its Theoretical Price, to sell it as a credit spread above the market value. See Price Scout: Work the Entry Hard.

 

Open Interest & Days to Expiry 

❑ For the entire position, choose strikes with Open Interest between 10–20 times the number of Short Iron Condor contracts you plan to fill.  This ensures adequate liquidity, especially when its time to exit the trade.

❑  Look to fill the Iron Condor more than 35 days at minimum up to 50 days at maximum before expiration.  Below 30 days, the Credit collected is insufficient to reward the position for the Delta & Gamma risk going into the 5-10 days before expiry. Above 50 days, exposes the Iron Condor to too much IV uncertainty and possibly changes in interest rates.

 

Exit Criteria for Profit/Loss (versus Stay In-Play)

 

Exit criteria for Profit

❑  ~10 days before expiry, exit all 4 legs; or …

❑  If the Short Call Vertical or Short Put Vertical’s value has dropped to $0.10-$0.15, buy back the Vertical to close out the Short side that is closer to where price is trading. Do not risk the possibility of price retracing in the opposite direction to hit either side of the Short Verticals in the week of expiration itself.

❑  For Long options in the Verticals trading near $0.05, do not close these legs out. Buy back only the Short options in the Verticals. This leaves you with Long options should price bounce back unexpectedly.

❑  Always observe the closing rule of 10 days before expiry.  Only if favourable pricing conditions occur as stated above, then use the variation in closing just the Short leg and leaving the Long option of the Vertical untouched. Otherwise, mechanically exit the entire Iron Condor. Some more experienced traders choose to hold the Iron Condor till 5–7 days within the expiry week itself, to close it out. Namely, this is what they have consistently done as a routine.  Stay consistent with the number of days to exit: if its 10 days stick to it, if the decision to exit is between 5–7 days stick with it.

❑  Before 10–15 days expiry, when 70%–80% of the Iron Condor’s credit has been reduced, exit the trade entirely. For e.g., an Iron Condor sold for $1.00 decays down to $0.20, close out all 4 legs. The remaining 20% of Profit is marginal and not worth the Delta and Gamma risk of remaining in play. It’s not logical to risk the entire $1.00 (of which you’ve already gained ~80%) for less than 20% more Profit to milk in 2+ weeks. Guard against the greed and let sensible fear prevail.

 

Stay In-Play, with 20-30 days before expiry …

❑  If the Probability of Touching the Upside/Downside wings is between 30%–40%; but, watch the position when the Probability of Touching the wings drifts higher towards 45%–55%.

❑  Watch the Iron Condor more closely, if the iVolatility Hi/Low Indicator drifts aimlessly between the 0.45–0.55 decile without a clear signal, if IV will drop further or stay range bound. For example, if IV has already dropped from the 0.80 decile down to the 0.60 decile, i.e. IV has fallen 2 full deciles = 20%, it may be bouncing against Support for the IV’s mid-range between the 0.45–0.55 decile range and fail to fall further.

❑  Be vigilant when the original Deltas of the short OTM Calls (+0.25 to +0.35) of the Credit Call Vertical grows larger, as price moves towards the Call Vertical side.  And when the original Deltas of the short OTM Puts (–0.25 to –0.35 ) for the Credit Put Vertical grows larger, as price moves towards the Put Vertical side.

– In either case, this signals the original OTM strikes are at risk of becoming more costly to buy back, which reduces the Profit of the trade.

 

Exit Criteria to Limit Losses

❑  Exit the entire trade before/during economic or political news that violently increases the overall market’s Volatility. i.e. VIX shoots up above its daily volatility range.

 

❑  The Probability of Touching the Exit on either the Upside or Downside of the Iron Condor increases from the original 40% to 60%–70% with 5-10 days before expiry.

 

IV rises to raise the Iron Condor’s original credit by ~125%, making it more expensive to buy back, instead of decreasing the premium collected, which is what is needed to make it cheaper to buy back.

❑  An Iron Condor needs to maintain a negative Vega, representing a drop in IV to stay profitable. The negative Vega needs to become an increasingly larger number for the forecasted fall in IV to add to Profit.  If the negative Vega number gets progressively smaller towards ~0.00, IV is rising and without sufficient positive Theta decay to offset the IV increase, the position starts incurring Losses. Theta collected as premium is wiped out by a rising IV, and there may be insufficient days remaining to collect the adequate amount of premium to restore the drop in the credit spread.  Remember, just as you can only lose 1 day’s worth of decay in a debit spread, you can only effectively collect one day’s worth of premium per day in a credit spread.

Straddle/Strangle (Debit Spread) Plan: Delta, Gamma & Vega affects Profit, Theta Impacts the Loss.

In terms of construction, there really is only one material difference between a Straddle and a Strangle. For any given product, if there is no +0.50 Delta Call with a corresponding exact – 0.50 Delta Put, there is no ATM Straddle. ATM by definition requires a precise 50:50 Delta for the Call and Put.  Construct a Strangle instead using a Near-The-Money Call and Put strike.

 

For a Straddle/Strangle, a price …

❑  Rise in the product, increases the Theoretical Price of the Call. Simultaneously, lowering the Theoretical Price of the Put.

❑  Drop in the product, increases the Theoretical Price of the Put. Simultaneously, lowering the Theoretical Price of the Call.

– This increase in Theoretical Price is necessary to generate a higher sale price than the original Debit paid, to make a Profit.

