Who is a "guy like me"? You mean because I questioned your assumptions about fair value that I'm automatically in a cult? I don't even know (or care) what optionetics is... I've never attended a seminar or followed someone's magic method. I learned about options primarily by reading McMillan and doing my own analysis. I'm just trying to have an adult discussion about directionality vs non-directionality, expectancy, etc. And I don't have a problem with you disagreeing, that's what the forum is here for...but when you start typing "Getting out early is not an edge!!!!!!" with 6 exclamation points, well I feel like you're either a nice guy having a bad moment or perhaps you're the one who can't handle disagreement... Hey what do I know, maybe you're sitting there calmly at your computer typing that stuff, but it certainly doesn't come across that way. Again, so much attitude... "If you are so good at legging...", it just makes me feel like you're very emotional about this topic. 1) I never said I was "so good" at legging, just that it can have positive expectancy. 2) I don't trade the underlying because I have no strong directional feeling at the outset of the trade. I have a hunch which way the market will move, but not usually enough to put money behind. I'm trading what I see to be a flaw in the way option volatility is priced, which you could certainly do using a different method with the underlying but I don't because of the other reasons below. 3) Increased leverage using verticals. 4) Can have lower trading costs than scalping, depending which broker, style of scalping, etc. 5) I'm not very good at scalping...not entirely sure why, but I find legging out of an IC to be easier psychologically than just making the straight underlying scalp. Probably something to do with the limited risk of the verticals. Those are my answers. If you think they're no good, please calmly explain why. Leave the "!" key alone and just tell me in a normal tone why you think legging out is going to blow up my account, and how I can make more money doing it your way. I'm happy to learn if you have something concrete to teach.
I'm on holiday so there is no tone here. I've just avoided these forums for a long time because of the steady erosion of the content here. Usually when a guy tells me fair value does not exist, that is my cue to take my conversation elsewhere as I feel that any kind of intellectual dialogue that was possible, just vanished. At the end of the day, options can be as simple or complicated as you want to make them. But every complex spread is comprised of little single options and those little single options are all probability bets. You can combine them many different ways but they are still a total of all the other probability bets you are making. Over time, what determines your success in trading "volatility" is probability and having an edge. Legging out early on a trade is the same as opening a new a trade. Obviously buying back .05 or .10 options always makes sense, but if you are doing spreads for .30 to .50 credits (not saying you are) then those nickel and dimes represent substantial costs to the position. Too many times option traders think they can overcome negative edge through adjusting a position a thousand times or they can simply "manage" the risk well. I believe these are all fallacies. At the end of the day you are simply just making even more trades with negative edge. Over a long enough time horizon and enough trades, the negative edge will become realized through the erosion of your account. Many guys are afraid to trade the underlying and they often end up in the options arena because they are told or they believe that they can be successful without trading direction. Simply not possible. Either you are trading the direction of the underlying or the direction of volatility. Either way, you have to make a bet. The best solution I have for a guy that tells me he has no feel for direction is to take a very small position, it can be 5 shares of SPY for that matter. Anything. Once you have money on the line, you get a feel for the market really fast. You can replicate the long term returns of an iron condor through the underlying by simply trading a mean reversion strategy with small size. Think about the p&l distribution of both and you will see they mimic each other with about 95% correlation. You trade very very small and you simply add shares on the way down and sell them on the way up. Now this might sound like gamma scalping except you are accumulating deltas as the market goes against you just as in an iron condor. In the end if your volatility assertions are correct, you should make money on both. All you have to do is replicate the deltas of the iron condor. Execution costs are not that great as you will not really be making that many trades and your p&l will be greater most of the time. You might even get lucky and catch a flyer. Another suggestion, if you really want to trade volatility, you should be trading 6 to 9 months out. Even selling naked ATM straddles produces very little delta risk as there is no gamma out there with much greater reward. Much easier to remove the delta risk and trade pure volatility. Selling 5 delta spreads is not really trading volatility regardless, you are simply selling the tails that smart money is usually buying. Tails really don't have any useful greeks associated with them, they lie dormant until awakened. And when they awake, it's usually to remove equity from your account, lots of it. At the end of the day, options are incredibly useful at manipulating your payoff structure. But there has to "be" a payoff. Earning small credits is not a payoff unless you are able to do that thousands of times a day via market making. The idea is to "manipulate" your payoff structure to actually "increase it" not decrease it. It's analogous to a futures trader who trades direction and moves his stop to break even once he is 10 ticks in the money and adds another contract. As the underlying moves higher he is able to geometrically expand his upside while keeping his risk fixed. I'll close this with a quote from the book "Ugly Americans". There is a section in there on the eight rules of Carney. Here is number 4: "You walk into a room with a grenade, and your best-case scenario is walking back out still holding that grenade. Your worst-case scenario is that the grenade explodes, blowing you into little bloody pieces. The moral of the story: donât make bets with no upside."
