January 2022

Iron Condor Adjustment: Rolling Up Put Spreads

Posted on January 24, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:32 pm

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 iron condor adjustment strategy of rolling up the short put spreads.

Additionally, we’ll discuss the benefits of this iron condor adjustment strategy, as well as its drawbacks.

What is Rolling?

In options trading, “rolling” refers to closing an existing option position and opening a similar option position with different strike prices, in a different expiration cycle, or a combination of the two.

Today, we’ll focus on “rolling up” the short put spread in a short iron condor position, which refers to buying back your current short put spread and “rolling it up” by selling a new put spread at higher strike prices.

Rolling an Option

The process of closing an existing option and opening a similar option position at different strike prices, in a different expiration cycle, or a combination of the two.

When Do You Roll Up the Put Spread?

When trading iron condors, the most typical time to roll up the short put spread is after the stock price increases towards your short call spread.

Consider the following visual:

Iron Condor Adjustment: Rolling Up the Short Put Spread

As we can see, the stock price is rising quickly and approaching the short call spread portion of the trade. Since short iron condors have negative gamma, the position’s delta grows negative (the position becomes bearish) as the stock price trends towards the short call.

The most common iron condor adjustment to make in this scenario is to roll up the short put spread to higher strike prices:

To roll up the short put spreads in an iron condor position, a trader has to buy back the old short put spread and sell a new put spread at higher strike prices.

What does this iron condor adjustment accomplish?

What Does Rolling Up the Put Spreads Accomplish?

By rolling up the short put spreads in an iron condor position, a trader accomplishes two things:

1. Collect More Option Premium

Rolling up the put spread is done for a net credit, as the new put spread is sold for more than the trader pays to buy back the old put spread. By collecting additional option premium, the maximum loss potential of the position is reduced and the maximum profit potential increases by the amount of the credit received from rolling.

However, the spreads are now closer together, which means the iron condor position has a narrower range of maximum profitability.

2. Neutralize Directional Exposure

By rolling up the put spreads, the iron condor’s directional exposure will shift from bearish to more neutral.

Why?

At the time of rolling up the put spreads, an iron condor will have a negative position delta, which means the trader will lose money from subsequent increases in the stock price.

When the put spreads are rolled to higher strike prices, the new put spreads will have a more positive position delta than the old spreads, which brings the iron condor’s overall delta exposure closer to zero.

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

#1: Collect More Option Premium

Consider a trader who is short the 130/120 put spread in their iron condor position but decides to roll up to the 145/135 put spread:

How much option premium is collected by rolling up this put spread?

Premium Collected:

$2.37 Collected from 145/135 Put Spread

– $0.44 Paid for the 130/120 Put Spread

= +$1.93 ($193 Less Risk & $193 More Profit Potential)

By rolling up the short put spread, the overall premium received in this iron condor position increases by $1.93, which means the position has $1.93 less risk and $1.93 more profit potential.

However, since the new put spread is much closer to the stock price, the stock has less room to move, leading to a tighter range of maximum profitability.

#2: Neutralize Your Position Delta

After rolling up the short put spreads in an iron condor, the directional exposure becomes more neutral.

At the time of rolling, lets say the iron condor’s position delta was -25 (the trader is expected to lose $25 with a $1 increase in the stock price, and make $25 with a $1 decrease in the stock price). Here’s how the position delta would change after rolling up the put spread:

To calculate the new iron condor delta exposure, let’s compare the old put spread’s delta to the new put spread’s delta, and add the difference to the iron condor’s current position delta of -25:

Old Put Spread Delta: +6 (+9 Short Put Position Delta – 3 Long Put Position Delta)

New Put Spread Delta: +24 (+39 Short Put Position Delta – 15 Long Put Position Delta)

Change in Put Spread Deltas: +18

New Iron Condor Delta: -25 + 18 = -7

To clarify, the put spread deltas are calculated with the following formula:

(Short Put Delta x -1 Contract x 100 Option Multiplier) – (Long Put Delta x +1 Contract x 100 Option Multiplier)

After rolling up the put spread, the iron condor’s delta exposure changes from -25 to -7, which means the iron condor is now 72% less sensitive to small changes in the stock price.

More specifically, the trader is only expected to lose $7 with a $1 increase in the stock price as opposed to a $25 loss before the iron condor adjustment.

What’s the Risk of Rolling Up the Put Spreads?

While rolling up a short put spread decreases trade risk, increases maximum profit potential, and neutralizes the iron condor’s directional exposure, there are some downsides:

1. Narrower Range of Profitability

An iron condor’s maximum profit zone lies between the short call and short put strike price. After rolling up the put spreads, the short call and short put strike prices are now much closer, which results in a much narrower range of maximum profitability.

2. Neutralized Directional Exposure

By neutralizing the iron condor’s directional exposure, a reversal in the stock price will yield less profits (or even losses) than before rolling up the put spreads.

As with any trade adjustment, there are benefits and downsides. The iron condor adjustment strategy of rolling up the short put spreads decreases the loss potential, increases the profit potential, but ultimately makes the trade a lower probability position since the maximum profit zone is now tighter.

Concept Checks

Here are the essential points to remember the iron condor adjustment of rolling up the short put spreads:

	1. When trading iron condors, if the share price appreciates towards your short call spread, you can adjust the position by rolling up the put spreads to higher strike prices.
	2. By rolling up the put spreads, you collect more option premium, which increases the profit potential and decreases the loss potential, but decreases the trade’s probability of profit since the profit zone is narrower. Additionally, the iron condor’s directional exposure becomes more neutral.
	3. The downside of rolling up the put spreads are a decreased range of profitability, and a more neutral directional exposure. If the stock price ends up falling after the put spreads are rolled to higher strikes, the iron condor may end up losing money on the downside.

Additional Resources

Iron Condor – tastytrade

Short Call Management Results from 41,600 Trades

Posted on January 24, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:35 pm

The short call option strategy is used by bearish traders with a high risk tolerance, as the strategy has unlimited loss potential (in theory).

In this post, we’ll examine over 10 years of 16-delta short call management data from 41,600 trades in the S&P 500 ETF (SPY).

More specifically, we’ll answer the following questions:

1. Which short call management strategies were the most profitable?

2. Which short call strategies were the least profitable?

3. How did implied volatility at the time of entering the trade impact the overall profitability?

Study Methodology

Underlying: S&P 500 ETF (SPY).

Time Frame: January 2007 to May 2017 (most recent standard expiration, as of this writing).

Entry Dates: Every trading day.

Expiration Cycle: Standard expiration closest to 45 days to expiration (resulted in trades between 30-60 days to expiration).

Trade: Sell the 16-Delta call option

Number of Contracts: 1

Short Call Trade Management

For each entry, we tested 16 different management combinations:

Profit or Expiration: 25% Profit, 50% Profit, 75% Profit, OR Expiration.

Profit or -100% Loss: 25% Profit, 50% Profit, 75% Profit, OR -100% Loss.

Profit or -200% Loss: 25% Profit, 50% Profit, 75% Profit, OR -200% Loss.

Profit or -300% Loss: 25% Profit, 50% Profit, 75% Profit, OR -300% Loss.

Management Example: 50% Profit or -200% Loss

To demonstrate how we calculated the profit and loss levels, let’s run through a quick example using a 50% profit OR -200% loss target.

Entry Credit: $1.00

Profit Target: $0.50 ($1.00 Entry Credit – $1.00 x 50%)

Loss Limit: $2.00 ($1.00 Entry Credit x 200%). A $2.00 loss would occur when the call option traded $3.00 ($1.00 Entry Credit + $2.00 Loss).

