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Month: January 2022

Option Greeks | 5 Visual Guides to Measuring Risk

Posted on by Mike Martin

Last updated on February 9th, 2022 , 10:02 am

Greek Pillars

In the below guides, projectfinance will teach you everything there is to know about the Greeks in options trading!

Option Greeks 101

greeks 2

If you want to trade options, you must know the Greeks. The good news? They can be simplified. Delta · Gamma · Theta · Vega. 

Start Learning!

Option Risk #1: Delta

Delta estimates an option’s price change when the stock price rises or falls by $1. In other words, delta is used to gauge an option’s directional exposure.

Learn Delta!

Option Risk #2: Gamma

An option’s directional exposure changes when the stock price shifts. Gamma estimates how much an option’s delta will change when the stock price rises or falls by $1.

Learn Gamma!

Option Risk #3: Theta

The passage of time is the enemy of option buyers, and the best friend of option sellers. Theta estimates how much an option’s price will fall with each day that passes.

Learn Theta!

Option Risk #4: Vega

greeks

Implied volatility rises and falls with investor sentiment. Vega estimates an option’s price sensitivity relative to changes in implied volatility.

Learn Vega!

Additional Resources

Greeks (finance) – Wikipedia

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tastytrade Trading Platform Tutorial

Posted on by Chris Butler

Last updated on September 4th, 2024 , 12:55 pm

tasty logos

The tastyworks trading platform is what we use to trade stock, options and futures. tastyworks has changed the trading industry by introducing a revolutionary commission structure (close trades for free, $10 commission-cap per option leg, and more), and clean, intuitive trading software.

In this tastyworks tutorial, we’ll cover the basic features and look at how to navigate through the tastyworks platform. More specifically, you’ll learn:

✓ How to add symbols to a watchlist, and one powerful watchlist feature you should know.

✓ Using the ‘Recent Symbols’ tab to quickly check your frequently viewed stocks.

✓ How to search for various stocks using the search box.

✓ How to easily navigate through the trade page, and some awesome features on the trade page that make for a better trading experience.

Back to tastyworks Tutorials
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Volatility Skew in Options Trading (Guide w/ Visuals)

Posted on by Chris Butler

Last updated on March 11th, 2022 , 08:50 am

A stock’s implied volatility represents the overall level of a stock’s option prices. However, each individual option trades with its own implied volatility. By analyzing the prices (implied volatility) of options at various strike prices, we can learn if a particular stock trades with volatility skew, as well as other useful bits of information from that skew.

What is Volatility Skew?

Volatility skew refers to the inequality of the implied volatility of out-of-the-money calls and puts (you can look at in-the-money options, too, but in this post, we’ll keep things simple and focus on out-of-the-money options). For example, on most equities, the volatility skew lies with out-of-the-money puts. That is, the implied volatilities of out-of-the-money puts exceed the implied volatilities of out-of-the-money calls at similar distances from the current stock price.

Downside Volatility Skew

To illustrate downside volatility skew, let’s take a look at an example in the S&P 500 Index (SPX):

volatility skew 2

As we can see, the at-the-money put (2,310) is trading at a premium to the at-the-money call (2,310), and has an implied volatility 1.5% greater than the call. If we look at the put that’s 100 points lower than SPX, we see that the 2,210 put is trading for $7.75 (an implied volatility of 13.7%). On the other hand, if we look at the call that’s 100 points above SPX, we see that the 2,410 call is trading for $1.25 (an implied volatility of 8.2%).

So, since the out-of-the-money put is trading at a higher price (and therefore implied volatility) than the out-of-the-money call that’s the same distance away from SPX, we learn that SPX has downside volatility skew. 

What Causes Downside Volatility Skew?

In most equities, downside volatility skew is present. Why? Well, most people own stocks in their investment portfolios. There are two very simple and common ways to use options in a long stock portfolio:

1. Purchase out-of-the-money puts to hedge off the risk of a decrease in the stock price (a protective put)

2. Sell out-of-the-money calls to create a potential stream of income on shares of stock without adding any risk (a covered call position).

These two activities cause natural buying pressure in put options and selling pressure in call options, which results in more expensive puts and cheaper calls. Of course, not all of the skew comes from long stock investors, there are speculators as well. The bottom line is that in most equities, the risk is perceived to the downside, not the upside. So, you’ll typically observe downside volatility skew in equities.

Upside Volatility Skew

On the other side of the spectrum, we have upside volatility skew, where out-of-the-money call options are more expensive (higher implied volatility) than out-of-the-money puts.

Which products tend to have upside volatility skew? The most obvious products that come to mind are volatility-related underlyings, such as VIX options, VXX, and UVXY. Why? These products have the potential to explode when the stock market falls, which means purchasing call options in these products is similar to buying puts in equities.

As an example, let’s take a look at options in VXX (the Short-Term VIX Futures ETN), a product that attempts to track the performance of S&P 500 implied volatility:

volatility skew 4

In this case, we can see that the price and implied volatility of the out-of-the-money put (15) are far less than the price and implied volatility of the out-of-the-money call (22) that’s the same distance from the current price of VXX. As a result, the volatility skew in VXX is to the upside.

What Does Volatility Skew Tell You?

There are three useful pieces of information that one can glean from an underlying’s volatility skew:

1. The direction in which the risk is perceived to be in the underlying.

2. How implied volatility will change relative to movements in the underlying.

3. The prices of call spreads and put spreads on that underlying.

#1: An Underlying’s Perceived Risk

As discussed earlier, a downside volatility skew indicates that the market is pricing in more risk for decreases in the underlying than increases in the underlying. On the other hand, upside volatility skew indicates more risk being priced into increases in the underlying than decreases in the underlying.