A fair amount of what you just said I do agree with. I'm still not convinced that I need to trade the underlying, but I don't dispute that my method of legging can be very similar to your method of building up delta. A problem with mean reversion, however, is the larger trend within which the reversion bet is embedded. In other words, I can look at standard deviations from the mean and buy/sell at the tails all day long...the price and it's average will always converge eventually, but often it's the average that "moves" to meet the price. You could have a situation where price moves away from the mean by 10 standard deviations and then continues to drift slowly away until the mean catches up. In that case entering an OTM vertical credit spread following the 10 SD move MIGHT at least earn me something through theta decay as the underlying stays relatively still. Trading the underlying itself would either earn nothing or lose money. But that's not what scares me the most. What about a nice 3 deviation move away from the mean, followed by a period of calm while the average catches up, followed by a further 3 deviation move in the same direction...repeated until losses are large? Using a vertical my risk is limited without necessarily locking in the loss for good like an equity stop. If you have suggestions for dealing with those scenarios effectively using just the underlying, I will gladly listen. I've played with mean reversion using SPY itself for a long time. To me it's almost the reverse example of your hand grenade analogy. Some decent scalped returns until those get blown away by a continuation of the trend.
Let me give you an example and demonstrate to you why they are the same. First, you need to treat the mean reversion trade exactly like the iron condor. So to start with, there has to be fixed risk. Let's use the SPY in this example and say you are doing 10 lots in iron condors. This is the same as being long or short 1k shares at the worst possible point. This is the share position you will build up to. You might start with 20 shares to get to that 1k and build them up to higher amounts as you go further out. At some point you are going to have a fixed stop loss just like you do in the iron condor. Let me use some generic numbers here. With a 10 lot, you might be risking 9 pts to make 1.00 credit. So let's use 9k in max risk for both. Your stop out with the shares will also be 9k. That could be a price point 10 pts lower in SPY or 20 pts lower. It could be similar to the strikes you are using on SPY. So say SPY is at 125 and for Jan you are selling the 115/113 vertical and the 135/137 vertical. Use that underlying price to build up your max position size. That gives you 100 handles in the spoos in both directions. Again, your size will be minuscule in the middle of that range. In fact, a majority of it will not be put on till you get close to those extremes. Once you buy or sell some shares, you will immediately bid or offer them out for small profits and then re-center your prices. This would allow you to scalp the shares even in a strong trend. And any one way trending move that would stop you out of the share position would also cause a large loss for your condor. And whatever answer you give, oh I would just close out that leg of the condor and keep the loss small, well, you can do exactly the same with the shares and stop yourself out of them as well for a small loss. Remember, your max size is only going to be on maybe 2% to 5% of the time. Most of the time, your 1k share max position will probably have no more then 100 to 200 shares that you keep scalping out of. So let's trade. SPY at 125.00. Let's say my first buy point is 124.00 for 10 shares. SPY trades down to 123.98 I'm filled for 20 shares. I might use one ATR of the SPY as my net profit target. Let's say right now that is 1.00. SPY trades back to 125.10 and I'm filled for a 1.00 profit on shares. SPY now rallies up to 126.00. I sell 20 shares there. It goes on to 127.00, I sell another 40 shares there for a total of 60 shares short at avg price of 126.66. I put in a bid at 125.66 to cover and I get filled two days later. I re-set and start over again. You keep doing this over and over. If you don't want your max risk to be reached as in an iron condor, you can stop yourself out much earlier and limit your risk to 2k or 3k, whatever you want. A one way trend can't kill you because if the market is trending, you can liquidate your shares at the same level that you would buy back your vertical. Over time, this strategy should outperform the iron condor as you get a better feel for the market as it can turn into an asymmetric payoff. Over the short term, it should mimic the p&l profile of the iron condor. In some circumstances the condor would perform better when the market is literally just not moving. In other markets where there is a lot of back and forth, the shares would outperform. Both have the same risk profile and a payoff distribution that is also similar. Also, you can manipulate your shares just as with a condor. Say I'm bullish in the SPY. I can scale in more aggressively on the downside and lightly on the upside to account for my long bias. Let's add another wrinkle. Once you add shares long or short, you can sell the options against those shares if you think the market has been very volatile and might quiet down for sometime. Say you have built up 200 shares long , you could sell some calls 2 strikes out of the money for 1.50 say and lock in some premium in a quiet market. I'm just throwing ideas out there. There are a million ways you can do this. And I do believe this will outperform a static iron condor over a long period of time.
