Monday, July 12, 2010

Condor Rolls and Strangle Musings

Last week's sparse posting (ok, non-existent) was due to being away on vacation. Now that I'm back in the saddle things should return to normal. Let's kick things off with my response to a condor question from David:

My position is this: I sell iron condors on SPY, GLD, USO and selected world currencies each month. For risk control, I've used diversification among market strikes, expiry months, as well as the natural protection offered by the condors. Recently I've been wrestling with the trade-offs between iron condors and strangles, and, for me, they come down to the relative merits of the defensive techniques. (I know there are also differences in terms of margin and the emotional comfort from having protective strikes). Most months, I just want to roll when the short strike is threatened rather than buy extra protection. So, with this in mind, my questions are:

1. When is the best time to roll (is it better to roll early- which means it's cheaper but often unnecessary- or is it personal preference, or just too hard to give a simple answer?)
2. Is it easier/harder/the same to roll naked options instead of spreads (lower commissions, less loss from bid/ask spreads, less problems with liquidity).

At this stage I'm leaning towards switching to strangles, selling roughly 1.25 standard deviations out, and rolling the threatened strike when it approaches at-the-money. This would be necessary roughly 50% of the time, and if I sell a few extra contracts when I roll, I can get that side to net out to about zero. I then just book a profit from the other side of the strangle. Any thoughts you have would be greatly appreciated.


Thanks for the questions David. Let's start with the first one. There is no best time to roll in my opinion. No matter which technique you choose (rolling early or later), you will inevitably face scenarios where the adjustment either proved unnecessary or resulted in more losses than had you simply exited the original trade. At the end of the day you've got to choose which technique best fits your personal preference and risk tolerance. Perhaps you've explored this before, but you may consider rolling in stages particularly if you have a larger position on. I've found staggering these adjustments more psychologically appealing versus the all-or-none approach; a nice compromise to those dithering on whether to roll or not. So, if you're short ten put spreads and the stock drops to a pre-determined threshold, rather than rolling all ten spreads, perhaps you roll three or five and then roll the rest later if needed.

From the quality of your question and explanation, I suspect you already know the main dilemmas with rolling. The key at this point is to settle on the one technique you find most appealing and put it to the test.

As for your second question- You've done a commendable job listing the usual suspects when it comes to the differences between the two. In terms of the mechanics of rolling, I can't really think of any additional differences off the top of my head, other than what you've mentioned.

Now, on to the short strangles. They can be quite alluring to those only focused on potential reward. Compared to the condor, you've got more potential reward (higher net credit), less commission, less slippage,and probably easier fills (as you basically outlined previously). However, with the higher reward comes higher risk. The elevated gamma risk is probably the most treacherous. I've seen trader's focusing on short strangles attempt to mitigate the additional gamma risk one of two ways (or both).

1. Use smaller position size. If you're used to selling a ten lot of condors, perhaps you would only sell a five lot of strangles.
2. Use longer dated options. As opposed to selling front month strangles, you may opt for second or third month options. By going out in time you can typically sell options further out-of-the-money (gaining a larger profit zone) while reducing the net gamma of the trade.

One final point- be cautious with increasing your contract size when rolling just to try to get back to even. That's a slippery slope that can turn quite painful if the stock continues to move adversely.


MarkWolfinger said...

Good reply.

Strangles remain too risky for my comfort zone.

Selling extra options - just to do the trade for a cash credit is more than a slippery slope. It's a death wish.

Tyler Craig said...

Thanks Mark. The temptation to sell extra contracts proves too much for some traders, but it always comes back to bite ya at some point.

David said...

Thanks Mark and Tyler.

Mark, I've just started reading your book, "The rookie's guide to options." I've enjoyed the sections on adjustments. I trade second month options, so your chapter on buying pre-insurance was especially helpful.

Tyler, thanks for your excellent reply. I agree with all your points, including the warning on selling extra options to regain the the lost credit. I have one caveat, however: All my trades, whether condors or strangles, are protected first and foremost by position sizing. For my stock trading program, I trade very illiquid microcaps here in Australia, and I know what a gap down can do to one's position. I've experienced "flash crashes" many, many times over the years and understand the risks. For options too, I never rely on adjustments or FOTM strikes as a first line of defense. Within that context, I see Dan Sheridan's approach - rolling with a 50% increase in size - as quite sound, and not a death wish. Of course, he stresses, emphatically, the need to close the trade down and take the now bigger loss if the market threatens the new strike again. This bigger loss needs to be within one's risk parameters.
Thanks again for your excellent thoughts.

Tyler Craig said...

Your Welcome David.

In the end I think adding extra contracts when you roll a short option comes down to whether or not you planned on it from the beginning of your trade. The problem most traders have is they start with a full position and a full plate of risk with there original trade.
Then when the trade moves adversely, rather than sticking to there risk limits they increase there size.

I agree with you, it's perfectly acceptable to add more contracts provided you started with a smaller position not already maxing out your risk limits.

Best of Luck-


Interesting photo.