#2: How Implied Volatility Will Change Relative to Underlying Movements

In stocks with downside volatility skew, the implied volatility of the underlying will typically increase if the stock price falls. As an example, let’s look at the relationship between the S&P 500 Index and the VIX Index:

Volatility Skew and Volatility Path: SPX Index vs. VIX Index

The VIX Index quantifies the prices (implied volatility) of near-term options on the S&P 500 Index (SPX). As shown earlier, SPX typically has downside volatility skew. In the chart above, we can see that when SPX falls, SPX implied volatility (the VIX) tends to increase.

What about on an underlying with upside volatility skew? To illustrate changes in implied volatility on an underlying with upside volatility skew, let’s examine the relationship between changes in the VIX Index and the implied volatility of VIX options (quantified by VVIX):

Volatility Skew and Volatility Path: VIX vs. VVIX

As we can see here, as the VIX Index increase, so do the implied volatilities of VIX options (VVIX).

So, volatility skew can tell you how the implied volatility of the underlying’s options are expected to change relative to changes in the underlying price.

Why does this matter? Well, if you’re trading positive delta, positive vega strategies on a product with upside volatility skew, you’ll know that an increase in the underlying should lead to profits from changes in direction and volatility.

On the other hand, if you’re trading negative delta, negative vega strategies on a product with downside volatility skew, and that underlying falls in price, you can expect some of your directional profits to be offset by an increase in volatility.

#3: The Prices of Call Spreads and Put Spreads

The third helpful piece of information that the skew of an underlying’s option volatility can tell you is the price of call and put spreads (in a broad sense):

➥In products with upside volatility skew, call spreads trade cheap and put spreads trade expensive.
 
➥In products with downside volatility skew, put spreads trade cheap and call spreads trade expensive.

Let’s take a look at some examples:

As we know, SPX volatility is skewed to the downside. If we were to buy the put spread in this example, we’d be buying a put with 10% IV and selling a put with 11.7% IV. The higher IV we’re selling helps reduce the cost of the spread price.

If we look at the call spread from the long side, we’re buying an 8.5% IV option and selling a 7.7% IV option. Since we’re selling an option with a lower IV than the option we’re buying, the spread’s price is more expensive.

In both cases, the spreads are $50 wide and the long options are at-the-money. However, the downside skew results in a cheaper put spread and a more expensive call spread. Consequently, put spread buyers and call spread sellers benefit, while put spread sellers and call spread buyers have less advantageous risk/reward setups.

Now, let’s look at the prices of spreads on an underlying with volatility skewed to the upside. In this example, we’ll use VXX:

In the case of these VXX spreads, we can see that the 18/16 put spread is trading for $0.87, while the 19/21 call spread is trading for $0.43. This can be explained by the fact that we’re buying a 55.4% IV put, while selling a 46.2% IV put, resulting in an expensive spread.

On the other hand, the call spread is much cheaper since we’re buying a 58.3% IV option and selling a 66.2% IV option. Now, while VXX is slightly closer to the put spread, we’d still see the same result if VXX were $18.50 (right in the middle of both spreads).

So, in underlyings with upside volatility skew, call spreads will trade cheaper and put spreads will trade more expensive, which is beneficial for call spread buyers and put spread sellers. In the case of call spread sellers and put spread buyers, the risk/reward will be less favorable.

Summary

Well, that wraps up the post on volatility and skew! I hope you’ve learned something that can help you in your trading.

To summarize what this post has covered, here are the key points to remember:

  • Individual options trade with their own levels of implied volatility based on their respective prices.
  • In products where out-of-the-money puts are more expensive than out-of-the-money calls, volatility is said to be skewed to the downside.
  • In products where out-of-the-money calls are more expensive than out-of-the-money puts, volatility is skewed to the upside.
  • An underlying’s volatility skew can provide you with three helpful pieces of information: 1. Where the risk is perceived to be 2. How implied volatility is likely to change relative to the underlying’s movements 3. Which spreads will be more expensive, and which will be cheaper.

Next Lesson

Additional Resources

What Does Implied Volatility Skew Measure? – Derivatives Journal

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Top 3 Options Trading Strategies for Beginners

Posted on by Chris Butler

Last updated on February 17th, 2022 , 05:58 am

With so many options trading strategies available, where might beginners want to start? In this post, we’ll cover our picks for the top 3 options trading strategies for beginners.

Strategy #1: Selling Put Spreads

Our first options strategy for beginners is selling put spreads (short put spreads), as the strategy has bullish market exposure (which most investors want), has limited loss potential, and can be implemented in small trading accounts.

Setting Up the Trade

Here’s how a short put spread is constructed:

1. Sell a put option.

2. Buy another put option at a lower strike price than the sold put (same quantity and expiration cycle).

The position will be entered for a credit, which means you’ll be collecting money from selling the spread. This is because the put you sell will be more expensive than the put you buy.

How the Trade Makes Money

In the simplest explanation, a short put spread makes money as long as the stock price remains above the strike price of the short put as time passes:

 

Options Trading Strategies for Beginners: Selling a put spread

As we can see, there’s a point in time where the stock price is below its price from the entry point of the short put spread. But, since time has passed, the put spread has lost value and is therefore profitable.

Short put spreads lose money when the stock price falls, but have limited loss potential. The maximum loss occurs when the stock price is below the purchased put’s strike price at expiration.

Watch me set up a real short put spread in Netflix (NFLX).

Strategy #2: Selling Iron Condors

Selling an iron condor (short iron condor) is a great options trading strategy for beginners because the position is non-directional, providing profit potential in range-bound stocks. The trade can be as conservative or aggressive as you’d like.

Setting Up the Trade

Here’s how to set up a short iron condor:

1. Sell a put spread (sell a put, buy another put at a lower strike price).

2. Sell a call spread (sell a call option, buy another call at a higher strike price).

The position will be entered for a credit, since the puts and calls you sell will be more expensive than the puts and calls you purchase.