Metrics We’ll Analyze

Before we get started, I want to quickly cover the primary metrics we’ll analyze:

Win Rates: The percentage of trades that were profitable.

Win Rate – Breakeven Win Rate: The difference between the success rate and what the strategy required to break even (based on average profits and losses).

Average P/L: The average profitability of each trade. The average P/L figures will be consistent with the Win Rate – Breakeven Win Rate levels.

10th Percentile P/L: The P/L that 90% of trades exceeded (a probabilistic way of analyzing the worst drawdowns).

45-Day Adjusted P/L: Not all trades were held for the same amount of time. We standardized the average P/L of each trade to a 45-day period.

Win Rates: 16-Delta Short Calls

By closing profitable short call positions early, the success rates increased. Conversely, success rates declined when closing losing short call trades early:

To clarify the x-axis on these charts, I wanted to run through a quick example of how to interpret the labels. The following format is used: Profit Target / Loss Limit. If “Exp.” is present in one of those spots, then that combination had no profit target (if “Exp.” is first) or loss limit (if “Exp.” is second).

For example, “25% / Exp.” means the trades were closed for 25% of the maximum profit potential OR held to expiration (no loss management).

“Exp. / -200%” means the trades were held to expiration (no profit management) OR closed for a -200% loss.

Win Rates – Breakeven Win Rates

The Win Rate – Breakeven Win Rate metric helps us understand how each strategy performed relative to the required success rate to break even over time. For example, if a strategy’s average profits and average losses require a 75% success rate to break even, then a success rate of 80% would result in a Win Rate – Breakeven Win Rate of 5% (80% Realized Success Rate – 75% Required Breakeven Win Rate).

The metric puts more context around success rates.

Let’s take a look at the Win Rate – Breakeven Win Rate statistics for the short call trades:

As we can see, many of these short call management strategies barely cleared the required success rate that would result in breaking even over time (based on average profits and average losses).

The results make sense, as we’ve been in a strong bull market period since 2009, which means many of these short call positions were likely “blown out” as the S&P 500 moved higher in a swift fashion.

Average P/L Per Trade

Which short call management strategies were the most profitable, on average?

Based on these figures, we can see that most short call strategies in the S&P 500 have been only slightly profitable. Obviously, this can be attributed to the bull market period from 2009-2017 (the time of this writing).

Additionally, when factoring in commissions, most of these approaches may actually end up with losses, on average (depending on the commission rate).

For example, if we assume a trader’s commissions are $1 per option contract, then it costs $2 in commissions to open and close one short call contract. Based on a $2 round-trip fee, we can subtract $2 from the above Average P/L figures to get the average P/L per trade after commissions.

10th Percentile P/L

If you recall, the 10th percentile P/L tells us the P/L level that 90% of trades exceeded. For example, if the 10th percentile P/L is -$750, then 90% of short call trades had a P/L better than a loss of $750.

Let’s take a look at these “worst-case” drawdowns for each short call management approach:

As we might expect, taking losses substantially reduced the worst-case drawdowns.

Additionally, by not taking losses and managing profits sooner (25% or 50% of the maximum profit potential), the 10th percentile P/L was worse than the larger profit-taking combinations, as the larger profits help offset the losses.

Average Time in Trade

How long was each short call position held for, on average?

As we’d expect, incorporating some type of profit or loss management results in fewer days in each trade, on average. How does the reduced time in each trade impact the hypothetical average P/L for these short call positions over similar time periods?

To answer this question, we’ll adjust the average P/L per trade of each approach to a 45-day period:

45-Day Adjusted Average P/L = Avg. P/L Per Trade x (45 / Avg. Days in Trade)

Of course, this isn’t a perfect formula, but it does help put context around the “average profitability” of each approach based on the number of trades that can “fit” into similar periods of time.

After adjusting each short call management strategy’s average P/L per trade to a 45-day period, we find that the 25% to 50% profit targets generated the most profits, on average.

However, keep in mind that opening and closing trades more often will generate more commission costs.

What would the profitability of these strategy’s look like when taking out $2 per round-trip trade? That is, a $1 commission rate per contract multiplied by two (one trade to open the position and one to close it).

Let’s take a look:

SPY Short Call Management: Avg. P/L - Commissions

45-Day Avg. P/L – Commissions = 45-Day Avg. P/L – [(45 / Avg. Days in Trade) x $2]

While not a perfect estimation, the above graph should help put context around the commission impact of managing profitable trades sooner and ultimately trading more often.

These figures suggest that the 50% profit target level has historically had a good balance between the average P/L per trade, number of trades, and commissions for trading more often.

Additionally, the -100% loss limit has historically had the worst performance compared to the other short call management approaches, which suggests taking losses at -100% of the credit received has been “too soon.”

In other words, many of the short call positions that reached the -100% loss level came back and ended up as profitable trades.

Short Call Performance by VIX Level

In this final section, we’ll analyze some of the metrics from above, but we’ll evenly divide all of the trades into four buckets based on the VIX level at the time of entering the short call trades:

1. VIX Below 14

2. VIX Between 14 and 17.5

3. VIX Between 17.5 and 23.5

4. VIX Above 23.5

These VIX levels were selected based on the 25th, 50th, and 75th percentile of VIX levels at the time of all trade entries. By using these percentiles, we evenly divide all trades into four separate buckets and avoid any one bucket having substantially more or less occurrences than the rest.

Short Call Win Rates by VIX Level

At a quick glance, we can see that many of the short call management combinations had the highest success rates in the lowest and highest VIX environments:

SPY Short Call Management: Win Rates by VIX Level

How did these success rates compare to the required success rate to break even?

Win Rates – Breakeven Win Rates by VIX Level

As we can see, not all approaches had a win rate higher than what was required to break even (based on average profits and average losses):

Again, the lowest and highest VIX environments were the best-performing volatility environments for most of the short call management approaches.

Short Call Average P/L by VIX Level

Consistent with previous findings, the lowest and highest VIX environments have generated the highest average P/L per trade for most of the short call management approaches:

Interestingly, the best-performing groups included selling calls in the highest VIX environment and using a wide stop-loss (-200% or -300%) combined with high profit targets (75% or hold to expiration).

10th Percentile P/L by VIX Level

Similar to the short put management results, the largest short call losses occurred in the highest VIX entries:

When the VIX is high, it’s typically due to a recent downturn in the market. Since 2008, nearly every significant market dip (and therefore VIX spike) has been met with a strong and quick rally to the upside, which causes problems for short call positions.

45-Day Adjusted Average P/L by VIX Level

When normalizing each approach’s average P/L per trade to a 45-day period, we get the following results:

45-Day Average P/L = Avg. P/L Per Trade x (45 / Avg. Days in Trade)

Based on the data, closing profitable short call positions sooner (25-50% of max profit) has typically performed the best in the lowest VIX entry category, suggesting that holding longer for more profits has led to more short call positions getting “blown out” as the S&P 500 moved higher.

The short call management approaches that performed the best in the highest VIX entries included a generous stop-loss (-200% or -300%) with early profit management.

Checklist

While we’ve covered a ton of data in this post, here are the most important findings:

✓ Historically, the 16-delta short call strategy has performed best in high VIX environments when paired with a high profit target (50-100%) and a generous stop-loss (-200% or -300%)

✓ When factoring in a $1 commission per option contract, many of the short call management approaches analyzed in this study were not profitable. The ones that were probably were not worth the risk, as the profits after commissions were so small (resulting in very poor risk/reward).

