Commentary on an Iron Condor Trade

An experienced stock trader is learning to use options to enhance his earnings. We are looking for conservative trades that have a good chance to earn a modest profit (12% per year).

in my paper trading account today I sold the September SPY 140/145/180/185 IC for a credit of $0.67.

It is approximately one week later, but let’s take a look at these numbers.

    SPY is 164.4
    140/145 put spread midpoint: 40 cents
    180/185 call spread midpoint: 16 cents.

    Delta of options sold:
    145P: 13
    180C: 6

Immediate comments

–This trade is not market neutral. I have no criticism of that because our trader has a bullish bias

–The 5-point SPY spread width is equivalent to an SPX trade with a 50-point spread width

–The 5-point iron condor is equivalent to owning 5-different one-point iron condors, and the 5-point call and put spreads are each equivalent to selling the five consecutive 1-point spreads

Why is this important? Isn’t this a ‘who cares’ moment?
No. Understanding how equivalent positions work can help a trader make better decisions.

The call spread is equivalent to selling each of these spreads

let’s look at the bid/ask quotes for each of the spreads included in that 16-cent, 5-point call spread.

  • 180/181C; 0.03 to 0.07
  • 181/182C; 0.02 to 0.06
  • 182/183C; 0.01 to 0.05
  • 183/184C; 0.00 to 0.05
  • 184/185C; 0.00 to 0.04

It is not clear how to break up the individual spreads to arrive at a total of 16 cents. However, it is extremely unlikely that the 184/185 call spread premium was any higher than one penny. But, even if it were as high as 2 cents. would you want to sell it? There is so little profit potential. If you were short this spread from a previous trade, wouldn’t you want to pay $0.01 to cover – especially when expiration is three months away?

Consider an investor who has a large stock portfolio and will do very well on a rally. Let’s assume that he wants to collect some cash premium and is willing to sacrifice a portion of his upside gains in return for that premium. From my perspective, no one, not even this bullish trader should accept $1 in cash for the 3-month 184/185 call spread when the potential loss is $99.

Thus, I suggest that selling the 180/184 call spread represents a smarter choice. The premium would be 0.15, or perhaps even the same 0.16. [Do remember that I did not get the real numbers at the time the trade was made.]

For anyone who accepts that premise, what about the 183/184 call spread? How much did that contribute to the 16-cent premium? Probably not more than 2 cents, if that. Would you prefer to sell the 180/183 spread at 13 or 14 cents? with this spread only 3-points wide, you could sell 5 call spreads for every 3 put spreads and still have the same money at risk. The premium collected would be higher: 5 * 13 compared with 3 * 16.

The point is that the 5-point spread premium may seem attractive to sell, but there is no reason to give your money away. When selling spreads that are wider than the most narrow possible spread width, it is almost always worth your time to look at the premium available from selling each of the individual spread. You may discover than one is so much more attractive that you prefer to sell more of that spread than one of each. Or in this instance, you may discover that one is not worth selling. NOTE: DO NOT TRADE THE INDIVIDUAL SPREADS, BUT LOOK AT EACH SPREAD SEPARATELY TO DECIDE WHICH TRADE YOU WANT TO MAKE.

Next, there is another point worthy of discussion. I understand being bullish and not wanting to take a loss on the upside. But, is there any reason to sell this call spread? Is $16 a good enough premium when the possible loss is $484? It is for some traders, but not for me. I firmly believe that selling cheap, far-out-of-the-money spreads, is not a viable strategy over the longer term. They are difficult to manage when things don’t go well because there is no price at which it is comfortable to exit and accept a loss.

Suggestion

I love that this trade was made in a paper-trading account because it demonstrates a willingness to lean and get some trading experience before making a real-money trade.

The main lesson here is to be certain that the trade makes sense. In this example, I would encourage the trader to choose a different 5-point spread. However, he chose strikes that suit his comfort zone – always a good plan. However, by looking at the synthetic components of a spread separately, there are times when you will not want to make the trade. This is one such case. Selling the embedded 184/185 call spread does not offer anything in return for the tiny risk.

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