How the Trade Makes Money

Short iron condor positions make money when the stock price remains between the strike prices of the call and put that are sold:

 

Options Trading Strategies for Beginners: Selling an iron condor

You’ll lose money when selling iron condors if the stock price moves too much in either direction. The maximum loss potential occurs when the stock price is above the purchased call option’s strike price or below the purchased put option’s strike price at expiration.

Watch me set up a real iron condor position in the Russell 2000 ETF (IWM).

 

Strategy #3: Covered Calls

Our third options strategy for beginners is the covered call, which is great strategy to start with because those with stock investments can easily implement the strategy.

Covered calls require the ownership of 100 shares of stock, so the strategy requires more money to get started, making it less accessible to those with small trading accounts. However, for those with at least 100 shares of stock in their investment portfolios, covered calls can provide downside protection if the stock price falls, and profit potential when the stock remains flat.

Setting Up the Trade

Covered calls are structured with the following positions:

1. Buy 100 shares of stock.

2. Sell 1 call option against the shares (typically expiring in 30-60 days).

How the Trade Makes Money

Covered call positions make money as long as the stock price doesn’t fall substantially:

 

Options Trading Strategies for Beginners: Covered Calls

As we can see, the covered call position outperforms the stock position over the entire period, as the premium received from selling the call option against shares provides downside protection when the shares fall. Additionally, when the share price remains flat or increases gradually over time, the covered call position will also outperform.

The only time a covered call position will underperform a long stock position is when the share price increases substantially.

Watch me set up a real covered call position in the Brazil ETF (EWZ).

Closing Thoughts

When starting out as an options trader, the number of strategies that can be used may be intimidating, especially the more complex strategies.

In my opinion, the simplest strategies are the most effective for options traders of all levels. The three strategies discussed in this post are my picks for the best options trading strategies for beginners to start with.

Lastly, please be sure to check out the complete strategy guides for the listed strategies to fully understand how each strategy works and the risks involved.

Thanks for reading!

Next Lesson

Additional Resources

4 Best Options Trading Strategies in 2022 • Benzinga

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3 Best Credit Spread for Income Options Strategies

Posted on by Chris Butler

Last updated on April 25th, 2022 , 09:04 am

Top 3 Option Credit Spreads

Credit Spread Definition: A credit spread is a derivative strategy that involves the simultaneous purchase and sale of options contracts of the same class (puts or calls) on the same underlying stock or ETF. In order to be a “credit” spread, the net position effect will be a credit. “Debit spreads” result in a net debit. 

Credit spreads are very common among traders who trade options for income, as credit spread option strategies can profit in more than one way. Additionally, credit spreads have limited loss potential, which means losing trades won’t break the bank if sized properly.

Credit spreads profit from time decay or theta. Over time, options tend to go down in value. Being a net seller of options helps to capitalize on this.  

In this post, we’ll cover our picks for the top 3 credit spread option strategies for generating income.

Care to watch the video instead? Check it out below!

What is a Credit Spread?

Before getting to the strategies, let’s cover what a credit spread is.

A credit spread option strategy collects premium when the trade is entered. In other words, the options that are sold bring in more premium than what’s paid out for the options that are purchased.

For example, if we sell a put option for $3.00 and buy another put option at a different strike price for $2.00, we’ll be collecting $3.00 from the option we sold and paying out $2.00 for the option we bought.

The net result is that the trade is entered for a $1.00 “credit” since we’re collecting more premium than we’re paying out.

Let’s look at a real example of a put spread that is entered for a net credit:

put credit spread strike prices

In this example, if we sell the 142 put for $5.96 and buy the 135 put for $2.56, we collect a net credit of:

$5.96 Collected – $2.56 Paid = $3.40 Credit

The trade in this example is sometimes called a “put credit spread,” but is also referred to as a “short put spread” or “bull put spread.”

The Top 3 Credit Spread Option Strategies

Now that we’ve covered what a credit spread is, let’s get to the fun stuff!

Option Strategy #1: Put Credit Spread

The first options strategy on our list is the put credit spread, which is constructed by selling a put option and purchasing another put option at a lower strike price. This strategy is both market neutral and bullish. 

Both options for the put credit spread should use the same quantity and expiration cycle.

The following table summarizes the key characteristics of the put credit spread strategy:

options table

Consider the following trade example:

put strike

Here are the trade’s characteristics:

trade

As long as the stock price remains above $97.50 as time passes, the position will start to see profits from the decay of the options in the spread. If the stock price is above $97.50 at the expiration date, the position will be profitable. If the stock price is above $100 at expiration, the profit will be $250 per put credit spread.

The worst-case scenario is that the stock plummets through the put spread. If the stock price is below the long put strike at expiration, the put credit spread will realize the maximum loss.

Put Credit Spread Example Trade

Let’s take a look at a put credit spread example trade so you can see how the strategy performs as the stock price changes. In this example, the 700 put is sold and the 640 put is purchased for a net premium of $18.05.

As a result, the maximum profit potential is $1,805 and the maximum loss potential is $4,195. Let’s see how the trade performed over time:

put credit spread example

 

As we can see, the spread does well when the stock price rises or remains flat over time, and the spread loses money when the stock price falls quickly. In this case, the spread was maximally profitable at expiration, as both puts expired worthless.

So, the put credit spread is a great trade to use when you believe a stock will remain above a certain price, but you want limited loss potential if you’re wrong.

Option Strategy #2: Call Credit Spread

The second credit spread option strategy on our list is the call credit spread, which is constructed by selling a call option and purchasing another call option at a higher strike price.  This strategy is both market neutral and bearish. Both options use the same quantity and expiration cycle.

Here are the call credit spread’s trade characteristics:

options table 5

Let’s take a look at an example trade:

options table 7

Here are the characteristics of this particular call credit spread:

table 8

In this case, the call credit spread will be profitable as long as the underlying asset (stock price) remains below the breakeven price of $128 as time passes. If the stock price is below $128 at expiration, the spread will be profitable. If the stock price is below $125 (the short call’s strike price) at expiration, the spread will expire worthless and the spread seller will keep all of the premium.

