Track that Trade 110426

IRON CONDOR and DOUBLE DIAGONAL combination, using Jun/Jul RUT options.

It’s unusual to open a position with six different legs. Although that’s what we did here, the trade is really simpler than a 6-legged beast.

Using RUT as the underlying asset, and assuming a $100,000 account, this trade requires a good deal of margin. The number of contracts traded is small, but the margin requirement is not ($24,000).

If you are not familiar with an iron condor or a double diagonal, take a look at our first (110404) and most recent (110418) trades for an example of each. You can find a whole lot more on each of these strategies at my original blog or in my Rookie’s Guide to Options. However, the purpose of following a trade is not to send you off to do a great deal of reading – especially if you are new to options.

These trades are not the type that a beginner would make, but I do want to offer a variety of trades as a learning experience.

The Trade

Part I. The iron condor
iron condor

Buy 5 RUT Jun 760 P @ $5.00 {or $4.65 – see the discussion below}
Sell 5 RUT Jun 770 P @ $5.80

Sell 5 RUT Jun 910 C @ $4.10
Buy 5 RUT Jun 920 C @ $2.95

Net credit (cash collected) per iron condor = $1.95

The very first point to mention is that is execution price is a bunch of hooey. When using a paper-trading account, most brokers do not provide a fill unless you pay the ask price on the options bought and sell at the bid price for the options sold. In reality, we can ALWAYS do better than that. The difficult is finding a good estimate of those prices for our purposes.

The iron condor asking price: $1.95 cash credit [As buyers, out software forced us to pay this price]
The iron condor bid price: $3.05 cash credit

The midpoint between the bid and ask prices was $2.50. I believe we could have been filled easily by collecting a premium of $2.35, but to be conservative, I’ll settle for $2.30.

That’s $0.35 better than out ‘fill.’ If you want to ‘keep score’ then change the buy price for the Jun 760 puts to $4.65.

The double diagonal (DD) spread
Buy 3 Jul 740 P @ $7.90
Sell 3 Jun 770 P @ $5.80

Sell 3 Jun 910 C @ $4.10
Buy 3 Jul 940 C @ $ 4.10

Net cost: $2.10 per spread.
The real market for this double diagonal spread was:

    Bid: $0.30
    Ask: $2.10

    Midpoint: $1.20.
    I’m making the assumption that we could get filled by paying $1.40, or a full 65 cents better than we were obligated to pay by using a paper-trading account.

    To ‘keep score’, change the Jul 740 P to $ 7.25


+ $230 * 5 for the iron condors
– $140 * 3 for the double diagonals

Net: + $730

Both of these trades earn money when the underlying asset remains between the strike prices of the options that we sold.
If expiration arrives and that condition obtains, then

  • the iron condor becomes worthless and we keep the entire premium collected
  • The June options of the DD expire worthless, and we sell the Jul options for whatever we can collect for them

That’s the easy part.
Below is a summary of the greeks (if you are new to options, the greeks measure various risk factors).

As the risk graph (below) shows, we don’t fare as well when RUT moves towards or though 770 or 910 (the strike prices of our short options.

Iron Condor + Double Diagonal Risk Graph

Apr 26, 2011

Note that the dotted line is below the zero line. This tells us we cannot earn any money on this trade until time passes, and we know that is bogus. I know that the shape of the graph is correct, but have (new software) not yet discovered how to set the trade prices into the software.

The main point for now is understanding that a big move is bad. Time is on our side and that we are still short a small amount of vega (the volatility component of the value of an option). Adding three DD spreads to the five IC reduced the negative vega and also reduced positive time decay. Addendum: It did not reduce positive theta. In fact, positive theta increased.

This is the IB graph. Seems to be working now.

Additional discussion

The IB graph represents what I expected to see. The dotted line (June expiration) shows us the P/L line as time passes. As we know, when RUT doesn’t move much and time passes, that’s payoff time for our position.

Similarly, if RUT moves in either direction, losses begin to accrue. It’s the battle between time decay and the passage of time that determines the winner for this position – assuming that no changes are made.

When trading iron condors, we can also earn decent profits – and quickly – when implied volatility (IV) declines. By taking less vega risk (owning vega rich diagonal spreads makes the overall position short a small amount of vega), we have given up that opportunity. As a tradeoff, if time passes and if IV increases as Jun expiration approaches, we can earn an extra profit by being long vega (in that scenario – two weeks to expiration and RUT in our safe zone, the long July options will have more vega than the short-term Jun options).

Trade Plan

The biggest part of the trade plan calls for deciding just how much loss we are willing to take before we are uncomfortable holding the position.