✓ Lastly, the largest short call drawdowns have occurred in high VIX environments, which explains why adding a -200% or -300% stop-loss has been beneficial for high implied volatility entries.

Next Lesson

Additional Resources

Short Call Strategy Guide – OptionAlpha

7 Best Options Trading Tips for Beginners in 2022

Posted on January 21, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:38 pm

As an options trading beginner, there’s so much to learn and it can be overwhelming. In addition, there are common pitfalls many beginner traders experience.

In this video, we’ll give you our top 7 options trading tips for beginners, which should help you make better trading decisions (and less mistakes) when starting out.

Implied Volatility in Options for Beginners (Guide w/ Visuals)

Posted on January 21, 2022February 10, 2022 by Chris Butler

Last updated on February 10th, 2022 , 07:41 pm

Implied volatility is a crucial options trading concept for beginners to understand, but it can be a daunting thing to learn because it seems very complex.

While the math behind calculating implied volatility is complex, all we need to know as options traders is this:

➜ Implied volatility quantifies option prices and expresses those option prices as one number.

Instead of looking at 100s of option prices on various stocks and wondering whether they’re “cheap” or “expensive,” we can look at implied volatility to quickly assess a stock’s option prices, and what the market thinks about that stock in terms of risk.

Understanding Implied Volatility: What Do Option Prices Represent?

Before talking about why implied volatility changes, let’s quickly discuss what option prices actually represent:

➜ Option prices are representative of the market’s anticipation of a stock’s volatility over some period of time in the future.

When trying to understand why implied volatility changes, we need to take one step back and think about why option prices change.

The #1 Driver of Option Price Changes

Perhaps the #1 general driver of option prices changes is historical/realized volatility, or how large a stock’s recent price movements have been.

To verify this statement, I plotted the relationship between 1-month historical volatility of the S&P 500 and the VIX Index, which measures 1-month option prices on the S&P 500:

VIX Index vs. Historical Volatility (SPX)

The horizontal axis (x-axis) represents the 1-month historical volatility of the S&P 500 Index (SPX) on each trading day since the VIX Index began.

The vertical axis (y-axis) represents the VIX Index closing value on each of the days the historical volatility was recorded. When plotted against each other, there is a clear relationship between historical volatility and implied volatility (option prices):

➜ When the market is experiencing more volatility (higher 1-month historical volatility readings), the 1-month option prices on the S&P 500 tend to be higher as well (higher 1-month option prices = higher VIX Index).

➜ When the market is less volatile (left side of chart), option prices are cheaper.

Let’s look at some real market examples and validate this idea even further.

Market Volatility vs. Option Prices

In the chart below, we’ve placed a box around a very low volatility period. As we can see, the market was grinding higher during this period and did not experience any large decreases:

Software Used: tastyworks

The very end of the boxed region in the chart above is November 1st, 2018.

On that day, we looked at the 30-day straddle price on SPY.

Here are the relevant statistics:

SPY Closing Price: $257.49

Expiration/Options Analyzed: 30 Days to Expiration

257.50 Straddle Price: $4.59 (1.78% of SPY’s Closing Price)

VIX Index (30-Day Implied Volatility): 10.2%

After a period of low volatility, the 30-day straddle on SPY was trading for 1.8% of SPY’s closing price, and the VIX Index was at 10.20.

Let’s look at the same exact metrics in a high volatility market.

The chart below features an extremely high volatility period. The end of the boxed region is December 20th, 2018:

Software Used: tastyworks

Here are the relevant statistics from December 20th, 2018:

SPY Closing Price: $247.17

Expiration/Options Analyzed: 29 Days to Expiration

247 Straddle Price: $13.86 (5.6% of SPY’s Closing Price)

VIX Index (30-Day Implied Volatility): 28.50%

As we can see, the at-the-money straddle price was significantly higher after this particular high volatility period, as the 29-day straddle was trading for 5.6% of SPY’s closing price. As a result, the VIX Index was at 28.50.

Comparison: Option Prices in High vs. Low Volatility Markets

Let’s compare each volatility environment and the respective option prices side-by-side:

Clearly, when markets are calm, option prices are cheaper because there’s not nearly as much perceived risk compared to when the market is very volatile.

If you can imagine a transition from Scenario #1 (low volatility) to Scenario #2 (high volatility), then you will understand why option prices change.

Just like insurance policies, an increase in health risks means the insurance company will require higher premium payments from the individual being insured. The same concept holds true in regards to option prices.

Implied Volatility and Earnings

There’s one special case where implied volatility “increases” but option prices stay the same or decrease.

When a stock has an earnings announcement approaching, the stock’s option prices in the expiration cycle immediately after earnings will remain inflated, as sometimes stocks make big movements after earnings reports.

Because of this, the option prices exposed to that potentially large movement remain inflated, even as their expiration dates rapidly approach. Let’s look at an example from AAPL’s earnings in November of 2018:

In the table above, we can see that the at-the-money straddle price in the earnings expiration cycle actually lost some value as the expiration date approached.

However, even with the slight decrease in option prices, implied volatility increased from 50% to 103%!

The reason for this is implied volatility is a function of not just option prices, but how much value the options have relative to their time to expiration.

In the event where option prices remain constant as time passes, implied volatility will increase. That’s because with less time to expiration and the same option prices, the market is expecting higher levels of volatility when adjusted for time.

In other words, a ±$10 expected move over one trading day will result in a significantly higher implied volatility reading compared to a ±$10 expected move over 60 trading days.

Next Lesson

Additional Resources

What Is Historical Volatility? – Fidelity Investments

Option Vega Explained (Guide w/ Examples & Visuals)

Posted on January 20, 2022May 3, 2022 by Chris Butler

Last updated on May 3rd, 2022 , 08:48 am

Option Vega Definition: In options trading, the Greek “Vega” (Greek letter v) measures an option’s sensitivity to implied volatility. Vega tells us how much the option premium of a derivative will increase by when volatility increases by 1%.

What Is Vega In Options Trading?

Before we get into what an option’s vega is, let’s review the biggest risks every options trader must be aware of:

1) Changes in the price of the stock (directional risk – delta)

2) Changes in the directional risk of a position (gamma risk)

3) The passing of time (referred to as time decay or theta decay)

4) Changes in implied volatility of the underlying asset (volatility or vega risk)

5) Changes in interest rates (Rho)

Vega is the option Greek that relates to the fourth risk, which is volatility or vega risk. More specifically, vega estimates the change in an option’s price relative to changes in implied volatility.

Read! Historical Volatility vs Implied Volatility

Vega is always presented as a positive number because as option prices increase, implied volatility increases (all else equal). Conversely, as option prices decrease, implied volatility decreases. Let’s go through some examples of how vega is applied.

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

Basic Option Vega Example

Vega is expressed as an option’s expected price changes relative each 1% (absolute) changes in implied volatility.

In the following table, work your way from left to right, and notice how an option’s price is expected to change relative to movements in implied volatility:

As you can see, an option vega of 0.25 represents a $0.25 increase in the option’s price per 1% increase in implied volatility, and vice versa. With a 3% decrease in implied volatility, the option’s value is expected to be $0.75 lower.

In order to estimate an option’s expected price relative to a 1% increase in implied volatility, simply add the option’s vega to its price. For 1% decreases in implied volatility, an option’s price can be estimated by subtracting vega from its price.

Nice! You’ve learned the basics of an option’s vega! We’ve just got one more section to go. Next, you’ll learn about the options with the most vega risk.