If the stock price rises substantially and is above the long call strike at expiration, the call credit spread will realize the maximum loss potential.

Call Credit Spread Example Trade

Let’s look at a successful call credit spread trade so that you can see how the spread works in relation to changes in the stock price.

In this example, we’ll look at a call credit spread in which the 120 call is sold and the 125 call is purchased for a net credit of $1.93. In this case, the maximum profit potential is $193 and the maximum loss potential is $307:

selling a call spread

As we can see, the strategy starts losing money when the stock price increases after the spread is sold. However, as long as the stock price is below the breakeven price of the spread as time passes, the position will start to see profits from the decay of the options. 

As a result, the call credit spread is a great strategy to use when you believe a stock will remain below a certain price, but want limited loss potential if you’re wrong.

Like put credit spreads, call credit spreads are impacted negatively by rises in implied volatility.  

Option Strategy #3: The Iron Condor

The third and final credit spread option strategy we’ll discuss is the combination of the first two strategies!

The short iron condor option strategy consists of a call credit spread and a put credit spread. As a result, the position is directionally neutral, and profits when the stock price remains between the two spreads as time passes.

Here are the key characteristics of the iron condor strategy:

iron condor characteristics

Here’s an iron condor example trade:

iron condor 9

Based on the strikes, entry credit, and strike widths, here are the trade’s profit/loss characteristics:

iron condor 19

In this case, the 110 call is sold and the 90 put is sold. As a result, the trade’s maximum profit zone is between $90 and $110 at expiration. However, as long as the stock price remains between the breakeven prices of $87.36 and $112.64 as time passes, the spread will begin to see profits from the decay of the options.

The maximum loss potential is $236 per iron condor, which occurs when the stock price is beyond the long call strike price or long put strike price at expiration.

Iron Condor Example Trade

Let’s finish by looking at a successful iron condor trade so you can see how the strategy performs relative to changes in the stock price.

In this particular example, we’ll look at an iron condor comprised of a 216/209 put credit spread and a 230/234 call credit spread. The net credit in this case is $1.18.

Here’s how the trade performed:

iron condor chart

In the beginning of the period, the stock price starts to rise towards the short call strike price of $230, and the trade starts to lose money. However, the stock comes back down and trades between the short strikes as time passes, leading to steady profits for the iron condor seller.

Summary of Main Concepts

We’ve covered a lot of ground here, so here are the key points to remember from this post:

•Credit spread option strategies are strategies that collect more premium from the sold options than what’s paid out for any purchased options.

•Credit spreads are very common among traders who trade options for income, as credit spread strategies can profit in more than one way (making them high probability trades), and have limited loss potential.

•Put credit spreads profit when the stock price remains above the spread’s breakeven price as time passes, and lose money if the stock price falls quickly and significantly.

•Call credit spreads profit when the stock price remains below the short call strike price as time passes, and lose money when the stock price increases quickly and significantly.

•The short iron condor option strategy consists of a call credit spread and a put credit spread. As a result, the position is a neutral strategy that profits when the stock price remains between the two spreads, but loses money when the stock price moves substantially in either direction.

Note! Trading options (particularly short options) come with significant risks. In order to better understand the risks of standardized options, read this guide from the OCC.

Credit Spreads FAQs

Credit spreads profit when the spread narrows. Over time, options tend to decay in value. This decay in value helps credit spreads become profitable. 

On a credit spread, the maximum profit is limited to the credit received. 

An example of a call credit spread can be seen in AAPL. If a trader believes AAPL will stay below $160/share, that trader could sell a 165 call and buy a 170 call for a net credit of $1. If AAPL is trading under 165 at the time these options expire, that trader will realize a profit of $1, or $100. 

Next Lesson

Additional Resources

4 Keys To Placing Your First Credit Spread | tastytrade

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Iron Condors vs. Strangles: Profit/Loss Analysis

Posted on by Chris Butler

Last updated on February 10th, 2022 , 07:22 pm

Short iron condors and short strangles are very common strategies among market-neutral traders, as both strategies profit from range-bound stock price movements.

However, iron condors have less risk (and therefore less reward), while strangles have more risk and more reward.

How much reward do you give up when selling an iron condor instead of a short strangle?

In this post, we’ll compare iron condors vs. strangles in regards to historical profits and losses in the S&P 500.

Study Methodology: 16-Delta Short Options

For our iron condors vs. strangles study, we used the following methodology to maximize the number of trades tested:

Underlying: S&P 500 ETF (SPY) from 2007 to Present

Entry Dates: Every Trading Day

Target Time to Expiration: 60 Days

Trade #1: Short 16-Delta Strangle (Short 16-Delta Call; Short 16-Delta Put)

Trade #2: Short Iron Condor (16-Delta Short Calls & Puts; 5-Delta Long Calls & Puts)

Trade #3: Short Iron Condor (16-Delta Short Calls & Puts; 10-Delta Long Calls & Puts)

We entered each of the above positions on every trading day and held the positions to expiration. Of course, a new trade wouldn’t be entered every single trading day, but by conducting our study this way, we remove the sensitivity of the start date from the results.

Finally, we summed the cumulative profit/loss of each approach to visualize the performance.

Here were the results:

 

Iron Condors vs. Strangles: SPY 16-Delta

To clarify, a “16-Delta / 5-Delta Iron Condor” indicates 16-delta short calls and puts with 5-delta long calls and puts.

As we might expect, the short strangles performed the best. Since the iron condor positions purchase out-of-the-money options against the short options, the net premium received is lower, which reduces profit potential.

At the same time, the short strangle approach had the most substantial drawdown in 2008, as strangles have no protection.

Furthermore, the strategy with the least volatility and profitability was the iron condor approach that purchased 10-delta options agains the 16-delta short options. Understandably, this approach had the “smoothest” path, as the strategy has the least profit and loss potential because the long options were much closer to the short options.