Alright, I would agree that in theory those two strategies can be played equivalently. And if, as you say, condors would be superior in calm markets and equity scalping would outperform in volatile markets, then you must be saying that the market is volatile more often than calm? I'm not sure if I agree or not, never tried to quantify that. Something that would still worry me are the flash-crash events like we saw in May. If we're talking realistically, that kind of a move will jump right through my equity stop without hitting it...so I'm left with a decision whether to take a monster loss or just hold on and pray. OTOH, a move like that can never completely wipe me out with ICs. Not to be nit-picky on your example, I know you were just throwing out some numbers...but I will usually collect more like 30 cents in premium for 70 cents in risk. So the max IC loss will definitely set me back a few trades, but I'm not crapping my pants at that point. A trade I might consider would be mean-reversion scalping the underlying WITH a condor at the same time as a safety net. What do you think, best of both worlds?
A flash crash can easily cause the bull put spread side of your IC to be fully in the money. If you're trading iron condors in significant size, so that you are using up most of your trading capital in the margin requirements, that will quickly wipe out your capital. Now fortunately in the flash crash the market quickly popped right back up, which would let you get out with a loss but not a catastrophic loss. But the same can be said about people who were long stocks -- so long as they didn't stop out during the worst few minutes of the flash crash (and weren't forced out by a margin call on an over leveraged position) they survived. (What really wipes out iron condor traders is not a flash crash but an old fashioned crash like what happened in 2008, where the market goes down quickly and stays down.) Some people in the forum insist that the edge lies in selling options, because that is what the big guys do. Actually, many of the big guys buy and sell options. Market makers are as happy to buy from you at the bid as they are to sell to you at the ask, they make their money on the spread and hedge away the directional risk as best they can. Certainly in my case the worst losses have been of two types: First, when I went long on options making a directional bet in too large a size (far bigger positions than I would ever had dared to be short) and the market went the wrong way. Second, when I went short on options in modest size when the market went the wrong way. Sure, most OTM options expire worthless. But that means little if you get wiped out by the few short positions that go up in value by a factor of 20. From what I can see, options in liquid option chains tend to be priced fairly. That means that on the whole there is no edge to be had in buying or selling, and given the bid/ask spreads and commissions that means if you buy or sell at random you will lose money. To make money, whether buying or selling, you have to be able to predict direction or volatility or both significantly better than chance. One thing that can be said is that the selling of well OTM options (including OTM credit spreads) is a type of trading where it is particularly difficult to determine whether a trader really has a positive edge. A trader can have 20 successful put sales in a row, each expiring worthless, only to have the 21st sale cause a loss that erases all the previous gains. Statistically you have to see a much bigger track record than with other types of trading before you can be confident that a good record isn't just a matter of dumb luck.
Maverick74 made some very good points here as far as he didn't try to get a statistical sense of what he points out. "We can solve backwards for fair value at expiration and derive what each call and put should have traded at a specific point of time based on the expiration value of each". No offense, but you gotta be kidding.
Yes, I would agree that you can't use so much margin for an IC that the max loss would wipe out the account. Personally I would never open a position where the max loss would be > 5% of my account. I don't agree that "options in liquid option chains tend to be priced fairly" because I honestly don't believe in the concept of fair value (as defined in this thread). All pricing models are flawed in some way. Using IV as an input to price is what I would call an "elegant flaw", in that all (for European options) or much of (for American options) the variability of the model is neatly consolidated in a single factor. But IV itself has to be flawed, IMO, because it's largely fear-based. Invert an IV graph (available at CBOE website) and superimpose over the underlying price graph, and there's clearly a large negative correlation. For me that's enough proof that IV isn't doing what it claims to be (at least not very well). So any "fair value" derived from a flawed measure like IV will itself be flawed...and therefore not really "fair". It's the whole reason we can buy or sell option volatility for a profit. So suggesting that volatility plays are possible is inherently suggesting that fair value is an illusion. I need to correct my earlier post: Rather than scalping and opening an iron condor at the same time, I meant to suggest opening a long straddle at the same time for black swan protection.