 

Greeks Profile: (– / +)Delta, +Gamma, +Vega and – Theta

❑  Profit from increasing amounts of – / + Delta, + Gamma and a rising +Vega  (IV needs to increase from a lower range to a higher range).

❑  The Straddle/Strangle’s risk is characterized by its V-shaped “Valley of Loss”. It is the size of Delta & Gamma’s move that needs to overcome the Valley’s width. And the Valley’s depth is a battle between how much Profit a positive Vega indicating a rising IV can contribute against how much Loss a negative and increasing Theta takes away with each day of decay.

 

❑  The sum of a Call’s Delta and Put’s Delta is mean to approximate ~1.00. It seldom equals 1.00 exactly because of the inherent Skew bias towards the Put/Call side, in any given product.  At any given OTM/ATM/ITM strike, the sum of the absolute value of a Call Delta plus the corresponding Put Delta is typically equal to between ~0.95–1.05 (i.e. no exactly 1.00). Absolute value means removing the + sign in front of the Call Delta and  – sign in front of the Put Delta.

– Specific to a Straddle/Strangle, an increase in the Call Delta results in a near equal decrease in the Put Delta; and vice-versa.

 

❑  Loss arises from sizeable Gamma reduction, Vega reduction and increasing Theta decay.

 

Specific to a Straddle/Strangle, it is the Gamma and Vega that needs to work together to overcome Theta’s decay. Gamma is at its highest ATM. Theta is also at its highest ATM.

❑ So, as the product’s price moves towards being more ITM on the Call side (consequently, more OTM on the Put side), IV must rise to supplement the Loss in Gamma to overcome Theta’s acceleration. Conversely, if price moves towards the more ITM strikes on the Put side (consequently, more OTM on the Call side), IV needs to rise to bridge the gap of Gamma’s reduction to battle the increasing time decay.

 

❑  Gamma and Theta are irreconcilable enemies.

A Straddle/Strangle needs Gamma to hold out against Theta, until Delta moves the price outside either the Call or Put strike forming the boundary of the “Valley of Loss”.

 

With any of the 3 Theoretical Pricing models, the mathematical expression of Gamma (same for Calls and Puts) will show it does not share a 1:1 linear relationship with Theta (as Calls are expressed differently from Puts, with the interest rate built into Calls).

 

So, a Straddle/Strangle needs multiples of +Gamma to offset the exponentially increasing –Theta, with additional +Gamma left over to add to the acceleration of Delta’s directional speed of movement.  In a Straddle/Strangle, Gamma has 2 jobs: fight Theta and Support Delta. This also, why IV needs to rise to Support an ever-exhausting Gamma.

 

Think of Theta as the necessary cost incurred to pay for the much needed explosion in Gamma to push price outside the Valley of Loss.

 

Entry

Strike intervals. A Straddle/Strangle strategy, by definition needs the product’s price to explode outside 1 Standard Deviation (–1σ or +1σ) and move into 1/3rd to a half of the 2nd Standard Deviation (–2σ or +2σ) to make a reasonable Profit.

❑  So, choosing a product with strike increments of $1 at minimum and $2.50 at maximum between strikes, in the first place, avoids the risk of using a product that has strike intervals that are too far apart (e.g. $5, $10 intervals).  Tighten the “Valley of Loss” - make it narrow in the first place, by using $1–$2.50 strike intervals to reduce the Debit paid and lower the initial risk.

 

At maximum pay a Debit that is twice the strike intervals of the product. So, if the product’s strike intervals are $1 apart, pay $2.00 at maximum. If the product’s strike intervals are $2.50, pay $5.00 at maximum.

 

❑  Choose an ATM/Near The Money Call and Put strike that has between +/– 0.45-0.55 Deltas, to construct a Straddle/Strangle. Reject a +/– 0.60-0.40 Delta profile that is biased towards the Call or Put side. Otherwise, the Debit is misspent on a bias towards a “neutral” Delta, which you should be indifferent to directionally.

 

Other than direction, Delta denotes directional speed, look at the spatial differences between the Delta of the ATM/Near The Money strike and the Deltas of the prices at 1 Standard Deviation, moving away from the ATM strike.

– If the increments between strikes towards the price at the –1σ or +1σ boundary becomes increasingly bigger per strike, the product has “faster” Deltas. There is more directional speed in each strike the closer it gets to the boundary of –1σ or +1σ.  Fast Deltas moving toward the –1σ or +1σ boundary on either side is favourable for the Straddle/Strangle signalling acceleration towards the Upside/Downside Exit and the outer boundary of –1σ or +1σ.

– If the increments between strikes towards the prices at the –1σ or +1σ boundary becomes increasingly smaller per strike, the product has “slower” Deltas. There is less directional speed in each strike the closer it gets towards the boundary of –1σ or +1σ.  Slow Deltas moving toward the 1SD boundary on either side is not favourable for the Straddle/Strangle signalling deceleration towards the Upside/Downside Exit and the outer boundary of –1σ or +1σ.

 

❑  For a Long straddle, Gamma is always positive. At minimum, Gamma needs to be at least 3-4 times that of Theta. So, other than offsetting Theta’s decay, there is adequate Gamma remaining to manufacture enough Delta, for Delta  (be it on the Call or Put side) to grow between 1.5 to 2 times its original value to move price sufficiently for the spread to be profitable. 