Which Options Have the Most Vega?

In this section, we’re going to analyze various call options and put options to determine which ones have the most exposure to changes in implied volatility.

To do this, we’ll run a series of tests. First, we’re going to look at option vega values at each strike price. Then, we’ll analyze the vega of options with shorter and longer amounts of time until the expiration date. Let’s do it!

Option Vega vs. Strike Price

To illustrate which options have the most exposure to vega, we picked a random day in 2016 and graphed the vega of each out-of-the-money (OTM) call and put. We used the expiration cycle with nearly 50 days to expiration. Let’s take a look at the results!

As illustrated here, option contracts closest to the underlying stock price (at-the-money or “ATM”) have the highest vega values. In this particular example, the at-the-money options are expected to be worth $0.28 more with implied volatility 1% higher, and vice versa. On the other hand, an out-of-the-money put with a strike price of 170 is expected to increase by only $0.07 relative to each 1% increase in implied volatility, and vice versa.

Another thing this graph tells us is that an option’s vega is related to the amount of extrinsic value it has because at-the-money options have the most extrinsic value, and out-of-the-money options have the least amount of extrinsic value.

Read! Determining the Price Of An Option – Intrinsic Value vs Extrinsic Value in Options

Alright, we’ve checked off the first analytical test. Now, we’re going to build on this by analyzing the vega of each option over multiple expiration cycles.

Vega vs. Time to Expiration

Similar to before, we’re going to graph the vega of each out-of-the-money option, but this time we’ll do it for three expiration cycles. The cycles we chose were 15, 71, and 225 days to expiration, respectively. Let’s check it out!

As we can see here, options with more time until expiration have larger vega values. This means that longer-term options are expected to have more volatile price changes relative to implied volatility changes. Again, this makes sense because longer-term options have more extrinsic value.

To understand why options with more extrinsic value have higher vega values, consider the following hypothetical scenario:

Now, if these option prices both went to $0, implied volatility would be 0%. In order to reach $0, Option B has to lose $0.75 while Option A only has to lose $0.25. Therefore, Option B has a larger vega value.

Vega Calculation Using Black Scholes

According to columbia.edu, the below pricing model formula satisfies Vega:

Note! Trading options come with great risks. To better understand the risks of standardized options, please read this article from the OCC.

Option Vega FAQs

How does Vega affect options?

Vega tells us how much the price of an option will change in response to a 1% change in the implied volatility of the underlying. Option prices rise with implied volatility.

What does negative vega mean in options?

In options trading, a negative vega implies a net short position. This applies for both short single options and short spreads.

Why is Vega highest at the money?

Options that are trading at-the-money are most sensitive to changes in implied volatility. Therefore, at-the-money option have a higher vega than in-the-money and out-of-the-money options.

Next Lesson

Additional Resources

Vega Definition – Investopedia

Options Vega – The Greeks – CME Group

Option Gamma Explained: The Ultimate Guide w/ Visuals

Posted on January 20, 2022February 11, 2022 by Chris Butler

Last updated on February 11th, 2022 , 06:21 am

All option positions have four primary risk exposures:

1) Changes in the price of the stock (directional risk – delta)

2) Changes in the directional risk of a position (gamma risk)

3) The passing of time (sometimes called time decay or theta decay)

4) Changes in the implied volatility of the options (expressed by vega)

Gamma is the option Greek that relates to the second risk, as an option’s gamma is used to estimate the change in the option’s delta relative to $1 movements in the share price. In other words, gamma estimates the change in an option’s directional risk as the stock price changes.

To clarify, let’s look at an example.

Basic Option Gamma Example

As an illustration, let’s look at a basic example of gamma in action. In the following table, work your way from left to right. Specifically, note how each option’s gamma relates to the option’s new delta after $1 changes in the share price:

In this example, the bolded numbers represent a growth in the option’s directional exposure. Additionally, this table demonstrates how gamma can be applied:

1) To estimate an option’s new delta after a $1 increase in the share price, add the option’s gamma to its delta.

2) To estimate an option’s new delta after a $1 decrease in the share price, subtract the option’s gamma from its delta.

Recall that call deltas range from 0 to +1, and put deltas range from -1 to 0. This brings us to two key concepts:

1) When the share price increases, call deltas get closer to +1, and put deltas get closer to 0.

2) When the share price decreases, call deltas get closer to 0, and put deltas get closer to -1.

The image below visualizes these concepts:

Well done! You’ve learned the basics of what an option’s gamma represents. Now, let’s explore more important concepts related to gamma. First, you’ll see some examples of how gamma impacts call and put deltas. Second, you’ll learn which options tend to have the most gamma risk.

Gamma of Calls and Puts

To build on the previous section, we’re going to visualize option gamma by comparing call and put deltas to changes in the stock price. Let’s dive in!

To visualize the impact of both call and put gamma, we chose a call and put on AAPL with the same strike price and expiration. Here are the specifics:

Stock: Apple Inc. (ticker: AAPL)

Time Period: June 1st, 2015 to August 21st, 2015

Expiration: August 21st, 2015

Call and Put Strike Price: $120

In this visual, be sure to compare the changes in the call and put delta as the stock price changes. In the shaded region, the relationships are the clearest.

Option Gamma Example: Call and Put Deltas vs. Stock Price Changes

As illustrated here, call and put deltas move in the same direction as the stock price. At the beginning of the shaded region, both options were at-the-money and had deltas near ±0.50. As the share price moved higher, the call delta changed to +0.87, while the put delta changed to -0.13.

On the other hand, when the share price collapsed, the call delta fell to +0.25, and the put delta dropped to -0.75. The changes in each option’s delta can be attributed to gamma. To understand why, it helps to think about delta and gamma in terms of probabilities. Next, you’ll learn about how to think about gamma in a probabilistic perspective.

Option Gamma and Probabilities

You know that delta represents an option’s expected price change relative to stock price changes. In addition to that, delta is an estimation of the probability that an option expires in-the-money. Therefore, gamma represents the change in an option’s probability of expiring in-the-money with shifts in the stock price.

To conceptualize gamma as the change in an option’s probability of expiring in-the-money, consider the following scenarios:

With the stock price at $100, an option with a strike price of $100 has a probability of expiring in-the-money of approximately 50%, which means both the call and put will have deltas near ±0.50.

Now, if the stock price increases to $105, the call option with a strike price of $100 should have a much higher probability of expiring in-the-money because the stock price is $5 above the strike price. Conversely, the put option should have a lower probability of expiring in-the-money because the stock price must drop by more than $5 for the put to be in-the-money.

Gamma helps explains the change in each option’s probability of expiring in-the-money (delta) with changes in the stock price. In general, when the stock price increases:

➜ All call options have a higher probability of expiring in-the-money.

➜ All put options have a lower probability of expiring in-the-money.

Conversely, when the stock price decreases:

➜ All call options have a lower probability of expiring in-the-money.

➜ All put options have a higher probability of expiring in-the-money.

Hopefully, thinking about gamma in a probabilistic light makes it a little easier to comprehend!

In summary, when the price of a stock changes, the deltas of the options on that stock do as well. Gamma estimates how much each option’s delta will change.

Additionally, delta can be used as an approximation for the probability of an option expiring in-the-money. Therefore, gamma can be interpreted as the change in an option’s probability of expiring in-the-money.

Great job! At this point, you know lots of information about gamma as it relates to calls and puts. Now, it’s time to go a step further and learn which options have the most gamma exposure.

Which Options Have the Most Gamma Risk?

