The markets have been on a steady rise lately. Major indexes are up 15-20% in the last two months. This is very good news for longs, but not so good news for option sellers.
Consider for example the Volatility S&P 500 Index (^VIX). It declined from the high 40s in October to below 20. The VIX is supposed to reflex the expected volatility of the markets. The problem is it doesn't reflect the true volatility. If the markets were down 15%, VIX would shoot to the roof. But after a meteoric 15% rise, it is now back to the July 2011 levels. We all remember what happened next.
VIX and other volatility indexes have a major impact on options prices. VIX impacts S&P 500 index and S&P 500 index ETF (SPY) options while the Russell 2000 Volatility Index impacts the Russell 2000 Index and Russell 2000 Index ETF (IWM) options. Lower volatility indexes mean lower option premiums. When you sell premium, you want the options prices to be as high as possible.
One of my favorite strategies for sideways markets is an Iron Condor. The Iron Condor is a combination of a bull put spread and a bear call spread. The whole trade is done for a credit. Higher credit means higher profit potential.
Russell 2000 Index, S&P 500 index, NASDAQ 100 INDEX, Russell 2000 Index ETF and S&P 500 index ETF are among the best candidates for the Iron Condor strategy.
Iron Condor is a vega negative and theta positive trade. That means that it benefits from the decline in Implied Volatility (IV) and the time decay. If you initiate the trade when IV is high and IV is declining during the life of the trade, the trade wins twice: from the declining IV and the time passage.
Let's take a look at the following Russell 2000 Index (RUT) trade I shared with SA readers on December 6, 2011, about six weeks before January expiration:
- Buy RUT January 2012 670 put
- Sell RUT January 2012 680 put
- Sell RUT January 2012 800 call
- Buy RUT January 2012 810 call
When I do the Iron Condor trade, I choose the short strikes (680 puts and 800 calls) based on the deltas of the options. In this specific case, the deltas were around 25. RUT was trading at $742 so the short strikes were distanced about $60 or 8.1% from the price. The trade could be done for $4.60 credit.
The trade exceeded my wildest expectations. It gained a whopping 70.4% in 30 days. It was my best Iron Condor trade ever.
One month later, with RUT trading at $750, I shared the following trade:
- Buy RUT February 2012 690 put
- Sell RUT February 2012 700 put
- Sell RUT February 2012 800 call
- Buy RUT February 2012 810 call
The deltas of the short strikes were about 25 and the credit around $4.55. Everything was similar to the previous month trade: time to expiration, deltas of the options, the credit. But to get the same credit, I had to choose the short strikes only $50 or 6.6% from the price of RUT. The reason? The Russell 2000 Volatility Index (RXV) was at $37 on December 6, but only $29 on January 6.
Today we are one month later. RUT is at $831. Looking at March expiration, I can see that the following trade has the short strikes of 25 deltas:
- Buy RUT March 2012 780 put
- Sell RUT March 2012 790 put
- Sell RUT March 2012 870 call
- Buy RUT March 2012 880 call
The credit for this trade is around $4.40. So now we are the same six weeks from the March expiration, the deltas are the same, and the credit is actually slightly lower. But the big difference is that the strikes now are only $40 or 4.8% from the index. The reason? You guessed it - the Russell 2000 Volatility Index (RXV) is now below $24.
- Buy AAPL February 2012 375 put
- Sell AAPL February 2012 380 put
- Sell AAPL February 2012 470 call
- Buy AAPL February 2012 475 call
The stock was trading at $425 at the time of the trade. The trade could be done for $1.47 credit. The margin requirement was $353 hence the maximum gain was 41%. The trade was resilient to 10.5% move of the stock in either direction. The deltas of the short strikes were around 15.
Looking at March expiration today, I can do the following trade using short strikes with same deltas of 15 (the stock is at $460):
- Buy AAPL March 2012 425 put
- Sell AAPL March 2012 430 put
- Sell AAPL March 2012 490 call
- Buy AAPL March 2012 495 call
The trade can be done for $1.28 credit. The margin requirement is $372 hence the maximum gain is 34%. The trade is resilient to 6.5% move of the stock in either direction.
Do you get the picture? I get less credit, much lower potential return and need to go much closer to the stock price to get that credit.
The bottom line: If I trade Iron Condors today, I need to seriously compromise on the credit I get or choose strikes much closer to the stock prices to get the same credit. The options prices simply don't reflect the potential risk. Suddenly all the problems in Europe have been forgotten and all risk is off. This can change any day. Meanwhile, I wouldn't trade any vega negative trades like Iron Condors.