 

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

❑  Use the Longest column of Xs and Longest column of Os (widest trading ranges) as the worst-case test for a price move in either direction in evaluating a non-directional Straddle/Strangle’s probability of moving outside its Valley of Loss.

 

❑  Also, use P&F charting to identify price forming a Triangle pattern. Historically, if the product shows a tendency to have either/both Bullish Triangle Breakouts and/or Bearish Triangle Breakdowns, this makes it a stronger candidate versus one that fails to show Triangle behaviour.

– Ideally, the ATM/Near The Money strike you plan to buy is at a price that forms the intersection where the triangle forms its sideways V-shaped point.

 

IV. Straddles/Strangles are affordable at lower IV ranges. It is uneconomic to trade Straddles/Strangles when the IV of the product is in the mid to high ranges. IV forecasting tools from iVolatility.com have been blended into the Home Trading techniques.

❑  An IV forecast in the lower decile range of 0.20–0.30 or 0.60–0.70 rising by at least 0.10 (+10%) make for an ideal Straddle/Strangle opportunity. Between the 0.00–0.10 decile, IV could make a lower low, harming the Straddle/Strangle which is a debit spread in need of IV rising. Choose another product to construct the Straddle/Strangle on.

❑  Between the 0.90–1.00 decile range, IV may fail to make a higher high, harming the Straddle/Strangle which is a debit spread in need of IV rising. Choose another product to construct the Straddle/Strangle on.

 

Without sufficient Gamma, the risk is a 0.45– 0.55 ATM/Near the Money Delta fails to move at all and price sits in the middle of the “Valley” at the Maximum Loss, where Theta decay is also the highest eating into the debit paid without an adequate rise in IV to battle the Theta erosion.

 

Fast markets: Commodities (Gold, Oil, Metals), Currency ETFs and the VIX are ideal to trade Straddles/Strangles.

 

Any news is welcome, for e.g. good news: relief funds/government aid in response to bad news: floods destroying agricultural crops, fuel shortages, hurricanes, etc. Straddles/Strangles are indifferent to good or bad news.  The news just has to add sudden uncertainty to amplify the repercussions of the single event in fast markets.

– Much of the news is observable and embedded in the +/– Skew of the product for a given market, without having to subscribe to news services.  If you see a huge Skew (more than +/– 10%) and there’s nothing in the business news channels, someone knows something and that someone ain’t you.  Avoid the product.

 

❑  Seasonality. IV of Index Options – especially OEX options – for the last 20+ years drops more than 3-4% during the July to mid-August period. IV becomes volatile from the second half of August till September, rising 4%-5% or more.

– This makes it an opportune time to specifically scout for buying Straddles/Strangles throughout June, especially during the last 2 weeks of June for 80-90 day opportunities.

– For equity-based Indexes/ETFs, reconcile the IV range in relative terms to where the VIX is trading at.

– For Indexes/ETFs from other asset classes (Commodities/Currencies), use an IV forecasting service (for e.g. iVolatility’s Advanced Historical Data, which forecasts IV for 30-60-90-120-180 days for Calls, distinct of Puts and Calls+Puts combined).

 

As the Reward of the Straddle/Strangle only occurs after price moves past the boundaries of 1 Standard Deviation (–1σ or +1σ), there is a need to test the Probability of Touching the Upside/Downside Exits of an identified opportunity to qualify it as a candidate to trade.

❑  At minimum, the Probability of Touching either Exit points on the Call or Put side needs to be ~50-60%, without an increase in IV.

❑  Then, raise the IV by +10% to check if the Probability of Touching either strikes increases above 50%-60%. The use of +10% comes from the IV forecast specific to the IV forecast of the IV of Calls+Puts combined for the term that the Straddle/Strange is to be in–play.

❑  Use P&F charting to see the 3-4 prior trading ranges of the product for both the Upside/Downside to confirm a history of triangle formations. If the trading range for both the Upside or Downside gets progressively larger than –1σ or +1σ after the breakout, this improves the odds of price shooting outside the –1σ or +1σ boundary from the ATM/Near The Money strike.

 

❑  Remember to value the Long Straddle/Strangle for its Theoretical Price, to buy this as a Debit spread below the market value. See Price Scout: Work the Entry Hard.

 

Open Interest & Days to Expiry 

❑  For the Straddle/Strangle, choose strikes with a minimum Open Interest between 10–20 times the number of contracts you plan to buy.

– This ensures adequate liquidity to exit the spread, especially on the very day price shoots past the –1σ or +1σ boundary.  You want to sell off and close out the entire Straddle/Strangle on the day of such a big move, as the probability of price moving towards 2 Standard Deviations diminishes, after price has moved 1 Standard Deviation. At latest, you should only wait one day to lapse to close out the position. At this point of Maximum Profit with price having made its large move, do not risk not getting the position filled for 3-5 days. After such a violent move, price tends to stall or may reverse and this can happen within 3-5 days.

 

❑  Get at least 60-70 days before the last 20 days to expiry for a Straddle/Strangle. So, at 80-90 days before expiry, look at identifying candidates. Beyond 90 days, the Debit premium is likely to be more than twice the strike interval – do not overspend on extrinsic value – especially at the ATM strike where it is highest, even if the product is in the low IV range.