At this point, you understand how gamma impacts option deltas. However, not all options have the same amount of gamma exposure. In this section, you will learn which options tend to have the most exposure to gamma.

To demonstrate this, we’re going to analyze gamma in three different ways. First, we’re going to examine in-the-money, at-the-money, and out-of-the-money option gamma. Second, we’ll look at options with various lengths of time until expiration. Lastly, we’ll examine the gamma of in-the-money, at-the-money, and out-of-the-money options as expiration approaches.

Option Gamma and "Moneyness"

Regarding gamma risk, one of the two factors to consider about an option is whether its strike price is in-the-money (ITM), at-the-money (ATM), or out-of-the-money (OTM). There are two primary reasons for this:

1) In-the-money and out-of-the-money options have the least amount of gamma exposure.

2) At-the-money options have the most gamma exposure.

To illustrate this, we’ll look at a snapshot of SPY options from early 2016. In particular, we looked at options with approximately 50 days until expiration. Let’s take a look:

Clearly, options that are in-the-money or out-of-the-money have less gamma exposure than at-the-money options. In this particular example, the at-the-money option gamma suggests that the option deltas will change by ±0.05 with a $1 change in the stock price.

On the other hand, the further the strikes are away from the stock price, the less the option’s gamma exposure. Lower gamma indicates a smaller change in the option’s delta relative to changes in the stock price. Why is this? Well, one explanation is that a $1 change in the stock price doesn’t significantly lower the chances of deep-in-the-money or out-of-the-money options expiring in-the-money.

Next, we’ll explore the gamma of options with different lengths of time until expiration.

Option Gamma vs. Time to Expiration

The second most important factor that influences an option’s gamma is the amount of time left until the option expires. To analyze this, we averaged the gamma of calls and puts at each strike in SPY. Additionally, we investigated options with 14, 42, 77, and 197 days until expiration. Let’s look at the results!

As illustrated here, at-the-money options with little time until expiration have the most gamma exposure. Conversely, in-the-money and out-of-the-money options with fewer days until expiration have less gamma exposure.

Why is this? Well, as discussed earlier, gamma can be thought of as the change in an option’s probability of expiring in-the-money. When the stock price moves up or down by $1, at-the-money options with little time until expiration will experience the greatest change in the probability of expiring in-the-money (delta), since there’s less time for the option to become in-the-money again.

In regards to in-the-money and out-of-the-money options, the same concept can be applied. With such little time to expiration, in-the-money and out-of-the-money option gamma is less significant because a $1 shift in the underlying price doesn’t have a large impact on the probability of an option expiring in-the-money (delta).

For example, consider a stock that’s trading for $200. If there’s one day left until expiration, a 210 call’s delta will be close to zero because it’s almost certain to expire out-of-the-money. Now, if the stock price rises to $201, the 210 call’s delta will still be close to zero because there’s not much time left for the stock to increase the additional $9+ required for the 210 call to be in-the-money.

Hopefully this helps you understand in-the-money, at-the-money, and out-of-the-money option gamma over various time frames. We’ll be discussing these concepts further in the next examples.

Next, we’ll take a look at a visual example of at-the-money option gamma expansion as expiration approaches.

At-the-Money Option Gamma Near Expiration

As expiration approaches, at-the-money option gamma should increase significantly because smaller changes in the stock price have a larger impact the option’s probability of expiring in-the-money. Let’s visualize what this looks like with real data! Here is the setup:

Stock: Netflix (ticker symbol: NFLX)

Time Period: November 16th to December 18th (2015)

Expiration / Time to Expiration: December 18th, 2015 / 32 Days to Expiration

Put Strike Price: $120

Let’s take a look at what happens to the option’s delta and gamma as expiration approaches:

Option Gamma Example: NFLX Put Delta vs. Stock Price Changes

Early on in the period, NFLX increased from $110 to $130, which resulted in the put’s delta changing from -0.70 to -.20. In the final days of the period, NFLX decreased from $124 to $117, which resulted in the put’s delta changing from -0.25 to -1.00.

Even more specifically, early on in the trade, a $20 increase in the stock price caused the option’s delta to change by 0.50. However, when the option was closer to expiration, a $7 decrease in the stock price caused a 0.75 change in the option’s delta. In other words, a move one-third of the size resulted in a 50% larger change in the option’s delta. More significant changes in an option’s delta with smaller shifts in the stock price demonstrates the power of at-the-money option gamma near expiration.

Next, we’ll analyze in-the-money and out-of-the-money option gamma over the same time period.

ITM & OTM Option Gamma Near Expiration

Using the same stock and time period as before, let’s visualize what happens to the delta and gamma of a deep in-the-money put as expiration approaches:

In-the-Money Option Gamma Example #2: NFLX Put Delta vs. Stock Price Changes

As illustrated here, the put gamma decreased in the last few days before expiration because the option was nearly $20 in-the-money with little time until expiration. As a result, $1 changes in NFLX shares wouldn’t significantly decrease the probability of the option expiring in-the-money.

What about out-of-the-money option gamma? To answer this, we’ll examine the NFLX 135 call over the same period as above. Let’s take a look:

As illustrated here, the out-of-the-money call experienced a decrease in delta and gamma into expiration because the call was nearly $20 away from being in-the-money. As a result, $1 changes in the share price weren’t enough to have an impact on the option’s probability of expiring in-the-money.

To conclude this section, let’s recap what you’ve learned.

First, and most importantly, not all options have equal exposure to gamma. In general, at-the-money options with little time until expiration have the most gamma risk. On the other hand, in-the-money and out-of-the-money option gamma tend to be smaller, especially when the options get closer to expiration.

Next Lesson

Additional Resources

Gamma Definition – Investopedia

Gamma Explained | The Options & Futures Guide

Delta Hedging Explained (Visual Guide w/ Examples)

Posted on January 20, 2022April 14, 2022 by Chris Butler

Last updated on April 14th, 2022 , 10:22 am

In options trading, delta hedging is a derivative-based trading strategy used to balance positive and negative delta so their net effect is zero. When a position is delta-neutral, it will not rise or fall in value when the value of the underlying asset stays within certain bounds.

For options traders, this means their position is protected in the short term from price movements in the underlying stock, ETF, or index. When executed correctly, a delta neutral position can help offset changes in volatility.

However, maintaining a delta neutral position is an ongoing battle, and the transaction costs from constantly rebalancing can easily reduce the temporary benefits this strategy gives.

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

What is Delta Hedging?

Consider the following option positions:

In each of these option contract positions, the position delta may be large or small depending on the trader who has the position. In each of these scenarios, there may come a time when the trader wants to reduce the directional exposure.

For bullish positions (positive delta), directional exposure can be reduced by adding negative delta strategies to the position.

For bearish positions (negative delta), directional exposure can be reduced by adding positive delta strategies to the position.

Here is a list of strategies that can accomplish either one of these hedging goals:

Basic Delta Hedging Example

To demonstrate how delta hedging can be accomplished, consider Position B from the previous table shown above:

Position B has a delta of -3,700, which is bearish because the position is expected to profit by $3,700 when the stock price drops by $1. Alternatively, the strategy is anticipated to lose $3,700 when the stock price increases by $1.

In order to reduce the directional exposure of this position, the trader will have to add positive delta strategies to the position.

Let’s say the trader wants to buy shares of stock to hedge the position with a delta of -3,700. If the trader wanted to decrease the directional risk in half, the trader would have to buy 1,850 shares of stock.

Why 1,850?

