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As the founder of BetterBeta Trading, I bring an independent option trader's perspective to successfully trading iron condor options strategies, focused primarily on the Russell 2000. Reducing volatility and hedging against outlier risks while generating steady profits are the building blocks of... More
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  • Using The Straddle To Pick Your Strikes 0 comments
    Feb 16, 2014 3:10 PM | about stocks: IWM
    A Game of Probabilities

    One of the most talked about aspects of trading iron condors, especially among newer traders, is how to select your short strikes. Should it be based on premiums received, delta values of the short options, standard deviation estimates, open interest levels, a fixed percentage from the current price or maybe support and resistance levels?

    Deltas

    Frequently traders use delta values as a proxy for probability. Looking at the IWM options chain for March expiration below, a trader might decide that they want to get short the 109 puts and the 118 calls, each with deltas of 22. Using delta values to estimate probability, they would be lead to believe that there is a 56% that the puts and calls will expire worthless (100 - 22+2).

    (click to enlarge)

    One of key shortcomings with using this approach in isolation:

    The short options are not evenly distanced from the underlying - currently at 114. The calls are 3.5% out of the money while the puts are 4.4% out of the money. The purchase of downside puts as protection drives the premiums higher relative to calls that are equally out of the money. So while a trader might have offsetting deltas, the shorter distance to the upside could pose a problem if the market moves up.

    Using the Straddle

    An effective way to set your short strikes is by using what market participants are willing to pay as a guide. By looking at the front month ATM straddle (the purchase of an ATM put and call), we see that the March IWM straddle is priced at approx. 4.60. This means that in order for the owner of a straddle to make money, IWM has to move up or down by more than 4.60 before March expiration.

    So what does this tell us?

    Based on the price of $4.60, it tells use that market participants believe that the IWM will finish the month somewhere between 109.40 and 118.60. One of the benefits of this approach is that it isn't based on a pricing model - it's based on what traders are willing to do with their capital.

    Going back to our delta 22 level example above, we see that the 109 puts are just outside of the range of the front month ATM straddle. The 118 calls however, are inside of the current straddle pricing. This may cause a trader to rethink opening a short position in the 118 and might want to go with the 119 if they are more risk averse. Had they relied solely on deltas, they would not have been aware of this.

    A more aggressive trader may decide to short the 110 puts instead of the 109 puts to collect a larger premium and move both short strikes within the range suggested by the straddle.

    A Balanced view

    For any traders putting on an iron condor, they need to use a range of methods to determine where their strikes should be. Too many traders rely solely on delta values as a proxy for probability and are unpleasantly surprised when deltas spike and the positions become difficult to manage.

    in addition to using the straddles to set strikes, we'd encourage you to assess support and resistance levels, open interest peaks and of course the preferred risk/reward ratios that your particular strategy employs. Iron condors can be highly reliable trading structures when you take a comprehensive approach to setting them up and managing them throughout the lifecycle of the trade.

    Stocks: IWM
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