 

Exit Criteria for Profit/Loss (versus Stay In-Play)

 

Exit Criteria for Profit

❑  Target a minimum of 1.5 and a maximum of 1.75 gain in the Debit paid for the Straddle/Strangle.  Exit entirely, once you get between 150%-175% ROI. 

❑  To get more than 2 times the Profit on a Straddle/Strangle is a rare event, as price will need to shoot past the half-way point of the second Standard Deviation (–2σ or +2σ) into almost 2/3rds of it.

❑  For price to move outside –1σ or +1σ into half the area within the –2σ or +2σ is already a extremely huge move, beyond which Gamma will be exhausted as price has moved so far away from the original ATM/Near the Money strike (Delta +/–0.45–0.55), into a deep ITM strike (Delta +/– 1.00) on the Call or Put side.

 

Stay In-Play, 30–45 days before expiry, if price failed to move –1σ or +1σ but …

❑  The Probability of Touching either the Upside/Downside Exit remains 50%-60%. Watch the position more closely when the Probability of Touching drops below 50% and drifts between 40%-45%.

 

❑  Positive Gamma remains at least 2–2.5 times that of –Theta to offset the exponentially accelerating decay, as the debit spread approaches 30 days to expiry. Prioritize +Gamma’s ability to offset –Theta above the Probability of Touching Break Even Points. If +Gamma fails to offset –Theta, count the trade as a Loss. 

 

❑  IV is still rising between the 0.20-0.40 deciles but has not yet reached the 0.45–0.55 decile. If IV already has reached the mid-ranges of 0.45–0.55, IV is likely to stall; and, there may not be sufficient days remaining for IV to rise another full 0.10 decile (+10%) to lift the Straddle/Strangle.

❑ IV at the 0.45–0.55 mid-range risk area has “reverted” to its mean and is likely to rest at this level as both Support and Resistance. This also poses the risk that IV may fall – an IV crush damages the Straddle/Strangle.

 

Exit Criteria to Limit Losses

❑  Exit with 30 days to expiry, if price has not moved away from the ATM/Near The Money strike.

❑  Within 30 days to expiry, Gamma gets higher and higher, making its curve almost twice as tall at the ATM strike, compared to the original Gamma on the day the Straddle/Strangle was filled. This makes the width of the Gamma curve much narrower, effectively lowering the frequency of a potential price move outside the –1σ or +1σ boundary.  The less frequent a –1σ or +1σ  move is to occur, reduces the probability for price to move outside the Upside/Downside boundary.

 

❑  Positive Gamma falls to 1–1.5 times that of Theta. At this level, +Gamma is suffering exhaustion and lacks the strength to offset the increasingly magnified decay of –Theta.  Do not wait for Gamma to collapse,  coupled with –Theta decay, price ends up staying at the bottom of the Valley incurring the Maximum Loss.

 

❑  With less than 30 days to expiry, the Probability of Touching either Upside/Downside Exit falls below 40%, with the Probability of Touching the ATM/Near The Money strike between ~80%–90%.  Meaning, price will remain in the middle of the Valley of Loss, incurring the Maximum Risk.

 

❑  IV drifts between 0.45-0.55 deciles but fails to rise towards the 0.60 decile.  IV is running up against Resistance, as most of the mean reversion has occurred. This signals the end of IV’s rising trend.

 

Short Vertical Call/Put (Credit Spread) Plan: Vega & Theta affects Profit; Delta & Gamma Impacts the Loss.

Verticals are designed to be directional. The only material difference in choosing between constructing a Vertical for a Credit versus a Debit is the range at which the product’s IV is at and the +/– Skew of the product.

 

For a Credit Vertical (Bear) Call, identify a clear Support level. A Breakdown below old Support, forms new Resistance to identify OTM Call strikes to sell a Credit Vertical Call.

❑  A Positive Skew helps the Calls’ IV fall as price drops from higher call strikes to lower call strikes in favour of the direction of the Credit Vertical Call.

–  All the P&F Sell Confirmation (Breakdown) patterns, except the Bearish Triangle Breakdown are useful in identifying where price breaks Support towards the Downside. Only after Confirmation, sell the Credit Vertical Call.

– Given this is a Bearish trade, ensure the use of P&F Breakdown patterns is below the Bearish Resistance Trend Line.

 

For a Credit Vertical (Bull) Put, identify a clear Resistance level. A Breakout to the upside above old Resistance, forms new Support to identify OTM Put strikes to sell a Credit Vertical Put.

❑  A Negative Skew helps the Puts’ IV fall as price rises from lower put strikes to higher put strikes in favour of the direction of the Credit Vertical Put.

–  All the P&F Buy Confirmation (Breakout) patterns, except the Bullish Triangle Breakout are useful in identifying where price breaks Resistance towards the Upside. Only after Confirmation, then sell the Credit Vertical Put.

– Given this is a Bullish trade, ensure the use of P&F Breakout patterns is above the Bullish Support Trend Line.

 

Greeks Profile for Credit Vertical (Bear) Call: –Delta, –Gamma, –Vega and +Theta

❑  Profit from –Delta getting smaller and –Gamma getting bigger as price falls down. Profit from –Vega means (IV needs to drop from a higher range to a lower range).

❑  Loss arises from sizeable –Delta increases as price rises against the planned downward direction with –Gamma becoming smaller.