The trader needs to reduce their delta from -3,700 to -1,850 (a 50% reduction), which can be done by adding 1,850 deltas to the position. Each long share of stock has a delta of +1, so buying 1,850 shares will add 1,850 deltas to the position, therefore reducing the -3,700-delta position to a -1,850 delta position: -3,700 + 1,850 = -1,850.

With a new position delta of -1,850, the trader is expected to lose $1,850 if the stock price increases by $1, which is 50% less than the initial -$3,700 loss per $1 share increase. Here is how the hedge works:

Delta Hedging in Detail

So, as we can see here, the trader still has the full exposure from Position B. However, the long shares offset the P/L of Position B by 50%. Because of this, delta hedging reduces the risk of a position, but the reduction in risk comes at the cost of less potential reward.

At this point, you may be wondering why you wouldn’t always delta hedge a position. The answer is that hedging is expensive because it reduces your overall potential reward by the cost of the hedge. Additionally, constantly needing to hedge positions may be an indication that the initial trade size was too large.

In the next section, we’ll explore two real scenarios where a delta hedge might be implemented, as well as visualize the performance of the position with and without the hedge.

Visualized Delta Hedging Examples

To demonstrate how a delta hedge might work in practice, let’s take a look at two common scenarios where options or stock can be used to hedge the directional exposure of a position. First, we’ll look at a long stock position that is hedged with long puts.

Trade Example #1: Hedging Long Stock With Long Puts

In this first example, we’ll look at a scenario where a trader owns 500 shares of stock. Being long 500 shares of stock results in a position delta of +500. If the trader wanted to reduce this directional exposure, they would have to add a strategy with negative delta. In this example, the negative delta strategy we’ll use is buying puts.

Since the trader is long 500 shares of stock, we’ll purchase five -0.35 delta put options against the position. Here is how the position looks at the start of the period:

As we can see here, buying five -0.35 delta puts against 500 shares of stock reduces the delta exposure by 35%. Let’s take a look at the P/L of each of these positions when the stock price falls:

In the middle portion of this graph, the P/L of the long shares and the long puts are plotted separately. As you can see, when the stock price collapses, the long stock position loses money, but the long puts make money. In the lower portion of the graph, the combined P/L of the long stock and long puts is plotted.

The key takeaway from this chart is that the stock position by itself experiences a drawdown greater than $10,000. However, with the long puts implemented as a delta hedge, the combined position only experiences a $4,000 drawdown at the lowest point. By adding the negative delta strategy of buying puts to the positive delta strategy of buying stock, the directional exposure is less significant.

Let’s take a look at what happens to the actual deltas of each position as the stock price changes:

As we can see here, the position delta of owning 500 shares is always +500 because the delta of a share of stock is always +1. However, the delta of a put option will change as the stock price changes and time passes. As the stock price falls significantly below the put’s strike price of $205, the put’s delta gets closer to -1. Since this example tracks the delta of five puts, the most significant position delta of the puts is -500.

At option expiry, the 205 put’s delta was -1, resulting in a position delta of -500 for five long puts. Because of this, the delta of each position cancels out to zero. With a position delta near zero, the long stock and long put combination will experience very little P/L shifts when the stock price changes. When revisiting the first graph, you’ll notice that the P/L fluctuations in the last half of the period are insignificant when compared to the initial P/L changes.

Alright, so you’ve seen an example of how long puts can be used to delta hedge a long stock position. Next, we’ll look at buying calls against a short stock position.

Trade Example #2: Hedging Short Stock With Long Calls

In the final example, we’ll look at a scenario where a trader shorts 300 shares of stock sold at market price. Being short 300 shares of stock results in a position delta of -300. If the trader wanted to reduce this directional exposure, they would have to add a strategy with positive delta. In this example, the positive delta strategy we’ll use is buying calls.

Since the trader is short 300 shares of stock, we’ll purchase three +0.30 delta call options against the position. Here is how the position looks at the start of the period:

As we can see here, buying three +0.30 delta calls against -300 shares of stock reduces the delta exposure by nearly 33%. Let’s visualize the performance of these positions when the stock price rallies:

In the middle portion of this graph, the P/L of the short shares and the long calls are plotted separately. As you can see, when the stock price rises, the short stock position loses money, but the long calls make money. In the lower portion of the graph, the combined P/L of the short stock and long calls is plotted.

The key takeaway from this chart is that the short stock position by itself experiences a drawdown of nearly $30,000. However, with the long calls implemented as a delta hedge, the combined position only experiences a $15,000 drawdown at the lowest point. By adding the positive delta strategy of buying calls to the negative delta strategy of shorting stock, the directional exposure is less significant.

Let’s take a look at what happens to the actual deltas of each position as the stock price changes:

As we can see here, the position delta of shorting 300 shares is always -300 because the delta of a share of stock is always +1. However, the delta of a call option will change as the stock price changes and time passes. As the stock price rises, the call option’s delta gets closer to +1. Since this example tracks the delta of three calls, the most significant position delta of the calls is +300.

At the expiration date, the 535 call’s delta was +1, resulting in a position delta of +300 for three long calls. Because of this, the delta of each position cancels out to zero. With a position delta near zero, the short stock and long call combination will experience very little P/L shifts when the stock price changes.

If you revisit the first chart, you’ll notice that the P/L variations near the end of the period are much less significant than the beginning of the period. This can be explained by the long call position delta growing closer and closer to +300, resulting in a net position delta closer to 0.

Note! Curious how delta hedging is accomplished using the Black-Scholes model? Check out this article!

Delta Hedging FAQs

Is delta hedging profitable?

When executed properly, delta hedging can help traders offset short term market risk. This risk can be in the form of earnings, interest rate and economic data. Delta hedging works more on securing current profits (or preventing further losses) from swings in the price of the underlying stock or underlying security than being profitable in itself.

How do you hedge with delta?

Delta hedging helps traders offset risk in both stock and options by neutralizing directional exposure. Delta hedging is accomplished by either buying or selling shares of the underlying security to offset the market exposure of option positions.

What does delta mean in hedging?

Delta is the option Greek that represents the expected price move of an option based on a $1 move in the underlying security. Delta hedging involves trading shares of stock to offset the risk of trading options.

Next Lesson

Additional Resources

Delta Hedging Definition – Investopedia

What are common delta hedging strategies? – Investopedia

Long Iron Condor Explained – The Ultimate Guide w/ Visuals

Posted on January 20, 2022May 9, 2022 by Chris Butler

Last updated on May 9th, 2022 , 05:16 am

The long iron condor is an options strategy that consists of simultaneously buying an out-of-the-money call spread and put spread on a stock in the same expiration cycle.

Since the purchase of a call spread is a bullish strategy, and buying a put spread is a bearish strategy, a long iron condor isn’t technically a directional position.

However, even though a long iron condor isn’t directionally specific (bullish or bearish), the strategy requires movement in the stock price or an increase in implied volatility to profit.

The long iron condor strategy is very similar to the long strangle, except an iron condor has less risk due to using spreads as opposed to naked options.

TAKEAWAYS

A long iron condor consists of buying a put spread and a call spread at the same time.
Both of these spreads must be of the same width and expiration.
Long iron condor’s profit when the options bought rise in value.
Long iron condors are best suited for directional traders who expect either upside or downside moves.

Long Iron Condor Characteristics

Here are the strategy’s general characteristics:

➥Max Profit Potential: (Width of Wider Spread – Debit Paid) x 100

➥Max Loss Potential: Debit Paid x 100

➥Expiration Breakevens

1. Upper Breakeven = Long Call Strike Price + Debit Paid

2. Lower Breakeven = Long Put Strike Price – Debit Paid

To further examine these characteristics, let’s take a look at a basic example.