Iron Condors vs. Strangles By the Numbers

Let’s take a look at some metrics related to each approach:

 

iron condor vs strangle

By analyzing these metrics, we confirm our previous statements about the average profitability of each approach.

Interestingly, the 16 / 5 iron condor variation did not suffer too significant of a win rate or average P/L decrease, but the 10th percentile P/L was substantially better. In other words, limiting the loss potential on a short strangle by purchasing 5-delta calls and puts will reduce profit potential and the rate of success, but will help avoid catastrophic losses that strangles will suffer from during “black swan” market events.

Let’s do the same test on 30-delta iron condors and strangles.

Study Methodology: 30-Delta Short Options

Underlying: S&P 500 ETF (SPY) from 2007 to Present

Entry Dates: Every Trading Day

Target Time to Expiration: 60 Days

Trade #1: Short 30-Delta Strangle (Short 30-Delta Call; Short 30-Delta Put)

Trade #2: Short Iron Condor (30-Delta Short Calls & Puts; 16-Delta Long Calls & Puts)

Trade #3: Short Iron Condor (30-Delta Short Calls & Puts; 10-Delta Long Calls & Puts)

Like the previous test, all trades were held to expiration, and the expiration P/L for each trade was summed over the test period.

Here were the results:

Iron Condors vs. Strangles: SPY 30-Delta

Consistent with the previous iron condor and strangle variations, the strangles had the largest drawdowns and the highest overall P/L. Additionally, the 30 / 16 iron condor variation was much less risky, and therefore less rewarding than the 30 / 10 iron condor.

Iron Condors vs. Strangles By the Numbers

Here are the profitability metrics related to each approach:

condor vs strangle

Consistent with previous findings, purchasing closer options against the short strangles (therefore reducing the maximum profit potential and risk relative to the short strangle) reduced the percentage of profitable trades, and the average profitability.

However, compared to the short strangles, the iron condor approaches had notably better loss metrics.

Implied Volatility at Entry

How did all of these approaches perform when implied volatility was low or high at the time of trade entry?

To run this test, we equally divided all of the trades into two buckets based on the VIX Index at entry. Our threshold for the dividing line between high and low IV is 17.5, as that is the median VIX closing price over the period.

To run this test, we equally divided all of the trades into two buckets based on the VIX Index at entry. Our threshold for the dividing line between high and low IV is 17.5, as that is the median VIX closing price over the period.

Win Rates: High & Low IV

Let’s start by analyzing any changes in the percentage of profitable trades in the high vs. low IV entries:

Interestingly, the strategies with further short options (16-delta) realized a slightly higher percentage of profitable trades in the “low” implied volatility entries, while the 30-delta strategies didn’t see changes.

Average Profit/Loss: High & Low IV

Let’s look at the average P/L per trade for each approach in the high and low implied volatility entries.

We’ll start with the 16-delta iron condors and strangles:

 

Iron Condors vs. Strangles: Average P/L 16-Delta

And now the 30-delta iron condors and strangles:

 

Iron Condors vs. Strangles: Average P/L 30-Delta

In both the 16-delta and 30-delta short strangle setups, the trades experienced higher average P/L with the lower implied volatility entries.

In regards to the 16-delta iron condors, the results were somewhat similar. However, the 30-delta iron condor setups experienced higher average P/L with the higher implied volatility entries.

To understand where the differences are coming from, let’s analyze the worst-case losses for each approach.

10th Percentile P/L: High & Low IV

The 10th percentile P/L tells us the P/L figure that 90% of trades exceeded. In other words, only 10% of trades had a P/L lower than the 10th percentile P/L, which gives us an idea of the “outlier” returns for each strategy.

Let’s start with the 16-delta approaches:

 

Iron Condors vs. Strangles: 10th Percentile P/L

As we can see, the short strangles experienced substantially larger “worst-case” losses in the high implied volatility entries. The difference was less substantial for the iron condor setups.

Let’s see if we find the same relationship in the 30-delta setups:

 

Iron Condors vs. Strangles: 10th Percentile P/L

Consistent with previous findings, the short strangles entered in lower implied volatility environments realized substantially lower “worst-case” drawdowns than the high IV short strangles.

The data from the loss metrics suggest that the improvement in the average P/L for the lower implied volatility entries (regarding the short strangles in particular) stems from less severe drawdowns.

Summary of Main Concepts

Here are the primary findings from this iron condor vs. strangle analysis:

 

•As we’d expect, the average profitability of iron condors tends to be lower than a short strangle approach over time, as buying protection in the form of long calls and puts against short strangles reduces the profit potential.

 

•However, by limiting the loss potential (selling an iron condor instead of a strangle), the drawdowns are much less severe, which can improve average profitability over time.

 

•When filtering the trades for high vs. low implied volatility entries, we saw a substantial improvement in the average profitability of the 16-delta and 30-delta short strangles that were sold in the lower implied volatility environment.

 

•When filtering the iron condor trades for low and high IV entries, the differences were much more muted compared to the differences observed in the short strangles.

 

•The findings do not “crown” any of the studied strategies as the definite winners, but we do learn that selling uncovered options in high implied volatility environments can be very risky, as high implied volatility typically occurs when market fluctuations are substantial (high levels of historical volatility).

 

•In the same vein, traders should be very careful when selling uncovered options in lower implied volatility environments, as the transition into a high implied volatility environment with substantial realized market movements can lead to significant drawdowns.

Next Lesson

Additional Resources

Iron Condor vs Strangles – Options Jive | tastytrade

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9 Common Options Trading Mistakes – Don’t Do This!

Posted on by Mike Martin

Last updated on February 10th, 2022 , 07:24 pm

There are many options trading mistakes that new traders make, and that’s entirely ok! Part of the process when learning anything in life is through mistakes.

With that said, it’s always good to be aware of common “land mines,” so you can make an attempt to avoid them, and ultimately protect your hard-earned money.