 

Greeks Profile for Credit Vertical (Bull) Put: +Delta, –Gamma, –Vega and +Theta

❑  Profit from +Delta getting smaller and –Gamma getting smaller as price rises up. Profit from –Vega means (IV needs to drop from a higher range to a lower range).

❑  Loss arises from sizeable +Delta increases as price falls against the planned upward direction with –Gamma becoming smaller.

 

Both Verticals, share the same Theta and Vega characteristics:

❑  Profit from increasing amounts of Theta collected as premium each passing day, at the same time, a –Vega means IV needs to decrease from a higher range to a lower range.

 

❑  As the aim is to retain nearly all of the Credit sold within the Short Vertical (be it a Bear Call or Bull Put spread), a Short Vertical is typically constructed around where the Delta for Calls approximates +0.30 (+0.25 to +0.35 range) and the Delta for Puts approximates –0.30 (–0.25 to –0.35 range).

 

Selling OTM Calls/Puts within the Delta range of +/–0.25 to +/–0.35 gives the Short Verticals a ~65%-75% probability of success for the Credit received to expire worthless.  At maximum, increase the Delta to +/– 0.40 for the Short Vertical to have ~60% probability of retaining the credit sold; but, no higher, as you will be reaching strikes Near The Money and towards ATM: where Gamma is at its highest.

 

Entry

Strike width intervals. With a Short Vertical, as it is essentially a directional strategy, there needs to be sufficient room for the product’s price to rise or fall. For products with $1 strike intervals, widen the construction of the Vertical out to $2 strike intervals apart, only if you can sell a marginally higher credit by 0.05–0.10 with the $2 strike apart Vertical, than you can with the Vertical being $1 strike apart. At maximum, choose a product with strike increments of $2.50. Do not choose a product with $5-$10 strike intervals, as the change of larger Delta risks is amplified without any added benefit of improving the ROI on the trade.

 

You can sell $0.50–$0.70 out of $2 strike intervals, just as you can sell $2.50-$3.50 out of $10 strike intervals. Though it’s not identical.

❑  Choosing a Vertical from a product with $10 strike intervals does not guarantee that you can collect more Credit in selling the same fraction within the width of the strikes in a product widened out to $2 strike intervals.  The reason the $10 strikes are set that far apart in the first place, represents the propensity of the product to move at those intervals.

Using a product with $10 strike intervals, invites more Delta and Gamma risk than is necessary for Theta and Vega to cope with, diluting the amount of Profit contributed by these 2 Greeks.

 

Of note, in general because the interest rate component is built into Calls, OTM Calls are typically 30%-40% higher in Credit premium to sell than equidistant OTM Puts. The richer premium on the Call side is also driven by the inherent +/- Skew of the product.

– With richer premiums on the Call side, it is often easier to get filled on marginally higher than mid-price fills by selling a Credit Vertical Call when the product is going into a mild to moderate rally;

– Go Short on a Credit Vertical Put with a mild to moderate pull-back to get filled on marginally higher than mid-price fills.

So, use the Futures to gauge pre-market open trading activity, to see if the major broad-based Indices are opening higher that day to sell the credit at marginally higher prices (up to +0.10 above the Theoretical Price of the Credit Vertical) and work the order hard to fill within 60-90 minutes of the markets opening.

❑  As Delta denotes directional speed, look at the spatial differences between the Delta of the ATM strike and the Deltas of the OTM Calls/Puts you plan to sell.

– If the Delta increments from the OTM strikes becomes increasingly bigger per strike up/down, the product has “faster” Deltas. There is more directional speed in each strike the closer price moves towards ITM. This is helpful, as price can move quickly away from the OTM strikes, if it moves in the planned direction.

– If the Delta increments from the OTM strikes becomes increasingly smaller per strike up/down, the product has “slower” Deltas. There is less directional speed in each strike the closer price moves towards ITM. This is not helpful, as price moves slowly away from the OTM strikes, if it moves in the planned direction.

If the Delta of a product is missing an ATM/Near the Money Delta between +/–0.45-0.55; but, instead has an OTM Delta of +/–0.40 (or less) jumping to an ITM Delta of +/–0.60 (or more), the product has “fast” Deltas.  There is more directional speed in each strike. As Long as price moves in the direction planned for the Vertical, this is a benefit to the Vertical. Conversely, it can move fast against the position, if price fails to move in the planned direction; but, moves in the opposite direction instead.

❑  Never sell options in the Front Month.  In the last 21-23 days before expiration, the negative Gamma risk outweighs the Theta premium collected.  With 10-15 days to expiry, Gamma explodes for the ATM options.  Even if Delta stays flat (~0.00), the negative Gamma risk (in/stability of movement) expands exponentially at an acute curvature that is in multiples, which will overcome the Theta decaying also exponentially (at the square root of time).  During this period, there will be inadequate Theta collected as premium to offset Gamma’s explosion.  Do not initiate a Short Vertical with less than 20 days before expiry.

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

❑  Shortest column of Xs (tightest Upside range) as the worst-case test for a favourable price move up of a Credit Vertical Put’s probability. Use the Longest column of Os (widest Downside range) as the worst-case for price moving in the opposite direction of the bullish Vertical’s probability.

❑  Shortest column of Os (tightest Downside range) as the worst-case test for a favourable price move down of a Credit Vertical Call’s probability. Use the Longest column of Xs (widest Upside range) as the worst-case for price moving in the opposite direction of the bearish Vertical’s probability.

