Strategies to Avoid Big Risk in Option Trading

11/12/2010 12:01 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

Most traders want to own a market-neutral (avoiding large market move risk) position when opening new iron condor trades. And those traders generally assume that being “delta neutral” (in which the trade value remains unchanged due to small changes in the value of the underlying security) fits the bill. However, there are alternatives.

It’s perfectly reasonable to elect to be “distance neutral,” i.e., the short put and short call are equally far out of the money (OTM), regardless of delta.

Example:

When SPX is at 1,050:

  • Sell SPX 1,000 puts
  • Buy SPX 990 puts
  • Sell SPX 1,100 calls
  • Buy SPX 1,110 calls

Another choice is to be “dollar neutral,” i.e., the trader collects an equal premium when selling the call spread and the put spread. Puts almost always have a higher premium than calls when they are equally far out of the money. This is the result of volatility skew, which imposes a higher implied volatility (IV) to the options as the strike prices moves lower. It’s that higher implied volatility that makes the put spreads cost more (or sell for higher prices) than their call counterparts.

So for any trader who is more concerned about a downward move in the market, it’s perfectly acceptable to collect an equal number of dollars when selling the put spread as when selling the call spread. In practical terms, this means that the puts are going to be farther out of the money than the calls.

Then there is the idea of being “risk neutral” with an iron condor position. Making your best guess as to how the market will price the options (i.e., guess what implied volatility will be), choose an iron condor so that you lose the same number of dollars if and when the iron condor moves up or down by a certain amount (points, percentage, or standard deviations).

This is the type of trade that may make you feel most comfortable with the iron condor position, but it does involve being able to make a reasonable guess as to future implied volatility. It also requires taking the time to use a calculator (or risk graph) and studying the numbers.

There is also the opportunity for a “bias-neutral” iron condor in which you allow a market bias to dictate whether you accept more risk on the put side or the call side. This is not really “neutral,” but if you have a market opinion, this is one way to play it. This is done by selecting strike prices or by varying quantity. The traditional iron condor sells an equal number of call spreads as put spreads, but if it suits your risk profile, you may be happier selling a slightly off ratio iron condor. Perhaps selling 10% to 15% more calls than puts (or vice versa).

Trading “neutral” has its advantages because it minimizes risk, however, the definition of neutral is not written in stone.

By Mark Wolfinger of Options For Rookies

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