In this post, we’ll cover our picks for the top nine options trading mistakes that most new traders will make at some point.

1. No Exit Plan

It’s crucial to know exactly when you will close a trade, profitable or unprofitable.

Perhaps the most important thing to know is when you’ll close losing trades that carry a lot of risk, such as being short naked options. When trading limited-risk spreads, it’s ok to be accepting of the maximum loss potential of that position, so long as you’ve sized the position accordingly.

2. Trading Too Many Positions

Some may not agree that this is a mistake, but the fact of the matter is that it’s more difficult to keep track of your portfolio when you trade more and more positions.

Additionally, it’s likely that your positions are highly correlated, which means you’re really trading similar positions in different stocks. It’s ok to have multiple positions in different stocks, just be aware that they may react the same way when markets get volatile.

Lastly, during extremely volatile trading sessions, getting filled on your trades is next to impossible. If you have on 20 positions, good luck making timely adjustments in those positions at decent prices.

The only caveat to this particular point is that if you’re a brand new trader, you’ll benefit from more positions because you’ll gain more experience in regards to strategies and trade outcomes.

3. Trading Illiquid Products

Getting trapped in an option position that will be impossible to close can be costly. If you enter a position in options that are illiquid (very little to no volume or open interest), then it’s likely you’ll be exiting that position at a very unfavorable price

At the very minimum, trade options with open interest in the 1,000s and volume in the 100s (though volume will be lower early in the trading session).

4. Trying to Fix Entirely Broken Trades

Trying to fix broken trades is another common options trading mistake. At some point, the trade is no longer worth your commissions, and you’d be better off taking the loss and allocating your capital elsewhere.

There will always be another trading opportunity, so don’t waste your time trying to repair something that has a very low probability of getting fixed.

5. Taking Profits Too Soon

While taking profits on a trade is not a bad thing, creating a strategy that revolves around taking tiny profits may seem logical at first, as your probability of success will be incredibly high (90% or higher in some cases).

However, you must keep in mind that such approaches require you to have a very high success rate, as the inevitable losses will likely consume a good portion of your profits from winning trades.

Furthermore, commissions will eat into your returns when you take small profits, so try and let your profits run a little longer. A recent iron condor study we conducted showed that the 25% profit target combinations resulted in the lowest profit expectancy over time (sometimes negative when adjusting for estimated commissions), despite having success rates over 90%.

Of course, the strategy you implement should also be considered. For example, long calendar spreads are one example of trades that are typically closed at profit targets of 10-20%, as they don’t often reach profit levels of 50-100% on the debit paid. Another strategy in which profits are typically taken sooner is the short straddle, as the probability of reaching 50-100% of the profit potential is typically low.

6. Trading Too Big

This list of trading mistakes wouldn’t be complete without mentioning trade size.

Trading involves losses, and you can’t allow one losing trade to take you out. As a general guideline, you shouldn’t risk more than 2.5% of your portfolio in a short-term option position. Of course, this may vary based on risk tolerance, and it will be harder to comply with in smaller trading accounts, but don’t put 50% of your portfolio into a single option position!

If you’re trading longer-term options as a way to get leveraged exposure (such as buying 1-2 year call options on an equity), you may be able to get away with increasing your allocation.

7. Not Analyzing Implied Volatility

Implied volatility can be used to assess how “expensive” or “cheap” option prices currently are.

You should always analyze implied volatility before entering a trade to ensure that you won’t be battling changes in IV if your stock price outlook turns out to be correct.

One example of this would be buying call options after a severe market downturn. Typically, when stocks fall considerably, option prices get bid up and implied volatility rises. If you buy a call option in anticipation of a market increase, you might not make money if the market doesn’t increase enough to offset the inevitable decrease in implied volatility.

8. Not Checking for Market Catalysts

It’s always a good idea to make sure you’re aware of any upcoming events that could cause your stock to shift substantially in either direction.

More specifically, if a stock’s implied volatility has been rising and seems lofty, it’s usually for a good reason.

In regards to individual equities, earnings announcements will often cause a stock’s option prices to decay more slowly, leading to an increase in implied volatility as the earnings date approaches.

After the market catalyst passes and the uncertainty dissipates, option prices will change accordingly, but the stock/market may change significantly in one direction.

Be aware of such events before entering trades.

9. Trading Complex Products Without Researching Them First

There are some complicated products out there, particularly in the leveraged ETF and volatility space. Don’t worry! It takes some time to grasp how some of these products work. Just be sure that you read about them before trading them, as it will help avoid unexpected outcomes.

As an example, don’t sell that put spread in VXX until you understand what drives its movements!

That wraps up our picks for common options trading mistakes (in our opinion)!

Next Lesson

Supplemental Reading

Five Mistakes to Avoid When Trading Options – Options Playbook

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Short Strangle Adjustments: Rolling the Calls

Posted on by Chris Butler

Last updated on February 10th, 2022 , 07:27 pm

Short strangle chart

Sometimes, you’ll need to make an adjustment to your option positions when the stock price moves against you.

In this post, we’re going to discuss the short strangle adjustment strategy of “rolling down” the short call options.

What is “Rolling an Option?”

Rolling an option is the process of closing an existing option and opening a new option at a different strike price or in a different expiration cycle.

Today, we’ll focus on “rolling down” the short call option in a short strangle position, which refers to buying back your current call option and “rolling it down” by selling a new call at a lower strike price.

When Do You Roll Down the Call?

Let’s talk about when a trader would most likely roll down the short call.

Consider the following visual:

 

Short Strangle Adjustments: Rolling Down the Short Calls

When the stock price falls quickly and approaches the short put’s strike price, the trade becomes directionally bullish. Why? Since short strangles have negative gamma, the position’s delta grows positive as the stock price trends towards the short put.

The result?

The trader starts to lose more and more money as the stock price continues to fall.