 

IV. While at higher IV levels, you get to sell Short Verticals for more Credit, there is a need to guard against the risk of IV making a higher high.  IV forecasting tools from iVolatility.com have been blended into the Home Options Trading techniques.

❑  An IV forecast in the higher decile range of 0.70–0.80 or 0.30–0.40 decreasing by 0.10 decile (–10%)  makes for an ideal Short Vertical opportunity.

❑  If IV is in the decile range of 0.90–1.00, IV may make a higher high. IV increasing raises the Vertical’s Credit value, when we want it to fall to buy it back cheaper than when we sold it. Choose another product to construct a Credit Vertical trade on. For an existing Credit Vertical, exit the position entirely.

❑  If IV is in the decile range of 0.00–0.10, IV may fail to make lower lows, instead IV bounces back up. Again, IV increasing raises the Vertical’s Credit value, when we want it to fall to buy it back cheaper than when we sold it. Choose another product to construct a Credit Vertical trade on. For an existing Credit Vertical, exit the position entirely.

Sector Indexes that are interest rate sensitive (e.g. BKX Financials), seasonally cyclical  (e.g. UTY Utilities & XLB Materials) or oil-sensitive (e.g. SOX/SMH Semiconductors) are ideal to trade directional Verticals. ETFs in other asset classes (Currency, Emerging Markets & Real Estate) are suited for directional Verticals as well.

– The practical testing range of a Vertical of most major tracking Indexes for an IV rise/fall is +/– 10%. Any more will not be a realistic simulation.

 

The Reward:Risk Ratio evaluation of the Vertical is similar to that of the Iron Condor.

❑  Sell at minimum 25% up to a maximum of 40%, of the width of the Verticals (be it a Credit Vertical Call or Credit Vertical Put).

 

So, for a Short Vertical

❑  $2 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at  +/– Delta 0.25-0.35, to receive between $0.50 to $0.80 of Credit in Total.

 

❑  $2.50 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at  +/– Delta 0.25-0.35, to receive between $0.65 to $1.00 of Credit in Total.

 

If you have clear reasons to sell higher Call/Put Deltas, stop at +/- 0.40 Deltas as the maximum. Otherwise, the odds of retaining the Credit becomes unfavourable towards the OTM Short strike.

 

Selling these consistent fractions of the width of the Verticals making up the Vertical, regardless of the different strike intervals, exposes the Vertical’s Short leg to less than ~40% of being touched by price movement.  In turn, giving the Vertical’s Short leg a minimum of 60+% probability of price not touching it, for the position to retain the Total Credit received.

– At maximum, choose OTM strikes that give the Credit Vertical’s Short leg a 30% probability of being touched by price movement, i.e. 70% probability of not being touched. Lowering the probability beyond 30% is margining capital on a credit spread beyond what is efficient that could have been used for another strategy.

 

Regardless of the strike width chosen, the typical method of constructing an entire Vertical position is to contain the entire position within 1 Standard Deviation (–1σ and +1σ). Outside –1σ and +1σ makes it difficult to collect sufficient Credit premium to sell.

 

However, beyond the typical method and unique to trading Verticals is the method of staggering the number of contracts allocated for the entire trade, across an increasing number of strikes. This method of staggering contracts is similar to that used for the Credit Iron Condor.

So, for example, based on the money management rule of allocating 4% of the Net Liquidating Value per trade, say it translates into 6 Vertical contracts.

❑  Instead of placing 6 contracts at once on the same strikes, stagger the allocation of 2 contracts at the original OTM Call and Put strikes with the Delta criteria cited above, 45-50 days to expiry.

❑  Then, after 5 days (with 40-45 days from expiry remaining), if price moves in the planned direction, sell another 2 contracts with the same Delta criteria to Roll down the Credit Vertical Call; or, Roll up the Credit Vertical Put.

❑  Then, after 5 days (with 30-35 days from expiry remaining), if price moves in the planned direction, sell the remaining 2 contracts with the same Delta criteria to Roll down the Credit Vertical Call; or, Roll up the Credit Vertical Put.

– Within either period of staggering contracts, if price moves drastically against the planned direction, use the remaining contracts to sell the opposite Vertical to that initiated (e.g. if you originally sold 2 Credit Vertical Call contracts for $0.70 Credit; but, price rises, then sell 2 Credit Vertical Put contracts for ~$0.70 Credit) at an equivalent amount of Credit to offset the original Vertical for a near break even position. In this case, you’ve legged into an Iron Condor – contrary to the normal practice of not legging into spreads – but here it is deliberate to break even at ~$0.00 to write-off the original Vertical gone wrong.

– “Rolling” up/down the Credit Vertical Put Spread/Credit Vertical Call with each allocation of 2 contracts per Roll should be treated as a new trade with its own individual risk. As this pushes the Vertical’s Break Even point further aLong the same direction as price movement. If price moves in the planned direction – making the original 2 Verticals you sold profitable, try to sell the subsequent 2 Verticals progressively around ~1.25 times more Credit than the original Credit you sold. Staggering the allocation of Verticals builds in a step function into the risk, allowing you to ladder up the Profit potential of the Vertical; yet, still satisfy the money management rule of 2%–5% per trade.  Otherwise, allocating all 6 contracts at one limits the Profit potential to only one level.

❑  Remember to value the Credit Vertical for its Theoretical Price, to sell it as a credit spread marginally above the market value by ~0.10. See Price Scout: Work the Entry Hard.