When we own the longer-term options, we eventually become positive vega. Because we have no accurate method for predicting future IV, we don’t know how much cash we can collect when we covered the Junes and sell our July options. We can look at the risk graph at future dates, different RUT prices, and different IV levels. That may be a good exercise, but right now that serves no practical purpose.

However, if you have never done that and if you care to spend the time, it can be a worthwhile exercise. I’d prefer to see what the future brings before looking at profitable exit points. However, nothing has changed from my basic iron condor trading habits. If either the JUNE put or call spread gets to 20 cents, I’ll probably want to pay that price to cover. That’s not a rigid rule because time remaining (before June expiration) may induce me to pay a bit more or hold out for a bit less.

Exit: Looking at the lower risk graph, if RUT reaches 775 or 910, the loss would be ~$2,500 and that’s plenty for a position such as this. I estimate the maximum profit potential to be The $730 cash we collected, less perhaps $200 to exit the 5 iron condors, plus the value of the July calls at whatever date we choose to exit. If five weeks remain to July expiration and if RUT is 850, the longs may be work about $1. That would be an extra $300, or maybe $830 total.

Of course, it could be considerably higher and it anyone’s guess right now. However, with that as an estimate, $2,500 is too much to lose. We must be careful not to set the exit point too low because it becomes more and more likely that we will see that number.

Update May 5

I received a good question form a member and others may have been wondering the same.:

From: Chad

On the RUT DD trade,740/770/910/940, What prompted the strike prices? Why not more narrow?

There is never a satisfactory response to this question. For me, it’s the cost of the double diagonal. I would rather not play than pay ‘too much?’ If the spread then appears to face the chance of a large loss, I have two choices: cut size in half or don’t play at all. More narrow is just too costly for my comfort zone. But – there is nothing wrong with more narrow, if willing to risk that the long options will not have much value when it’s time to exit the trade.

Also, what was the original greeks of the position?

The greeks are included in the original post. [See top, right in the image with the data] I apologize for not highlighting them.

In particular the vega and what is not an out of bounds vega?

Good Q – again with no answer. Let’s assume that the straight iron condor was short too much vega and that number was out of bounds. Why would it be ‘out of bounds’? Because the trader feels that there is more vega risk than he is comfortable holding. Thus, it’s necessary (in my opinion, unless you just want to make a guess) to look at the risk graph, raise IV to some number that you believe is realistic (or fear happening) and decide if the resulting loss (remember it’s just an estimated loss) is too large for comfort. If it is, then vega is out of bounds. I know that is not a satisfactory reply. However, the truth is that risk is in the eye of the position holder.

There is a lot of art when trading options. And the risk graphs are not accurate because each greek affects the position and any can change more than anticipated. All we can do is take the easy profits, not get greedy, and be very wary when the profits are not so easy.

I hope this helps.

Update 110524 May 24, 2011

In taking another look at this position, with RUT trading near 815, there is no reason to take any action.

The cash credit we can collect for the call diagonal is in danger of disappearing as the market moves lower. Nevertheless, at this low price (for the spread) there is little risk of holding.

The put spread (from the iron condor) is still 45 points OTM. That may not be much considering the rate at which RUT has been declining, but it is far enough to allow us to watch the position, as it is right now, and take no immediate action. Gamma is -2 and represents no immediate threat. The +25 delta is more of a problem

The put diagonal can become a problem if and when the Jun put spread moves closer to the money. For now, this part of the trade is in fine shape.

Bottom line: Nothing to be done today.

Update May 26, 2011

Closing the 3-lot of put diagonal spread.

  • Can collect decent amount of cash, even if far less than potential maximum
  • Concerned that the market may move higher, reducing cash we can collect
    • Delta of Jul put still larger, so that threat is not immediate.
  • If this is a false rally, a sudden tumble can place this part of the position in jeopardy
  • Recognizing that the call portion of the IC has already been closed, am looking to cover the put side soon

Update May 31, 2011

Closed the remaining side of the iron condor by paying 30 cents. [With is paper trading account, I’m bidding 30 cents, but the spread is offered at 27 cents. Amazing!]
Also closed the remaining 3 lots of the diagonal call spread, collecting 30 cents cash.

This turned out to be a very profitable trade – with a gain on each of the four legs. I don’t expect to see that very often.

Bottom Line

The iron condor trade worked well. Owning the double diagonal as a hedge against being short too much vega turned out to be unnecessary as IV did not move higher.

This is one example in which our ‘insurance policy’ resulted in additional gains. The usual scenario is for insurance to cost something – and hopefully not too large a portion of the profits.

6 Responses to “Track that Trade 110426”

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