One potential short strangle adjustment a trader can make in this scenario is to roll down the short call options:

 

Short Strangle Adjustments: Rolling Down the Short Calls

To roll down the short call option, a trader simply has to buy back their current short call option and sell a new call option at a lower strike price (in the same expiration cycle).

What Does Rolling Down the Calls Accomplish?

By rolling down the short call option in a short strangle position, a trader accomplishes two things:

1. Collect more option premium since the new call you sell is more expensive than the call you buy back.

2. Your position’s delta becomes more neutral, which means you’ll lose less money if the stock price continues to decrease.

Let’s cover each of these points in more depth.

#1: Collect More Option Premium

Consider a trader who is short the 250 call in their short strangle position but rolls down to the 240 call:

delta options pic

Since the trader buys back the 250 call for $0.11 and sells the 240 call for $2.50, they collect more option premium from the roll.

Premium Collected:

$2.50 Collected – $0.11 Paid Out = +$2.39

In dollar terms, the additional $2.39 in premium means the maximum profit on the trade increases by $239 per short strangle, and the lower breakeven point is also pushed $2.39 lower.

As a result, the stock price can fall even further than it could before and the trade can still be profitable.

#2: Neutralize Your Position Delta

By rolling down the call option, the position also becomes more neutral.

Let’s say that at the time of the roll, the short strangle’s position delta is +45 (the trader is expected to lose $45 from a $1 decrease in the stock price, and make $45 from a $1 increase in the stock price).

Here’s how the position delta would change after the rolling adjustment from the previous example:

delta

Old Call Position Delta: -5 (+0.05 Call Delta x $100 Option Multiplier x -1 Contract)

New Call Position Delta: -47 (+0.47 Call Delta x $100 Option Multiplier x -1 Contract)

Change in Position Delta: -42

New Short Strangle Position Delta: +45 – 42 = +3

After rolling down the short call, the position delta becomes more neutral.

With a new position delta of +3, the trader is only expected to lose $3 if the stock price decreases by $1, as opposed to a $45 loss before the roll.

Of course, this also means the trader is only expected to gain $3 from a $1 increase in the share price, as opposed to a $45 gain before the short strangle adjustment.

With that said, it’s clear that there are some downsides to rolling down the short call.

What’s the Risk of Rolling Down the Short Calls?

While rolling down the short call increases the option premium received (higher maximum profit potential) and neutralizes your position delta, there are some downsides:

1. You decrease the range of maximum profitability, as your new call’s strike price is much closer to the short put’s strike price (and the maximum profit zone for a short strangle is the area in-between the short call and short put strike prices).

2. The position delta gets neutralized, which means a subsequent increase in the stock price results in less profits than if the rolling adjustment wasn’t made. Additionally, the position delta will start to grow negative if the stock price continues to increase after rolling down the short call (resulting in losses if the stock keeps rising).

As with any trade adjustment, there are benefits and downsides. However, if you’re looking for a short strangle adjustment to help reduce the directional risk after a decrease in the stock price, then rolling down the short call is one option available to you.

Concept Checks

➥When selling strangles, if the share price falls towards your short put, you can adjust the position by “rolling down” the short call (buy back the old short call, sell a new call at a lower strike price).

➥By rolling down the short call, you increase the amount of option premium collected and neutralize your position delta (resulting in a lower breakeven point on the downside and less notable losses if the stock price continues to fall).

➥The downside of rolling is that you decrease the range of maximum profitability since your new call strike is closer to the short put’s strike price. Additionally, you’ll make less money (or potentially lose money) from reversals in the stock price after rolling.

Next Lesson

Additional Resources

Get a Strong Hold On Profit With Strangles – Investopedia

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2 Conservative Option Strategies for 2022

Posted on by Chris Butler

Last updated on February 10th, 2022 , 07:28 pm

Covered Call P&L Graph

One common criticism of options trading is that the strategies are extremely risky.

While some strategies carry massive loss potential, there are two conservative option strategies that are always less risky than buying 100 shares of stock.

Option Strategies Less Risky Than Buying Stock

The two conservative option strategies that are less risky than buying 100 shares of stock are:

1. Covered Calls

2. Cash-Secured Puts

Let’s walk through each of these simple strategies.

Simple Covered Call Explanation

While we won’t get into the specific details of each strategy, we’ll cover a simple breakdown of each.

The covered call strategy consists of selling a call option against 100 shares of stock that you own.

By selling the call option, you collect “option premium,” which you keep if the stock price is below the call’s strike price at expiration.

For example, if you buy 100 shares of stock for $100 per share and sell a 110 call against it for $5.00, you collect $500 in option premium (since an option’s contract multiplier is $100, and $5.00 x $100 = $500).

What if the company goes out of business and the stock price goes to $0? Let’s compare the long stock and covered call strategies side-by-side:

covered call vs long stock

If the stock price goes to $0, the loss on a long stock position of 100 shares purchased at $100 per share would be $10,000: $100 Loss Per Share x 100 Shares = -$10,000.

However, if the stock price goes to $0, the 110 call option would also expire worthless, which means the covered call trader would have a $500 profit on the call they sold (since it was sold for $500 in premium and is now worth $0).

As a result, their net loss is $9,500: $100 Loss Per Share x 100 Shares + $500 Profit on Call = -$9,500.

In fact, at any price below $110 at the expiration date of the call option, the covered call position will outperform the long stock position by the amount of the call premium ($500 in this case).

Covered Calls vs. Long Stock

By selling a call option against 100 shares of stock, the premium collected reduces the maximum loss potential of the position.

At any price below the call’s strike price at expiration, the covered call position will outperform a long stock position by the amount of the call premium collected.

Simple Cash-Secured Put Explanation

The second conservative option strategy less risky than buying stock is the cash-secured put.

A cash-secured put refers to a short put option (a put is sold) that is fully secured by cash. For example, if you sell a put option with a strike price of $50, the maximum loss on that put option is $5,000, which means you’d need to have $5,000 in available option buying power to sell that put.