Open Interest & Days to Expiry 

❑  For a Short Vertical choose strikes with Open Interest between 10-20 times the number of contracts you plan to fill.  This ensures adequate liquidity, especially when its time to exit the trade.

❑  Look to fill the Vertical more than 35 days at minimum up to 50 days at maximum before expiration.  Below 30 days, the Credit collected is insufficient to reward the position for the Delta & Gamma risk going into the 5-10 days before expiry. Above 50 days, exposes the Short Vertical to too much IV uncertainty and possibly changes in interest rates.

Exit Criteria for Profit/Loss (versus Stay In-Play)

 

Exit Criteria for Profit

❑  10–15 days before expiry, exit both legs of the Vertical; or …

❑  If the Credit Vertical Call or Credit Vertical Puts value has dropped to $0.10–$0.15, buy back only the Short leg. Do not risk the possibility of price retracing in the opposite direction to hit the Short leg within the week of expiration itself.

❑  For the Long option remaining in the Vertical trading near $0.05, there is not much value remaining to sell this leg to close it. Buy back only the Short options in the Verticals. This leaves you with a Long option should price bounce back unexpectedly.

❑  Always observe the rule of exiting the entire Vertical 10 days before expiry. Only if favourable pricing conditions occur as stated above, then use the variation in closing just the Short leg and leaving the Long option untouched. Otherwise, mechanically exit entirely. Some more experienced traders choose to hold the Vertical till 5–7 days to close it out. Namely, this is what they have consistently done as a routine.  Stay consistent with the number of days to exit: if its 10 days stick to it, if the decision to exit is between 5–7 days stick with it.

❑  Before 10–15 days expiry, when 70%–80% of the Vertical’s premium has decayed, exit the entire trade. For e.g., a Vertical sold for $1.00 decays down to $0.20, close out both legs. The remaining 20% of Profit is marginal and not worth the Delta and Gamma risk of remaining in play.  It’s not logical to risk the entire $1.00 (of which you’ve already gained ~80%) for less than 20% more Profit to milk in 2+ weeks. Guard against the greed and let sensible fear prevail.

Stay In-Play, with 15-20 days before expiry, if the

❑  Probability of Touching the Upside Exit for the Credit Vertical Call and Downside Exit for the Credit Vertical Put is between 20%–40%.  Watch the position when the Probability of Touching the Short leg drifts between 40%–55%.

❑  Watch the Vertical more closely, if the iVolatility Hi/Low Indicator drifts aimlessly between the 0.45–0.55 decile without a clear signal, if IV will drop further or stay range bound. For example, if IV has already dropped from the 0.80 decile down to the 0.60 decile, i.e. IV has fallen 2 full deciles = 20%, it may be bouncing against Support for the IV’s mid-range between the 0.45–0.55 decile range and fail to fall further.

❑  Be vigilant when the original Deltas of the short OTM Calls (+0.25 to +0.35), as Credit Vertical Call grows larger, as price moves towards the Call Vertical side.  And when the original Deltas of the short OTM Puts (–0.25 to –0.35 ), as a Credit Vertical Put grows larger, as price moves towards the Put Vertical side.

❑ In either case, this signals the original OTM strikes are at risk of becoming more costly to buy back, which reduces the Profit of the trade.

 

Exit Criteria to Limit Losses

❑  Exit the entire trade before/during economic or political news that violently increases the overall market’s Volatility. i.e. VIX shoots up above its daily volatility range.

 

❑  The Probability of Touching the Vertical’s Upside Exit for the Credit Vertical Call and Downside Exit for the Credit Vertical Put increases from the original 40% to 60%-70% with 10-15 days before expiry. Either, close out the Short leg only or the entire Vertical.

 

❑  IV rises to raise the Vertical’s value to ~125% of what the Credit spread was sold for (making it more expensive to buy back), instead of decreasing the premium collected, which is what is needed to make it cheaper to buy back.

– A Vertical needs to maintain a negative Vega, representing a drop in IV to stay profitable. The negative Vega needs to become an increasingly larger number for the forecasted fall in IV to add to Profit. If the negative Vega number gets progressively smaller towards ~0.00, IV is rising and without sufficient positive Theta decay to offset the IV increase, the position starts incurring Losses. Theta collected as premium is wiped out by a rising IV, and there may be insufficient days remaining to collect the adequate amount of premium to restore the drop in the credit spread. Remember, just as you can only lose 1 day’s worth of decay in a debit spread, you can only effectively collect one day’s worth of premium per day in a credit spread.

 

Long Vertical Call/Put (Debit spread) Plan: Delta, Gamma & Vega affects Profit; Theta impacts the Loss.

Debit Vertical spreads are twins of their Credit counterparts (in reverse).  I will only state the obvious differences and refrain from repeating the opposite elements that you can work out.

 

Greeks Profile for Debit Vertical (Bear) Put: –Delta, +Gamma, +Vega and –Theta

❑  Profit from –Delta getting larger as price falls down and  +Gamma gets smaller towards 0.00 and becomes negative. Profit from +Vega means IV needs to increase from a lower range to a higher range.

❑  Loss arises from –Delta getting smaller as price rises opposing the downtrend, with positive Gamma becoming smaller.

 

The Debit Vertical (Bear) Put is the counterpart of the Credit Vertical (Bear) Call.