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

Long Iron Condor Profit/Loss Potential at Expiration

In the following example, we’ll construct a long iron condor from the following option chain:

In this case, we’ll buy the 450 put and the 550 call, and sell the 400 put and 600 call. Let’s also assume the stock price is trading for $500 when entering the position:

• Initial Stock Price: $500

• Short Strikes: $400 short put, $600 short call

• Long Strikes: $450 long put, $550 long call

• Credit Received From Short Options: $0.72 (400 put) + $1.94 (600 call) = $2.66

• Debit Paid for Long Options: $6.15 (450 put) + $7.89 (550 call) = $14.04

• Total Debit Paid: $14.04 Debit Paid – $2.66 Credit Received = $11.38

The following visual describes this position’s potential profits and losses at expiration.

Long Iron Condor at Expiration

As illustrated here, a long iron condor’s profit potential lies outside of the long strike of the trade, which means the stock price must increase or decrease for the position to be profitable at expiration. Regarding losses, a long iron condor realizes the maximum loss potential when the stock price does not trade beyond the long strikes by expiration.

Below explains the performance of this position based on various scenarios at expiration:

➥Stock Price Below the Short Put Strike ($400) -OR- Above the Short Call Strike ($600):

One of the spreads of the iron condor expires fully in-the-money. With spreads strikes that are $50 wide, the iron condor would be worth $50. With an initial purchase price of $11.38, the long iron condor trader realizes the maximum profit of $3,862: ($50 iron condor expiration value – $11.38 purchase price) x 100 = +$3,862.

➥Stock Price Between the Short Put Strike ($400) and the Lower Breakeven Price ($438.62):

The long 450 put expires with more intrinsic value than the initial $11.38 purchase price of the iron condor. As a result, the trader realizes profits.

➥Stock Price Between the Lower Breakeven Price ($438.62) and the Long Put Strike ($450):

The long 450 put expires with less value than the initial $11.38 iron condor purchase price. As a result, the position realizes a partial loss.

➥Stock Price Between the Long Put Strike ($450) and the Long Call Strike ($550):

All of the iron condor’s options expire worthless, resulting in the maximum loss of $1,138: ($0 iron condor expiration value – $11.38 purchase price) x 100 = -$1,138.

➥Stock Price Between the Long Call Strike ($550) and the Upper Breakeven Price ($561.38):

The long 550 call has intrinsic value, but not more than the initial $11.38 iron condor purchase price. Because of this, the position is not profitable.

➥Stock Price Between the Upper Breakeven Price ($561.38) and the Short Call Strike ($600):

The long 550 call expires worth more than $11.38, which is the initial purchase price of the iron condor. As a result, the position is profitable.

Nice job! You’ve learned the general characteristics of the long iron condor strategy. Now, let’s go through some visual trade examples to see how the strategy performs over time.

Long Iron Condor Trade Examples

In this section, we’re going to visualize the performance of long iron condors over time. Each example uses the prices of options that recently traded in the market. Note that we don’t specify the underlying, since the same concepts apply to iron condors on any stock. Additionally, each example demonstrates the performance of a single iron condor position. When trading more contracts, the profits and losses in each case will be magnified by the number of iron condors traded.

Trade Example #1: Partial Loss on an Iron Condor Purchase

In this first example, we’ll look at a scenario where a trader realizes a partial loss after buying an iron condor.

Here are the trade details:

• Initial Stock Price: $202.31

• Strikes and Expiration: Long 196 Put and 208 Call; Short 182 Put and 215 Call; All options expiring in 72 days

• Premium Paid for Long Options: $4.18 for the 196 put + $2.82 for the 208 call = $7.00 in premium paid

• Premium Collected for Short Options: $1.79 for the 182 put + $0.78 for the 215 call = $2.57 in premium collected

• Net Debit (Price Paid): $7.00 premium paid – $2.57 premium collected = $4.43 net debit

• Breakeven Prices: $191.57 and $212.43 ($196 – $4.43 and $208 + $4.43)

• Maximum Profit Potential (Upside): ($7-wide call spread – $4.43 debit) x 100 = $257

• Maximum Profit Potential (Downside): ($14-wide put spread – $4.43 debit) x 100 = $957

• Maximum Loss Potential: $4.43 net debit x 100 = $443

As mentioned earlier, the maximum profit potential of an iron condor depends on the wider spread. In this example, the long call spread is $7 wide, and the long put spread is $14 wide. Because of this, the maximum profit potential of this iron condor occurs when the stock price collapses through the long put spread. More specifically, this trade has $257 in profit potential on the upside and $957 in potential profits on the downside. Consequently, this long iron condor position has a slightly bearish bias.

Let’s see what happens!

Long Iron Condor #1 Trade Results

As we can see here, the iron condor suffers steady losses from time decay because the stock price is between the position’s breakevens as time passes. At expiration, the stock price is trading for $210.41, which means the long 208 call was worth $2.41. Meanwhile, all of the other options expire worthless, which means the final value of the iron condor at expiration is $2.41. With an initial purchase price of $4.43, the net loss on the position is $202: ($2.41 iron condor expiration value – $4.43 purchase price) x 100 = -$202.

Lastly, since the long 208 call is in-the-money at expiration, the trader would end up with +100 shares if the option was held through expiration. If the trader did not want a stock position, the 208 call would need to be sold before expiration.

Trade Example #2: Max Profit Iron Condor Purchase

In the following example, we’ll investigate a situation where the stock price rises continuosly and is above the iron condor’s long call spread at expiration.

Here are the trade details:

• Initial Stock Price: $121.45

• Strikes and Expiration: Long 119 Put and 124 Call; Short 115 Put and 128 Call; All options expiring in 46 days

• Premium Paid for Long Options: $1.25 for the 119 put + $1.05 for the 124 call = $2.30 in premium paid

• Premium Collected for Short Options: $0.39 for the 115 put + $0.38 for the 128 call = $0.77 in premium collected

• Net Debit (Price Paid): $2.30 premium paid – $0.77 premium collected = $1.53 net debit

• Breakeven Prices: $117.47 and $125.53 ($119 – $1.53 and $124 + $1.53)

• Maximum Profit Potential: ($4-wide spreads – $1.53 net debit) x 100 = $247

• Maximum Loss Potential: $1.53 net debit x 100 = $153

In this example, both the long call spread and long put spread are $4 wide, so the profit potential is equal on both sides of the trade.

Let’s take a look at the position’s performance:

Long Iron Condor #2 Trade Results

In this example, we can see that the iron condor performs very well because the stock price surges through the long call spread. At expiration, the 124/128 long call spread is entirely in-the-money, while the 119/115 put spread expires worthless. However, since the 124/128 call spread is worth $4 and the iron condor was purchased for $1.53, the trader realizes the maximum profit of $247: ($4 iron condor expiration value – $1.53 initial purchase price) x 100 = +$247.

Since the entire long call spread is in-the-money at expiration, the exercise and assignments would offset, resulting in no stock position for the trader. However, it’s always possibile for the trader to be assigned early on the short 128 call when it’s in-the-money before expiration.

Trade Example #3: Long Iron Condor Gone Wrong!

In the final example, we’ll look at a situation where a long iron condor expires worthless, resulting in the maximum loss potential for the trader who purchased the spread.