However, if you collect $2.50 ($250 in option premium) for selling that put, then you’d only need $4,750 in available option buying power to sell that put.

Let’s compare the long stock position to the cash-secured put position:

stock vs secured put

When comparing purchasing 100 shares of stock for $50 per share to selling a 50 put for $2.50, the cash-secured put position has less risk.

If the stock price goes to $0, the loss on the long stock position is $5,000: $50 Loss Per Share x 100 Shares = -$5,000.

At the same time, a put option with a strike price of $50 would be worth $50 if the stock fell to $0. However, since the put was sold for $2.50, the loss would only be $4,750: $47.50 Loss on the Put x $100 Option Contract Multiplier = -$4,750.

Cash-Secured Puts vs. Long Stock

By selling a cash-secured put option, the premium collected reduces the maximum loss potential on the position (compared to buying 100 shares of stock at that put’s strike price).

The Downsides of Covered Calls & Cash-Secured Puts

Unfortunately, it’s not all great news in regards to covered calls and cash-secured puts when compared to buying 100 shares of stock.

Unlike long stock positions, covered calls and cash-secured puts have limited profit potential, while owning shares of stock is an unlimited profit potential position (theoretically).

However, if the stock price does not increase substantially, covered calls and cash-secured put positions will outperform long stock positions, as they can profit when the stock price doesn’t increase, or even decreases slightly.

Concept Checks

Here are the essential points to remember about these two conservative option strategies:

➥ Covered calls and cash-secured puts both carry less loss potential compared to simply buying 100 shares of stock.

➥ However, both of these option strategies have limited profit potential, which means they will underperform just owning 100 shares of stock if the stock price surges.

Additional Resources

Conservative Option Strategies For 2022 and Beyond –  OptionTradingIQ

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Why Your Percentage of Profitable Trades Means Nothing

Posted on by Chris Butler

Last updated on February 10th, 2022 , 07:29 pm

One of the appeals of options trading is that you can trade strategies with high success rates (90% of higher in some cases).

This is especially true when you sell options and take profits at small profit percentages. In fact, one of our iron condor research reports found that managing iron condors at 25% of the maximum profit potential realized a 93% success rate. Unfortunately, that high success rate was met with the lowest profit expectancy of all the management approaches.

In this post, we’ll discuss why win rates alone mean nothing.

Percentage of Profitable Trades Comparison

Let’s look at three hypothetical traders and their percentage of profitable trades over the past year:

percent profitable trades

Based on these profit percentages, which trader did the best?

It might be easy to say that Trader C performed the best, but we actually have no idea how any of the traders performed. We need two other pieces of information to find the answer.

Success Rates, Average Profits, & Average Losses

Without knowing the average profits and average losses of each trader’s positions, the percentage of profitable trades means nothing and doesn’t tell us anything about the success of each trader’s approach.

Let’s look at the same table from the previous section with the added information of average profits and losses:

comparing option traders

*(Average Profit x Win Rate) – (Average Loss x Loss Rate)

With more information, we can now see that Trader B had the best performance, despite having a “middle of the road” percentage of profitable trades.

What’s the Point?

There are two reasons for bringing up this topic:

1. Just because a strategy has a low realized success rate, it doesn’t mean it’s a bad strategy.

2. If a strategy has an extremely high success rate, it’s not necessarily a great strategy.

What truly matters is each strategy’s performance relative to what’s required to break even over time, based on average profits and average losses.

Long Premium Example

As an example, let’s say your strategy is to buy $1,000 worth of options and sell them when the options double in price (100% return). Otherwise, you’ll let the options expire worthless (100% loss).

If we assume either outcome, you’d need a 50% success rate to break even over time:

(100% Return x 50% Win Rate) – (100% Loss x 50% Loss Rate) = $0

To achieve positive trade expectancy over the long-term, one of three things needs to occur:

1. Achieve a success rate greater than 50%

2. Realize losses smaller than 100% (with the same success rate and average profits)

3. Realize profits greater than 100% (with the same success rate and average losses)

Of course, a change in one variable is likely to have an impact on the others, but the bottom line is that a strategy will only be profitable if its realized success rate exceeds the required success rate determined by the average profits and losses.

Short Premium Example

In regards to a short premium approach, let’s say you plan to take profits at 50% of the maximum profit potential or take losses when the option prices doubles (100% loss relative to the credit received).

Based on a 50% profit or 100% loss, you’d need a 66.6% success rate to break even over time (assuming all trades are sized similarly):

(66.6% Win Rate x 50% Profit) – (33.4% Loss Rate x 100% Loss) = $0

To achieve positive trade expectancy over the long-term, one of three things needs to occur:

1. Achieve a success rate greater than 66.6% (same average profits and losses)

2. Realize losses smaller than 100% (with the same success rate and average profits)

3. Realize profits greater than 50% (with the same success rate and average losses)

Same as before, a change in one variable is likely to have an impact on the others, but the bottom line is that a strategy will only be profitable if its realized success rate exceeds the required success rate determined by the average profits and losses.

The Bottom Line

The bottom line is that it’s very easy to be deceived by the percentage of profitable trades when analyzing trading strategies.

Don’t be fooled.

The success rate matters, but only relative to the required success rate as determined by the average profits and average losses over time.

Concept Checks

Here are the essential points to remember about the percentage of profitable trades:

 

1. Option strategies can have extremely low or high percentages of profitable trades, but the success rate alone means nothing

 

2. The combination of the percentage of profitable trades, average profits, and average losses can be used to determine the “best” trading strategies.

 

3. Starting from a baseline expectancy of zero, positive trade expectancy can be achieved by increasing the win rate (with the same average profits and average losses), increasing profits (with average losses and success rate being the same), or decreasing losses (with average profits and success rate being the same).

Next Lesson

Additional Resources

When and How to Take Profits on Options – Investopedia

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