 

Greeks Profile for Debit Vertical (Bull) Call: +Delta, +Gamma, +Vega and –Theta

❑  Profit from +Delta getting larger as price rises up and +Gamma gets smaller towards 0.00 and becomes negative. Profit from +Vega means IV needs to increase from a lower range to a higher range.

 

❑  Loss arises from +Delta getting smaller as price falls down against the uptrend, with +Gamma becoming larger.

 

The Debit Vertical (Bull) Call is the counterpart of the Credit Vertical (Bull) Put.

 

The Exit and Entry criteria stated for Credit Vertical spreads applies, except it is reversed to recognize the Debit.

 

With Long Verticals, a wider width between strikes allows Delta & Gamma to expand (within reason) which is required in a directional Debit spread to gain from the price movement. For both types of Long Verticals:

 

❑  Buy at minimum 25% up to a maximum of 35%, of the width of the Verticals (be it a Debit Vertical Call or Debit Vertical Put).

 

So, for a Debit Vertical Call/ Debit Vertical Put with

❑  For products with $1 strike intervals, widen the construction of the Vertical out to $2 strike intervals apart, only if you can buy a marginally lower debit by 0.05–0.10 with the $2 strike apart Vertical, than you can with the Vertical being $1 strike apart. For a $2 strike width apart Vertical, buy the OTM Call/Put strikes at  +/– Delta 0.25-0.35, for a Debit between $0.50 to $0.70 in Total for the entire long Vertical.

 

At maximum, choose a product with strike increments of $2.50. Do not choose a product with $5-$10 strike intervals, as the change of larger Delta risks is amplified without any added benefit of improving the ROI on the trade.

 

❑  For $2.50 strike intervals, buy the OTM Call/Put strikes at  +/- Delta 0.25-0.35, for a Debit between $0.60 to $0.85 in Total for the entire Vertical.

 

IV. While at lower IV levels, you get to buy Long Verticals for a lower Debit, the risk of IV making lower lows increases. IV forecasting tools from iVolatility.com have been blended into the Home Options Trading techniques.

❑  An IV forecast in the lower decile range of 0.20–0.30 or 0.60–0.70 increasing by 0.10 decile (+10%) makes for an ideal Long Vertical opportunity.

❑  If IV is in the decile range of 0.00-0.10, IV could fall to a lower low. IV falling decreases the Vertical’s Debit value, when we want it to rise to sell it back for a higher price than what it was purchased for. Choose another product to construct a Debit Vertical trade on. For an existing Debit Vertical, exit the position entirely.

❑  If IV is in the decile range of 0.90-1.00, IV could fail to make a higher high. Again, IV falling decreases the Vertical’s Debit value, when we want it to rise to sell it back for a higher price than what it was purchased for. Choose another product to construct a Debit Vertical trade on. For an existing Debit Vertical, exit the position entirely.

 

Skew for Debit Verticals

❑  A Negative Skew helps the long Put’s IV rise as price drops from higher put strikes to lower put strikes in favour of the direction of the Debit Vertical Put.

❑  A Positive Skew helps the long Call’s IV rise as price rises from lower call strikes to higher call strikes in favour of the direction of the Debit Vertical Call.

 

Days to Expiry 

❑  Look to fill the Debit Vertical with 60 days at minimum before the last 30 days to expiry, i.e. look for candidates 80-90 days out. Only if the Debit paid is still within 25%–40% of the width of the Vertical, look for a candidate more than 90 days up to 120 days at maximum.

 

Exit Criteria for Profit, Stay In-Play and Limiting Losses

❑  Exit the entire Long Vertical before 30 days to expiry, Theta rises to its highest point of its exponential decay, poised to plummet with 30 days remaining.

❑  Within 45 days to expiry, if the Debit Vertical:

– increases in value by 1.5 times, scale-off 2/3 to 3/4 of the position to lock in Profits. Leaving only 1/3–1/4 of the position at risk with 70+% Probability of Touching the Upside Exit for the Debit Vertical Call and Downside Exit for the Debit Vertical Put that is profitable, giving you fair odds to sell the remaining Vertical contracts up to 1.75 times the original Debit.  Waiting to sell all contracts of the Vertical for 2-3 times its original Debit is not recommended.

– reduces in value by 30%–40%, take off 1/3 to 1/2 the position to limit Losses. Leaving 1/2 to 2/3 of the position at risk and stay in-play for another 10-15 days, if IV continues to rise. But if the Probability of Touching the short put of the Debit Vertical Put and the short call of the Debit Vertical Call decreases below ~40%, close out the remaining contracts and exit entirely.  Do not wait to incur the Maximum Loss.

 

❑  Watch the Vertical more closely, if IV drifts aimlessly between the 0.45– 0.55 decile without a clear signal, if IV will rise further or stay range bound. If IV has already risen from the 0.10 decile up to the 0.30 decile, i.e. IV has increased 2 full deciles, it may hitting Resistance at the IV’s mid-range and fail to rise further.

 

❑  Do not fix the busted Debit Vertical. If price moves drastically against the Debit Vertical spread, exit it entirely.

 

❑  Open Interest and remaining Probability of Touching criteria (Upside/Downside, –1σ or +1σ) for Entries/Exits is similar to that of Credit Verticals.

Now, you may know all the criteria stated here … but … how do you compress it all within 2 hours per day to turn it into a home-based business?