Is using the price of the ATM straddle a good way to select the short strikes for a long iron condor? That is, go long an ATM straddle, and go short an OTM strangle where each leg is OTM by at most the price of the ATM straddle. It seems that it would be effective, since the short strikes would be based on how much the market is expecting the underlying to move by expiration. Any insight? Thanks!
That position is a short butterfly. A volatility spread. Spread width is a tactical decision and there is no magic formula. While a back test can produced an optimized (curve fitted) width that produces the best risk return based on past stock market data, the actual unfolding of future events will surely be different. Selecting the width is an exercise in optimization as with most spreads. 1) size the fly based on the expected move in volatility and underlying. 2) size the fly based on cost and capital efficiency (payout) 3) size the fly based off something opportunistic such as a favorable bid/offer in an acceptable strike/leg. You can structure the same exposure with a different set of strikes anywhere in the option chain, if your not pegged to doing a specific width or quantity.
In my opinion it's not a bad method of strike selection for an ATM fly. I'll often do the same in my initial analysis of a potential position. But it always ultimately comes down to getting more granular and evaluating my greeks over various scenarios before I decide what to execute in the market.
As far as pure probability goes, the wing width doesn't really matter. So at the end of the day it comes down to your personal style of managing the trades that are open, and what expectation of winners : losers you are comfortable with. That's what determines how wide your wings should be. For me I like to have mostly uneventful winners and manage the losing trades by rolling out in time, so it suits my personal trading style to be at least 1.5 SD out, sometimes as far as 2 SD out. For others who like a tighter risk reward profile, they can be 1 SD out or less. Honestly there is no magic number that's "best." I've been extremely successful trading far OTM on condors, but some other successful traders I know have had a lot of success trading a lot closer to the money. Successful systems can be designed around any number of strike widths. What are YOU comfortable with? Do that, as consistently as you can.
I like high probability spreads, so I'm going to construct iron butterflies using a long ATM straddle, and a short strangle that's OTM by twice the price of the straddle, and short iron condors using a short strangle that's OTM by twice the price of straddle, and a long strangle that's further OTM by one strike.
What makes you think buying the straddle and selling a far OTM strangle is a high probability trade? Just curious.
I think perhaps we are using "high probability" to mean different things. I mean it just in the delta sense, but I get the impression you're using it as to mean the spread itself. Like somehow iron butterflies and Iron Condors are in of themselves high probability. A lot of people new to trading options get sidetracked on focusing on price at expiry. They see the wide price wings and call it a high probability trade. If you're going to be viewing probability in the sense you seem to be using it, you'd be far better off focusing on your next day expected P/L and forget about expiry all together. Those wide wings at expiry are fooling you into thinking it's inherently "high probability" when in fact most Iron Condors and Iron Butterflies, as well as Calendars and Diagonals actually have a much lower next day expected P/L than most people think. If you want help from some of the posters on the forum (entirely your call of course) then perhaps you should post the exact details of the trade you're planning, expiries, strikes, contract number, etc...
Considering that if the wings are 2 SDs away from the body, 95% of the time the underlying's movement will not exceed those boundaries. Although kurtosis may affect this in practice. I got the idea from these articles: http://www.betterbetatrading.com/using-the-straddle-to-pick-your-strikes/ http://www.seeitmarket.com/using-the-straddle-to-set-the-wings-of-the-iron-condor-13349/ The ATM straddle price is the market telling us how large of a move the market is expecting by expiration.
You are basically just buying a straddle (at a slight discount) and capping your upside potential. A straddle will lose 2 times out of 3 (assuming normality), but win big on the 3rd time, evening out the expectation to 0 (assuming fair value). So I disagree with your premise that this is a "high probability" trade. This trade will lose 2/3rds of the time, and when your gamma finally gets a chance to earn big for you it won't because you've sold a strangle against it.
So, I take it that taking the opposite side, i.e sell a straddle and buy a strangle, will win 2/3rds of the time, and lose 1/3rd of the time?