Here are the trade details:

• Stock Price: $574.81

• Strikes and Expiration: Long 535 Put and 615 Call; Short 505 Put and 645 Call; All options expiring in 46 days

• Premium Paid for Long Options: $11.75 for the 535 put + $10.40 for the 615 call = $22.15 in premium paid

• Premium Collected for Short Options: $6.03 for the 505 put + $4.47 for the 645 call = $10.50 in premium collected

• Net Debit (Price Paid): $22.15 premium paid – $10.50 premium collected = $11.65 net debit

• Breakeven Prices: $523.35 and $626.65 ($535 – $11.65 and $615 + $11.65)

• Maximum Profit Potential: ($30-wide spreads – $11.65 net credit) x 100 = $1,835

• Maximum Loss Potential: $11.65 net debit x 100 = $1,165

Let’s see how this trade performed:

Long Iron Condor #3 Trade Results

In this final example, we can see that the initial drop in the stock price leads to healthy profits for the long iron condor trader. However, the stock price rebounds back and is between the long strikes at expiration, in which case the iron condor expires worthless. With an initial purchase price of $11.65, the loss at expiration is $1,165: ($0 iron condor expiration value – $11.65 initial purchase price) x 100 = -$1,165

Long Iron Condor: Pros and Cons

Final Word

Congratulations! You now know how buying an iron condor works as a trading strategy. Be sure to recap the main concepts of this guide below.

An iron condor consists of buying both a put spread and a call spread simultaneously.
Both of these spreads must be of the same width and expiration.
The max loss for iron condors is always the debit paid.
Max gain for long iron condors is: (Width of Wider Spread – Debit Paid)

Long Iron Condor FAQs

Is the iron condor always profitable?

In order for a long iron condor to be profitable, either the long call or long put purchased must rise in value. For call breakeven, the stock must rise to long call strike + debit paid. For put breakeven, the stock must fall to long put strike – debit paid.

When should I take profit on iron condor?

For long iron condors that are in-the-money, profit should be taken before expiration to avoid being assigned on the short option and possibly exercised on the long option. It is best to have a pre-established profit taking price in place before placing iron condor trades.

How often are iron condors profitable?

The profitability of iron condors will depend upon the “moneyness” structure of the options traded, implied volatility and the price of the underlying security.

The further an iron condor is sold out-of-the-money, the greater its possibly of success will be.

Next Lesson

Additional Resources

Long Condor – Options Industry Council

Iron condor – Wikipedia

Bull Call Spread Explained – The Ultimate Guide w/ Visuals

Posted on January 17, 2022March 24, 2022 by Mike Martin

Last updated on March 24th, 2022 , 07:13 am

A bull call spread is an options strategy that consists of buying a call option while also selling a call option at a higher strike price.

Both options must be in the same expiration cycle. Buying call spreads is similar to buying calls outright, but less risky due to the premium collected from the sale of a call option at a higher strike. As the name suggests, a bull call spread is a bullish strategy, as it profits when the underlying stock price rises.

We’re going to cover all of this in great detail, so be sure to keep reading if you want to master this strategy!

Let’s go over the strategy’s general characteristics:

TAKEAWAYS

The bull call spread consists of: 1. buying a call at strike price A 2. Selling a call at strike price B.
Max profit in a bull call spread is the difference between strike A and strike B minus the net premium paid.
In bull call spreads, max loss is the total premium paid.
The Breakeven for bull call spreads is strike A plus net debit paid.
The bull call spread is a cheaper way to go long when compared to straight call buying.

Bull Call Spread Strategy Characteristics

➦Max Profit Potential: (Call Spread Width – Net Debit Paid) x 100

➦Max Loss Potential: Net Debit Paid x 100

➦Expiration Breakeven: Long Call Strike + Net Debit Paid

➦Position After Expiration:

If the long and short call are both in-the-money at expiration, the assignments offset, resulting in no stock position. If only the long call is in-the-money at expiration, the resulting position is +100 shares of stock per call contract.

➦Assignment Risk:

When the short call of a bull call spread is in-the-money, a bull call spread trader is at risk of being assigned -100 shares of stock per short call contract. The probability of being assigned on short calls is higher when the short call has little extrinsic value. Alternatively, short call assignments are common before a stock’s ex-dividend date, primarily when the dividend is greater than the short call’s extrinsic value.

To gain a better understanding of these concepts, let’s walk through a basic example.

Bull Call Spread Profit/Loss Potential at Expiration

In the following example, we’ll construct a bull call spread from the following option chain:

In this case, let’s assume the stock price is trading for $150 at the time of entering the spread. To construct a bull call spread, we’ll have to buy a call option and sell the same number of calls at a higher strike price. In this example, we’ll buy one of the 145 calls and sell one of the 155 calls.

Initial Stock Price: $150

Long Call Strike: $145

Short Call Strike: $155

Premium Paid for the 145 Call: $8.80

Premium Collected for the 155 Call: $3.99

In this example, buying the 145 call for $8.80 and selling the 155 call for $3.99 results in a net debit of $4.81 (since $8.80 is paid, and $3.99 is collected). Additionally, the “spread width” is the difference between the long and short call strike, which is $10 in this case. Based on a net debit of $4.81 on a $10-wide bull call spread, here are the position’s characteristics:

Max Profit Potential: ($10-wide call strikes – $4.81 net debit paid) x 100 = $519

Max Loss Potential: $4.81 net debit paid x 100 = $481

Expiration Breakeven: $145 long call strike price + $4.81 debit paid = $149.81

Probability of Profit

This bull call spread example has a probability of profit slightly greater than 50% because the breakeven price ($149.81) is less than the current stock price ($150), which means the stock price can fall slightly and the position can still profit.

Position After Expiration

If the stock price is above 155 at expiration, both calls expire in-the-money. At expiration, an in-the-money long call expires to +100 shares, and an in-the-money short call expires to -100 shares, which results in no stock position for the call spread buyer.

If the stock price is between 145 and 155 at expiration, only the long call expires in-the-money, resulting in a position of +100 shares for the call spread buyer.

The following visual demonstrates the potential profits and losses for this bull call spread at expiration:

If the stock price is at or below the long call’s strike price of $145 at expiration, both the 145 and 155 call options will expire worthless, resulting in the maximum loss of $481.

If the stock price is in-between the strike prices at expiration, such as $149.81, the long 145 call will have value while the 155 call will expire worthless. At $149.81, the 145 call will be worth $4.81 ($149.81 Stock Price – $145 Strike Price) and the 155 call will be worth $0, resulting in no profit or loss on the trade.

If the stock price is above the short call’s strike price of $155, the entire 145/155 call spread will be worth $10 (the width between the strike prices), which means the profit on each call spread will be +$519.

Bull Call Spread Trade Examples

The first example we’ll investigate is a situation where a trader purchases an at-the-money call spread. An at-the-money bull call spread consists of buying an in-the-money call and selling an out-of-the-money call. When constructed properly, the breakeven price is slightly below the current stock price. Here’s the setup:

Initial Stock Price: $109.82

Strikes and Expiration: Long 100 call expiring in 45 days. Short 115 call expiring in 45 days

Net Debit Paid: $11.18 paid for the 100 call – $1.94 received for the 115 call = $9.24

Breakeven Stock Price: 100 long call strike price + $9.24 net debit paid = $109.24

Maximum Profit Potential: ($15-wide call strikes – $9.24 debit paid) x 100 = $576

Maximum Loss Potential: $9.24 net debit paid x 100 = $924

Let’s see what happens!

Bull Call #1 Results

In this example, the bull call spread position had both profits and losses at some point. With 14 days left until expiration, the call spread was worth slightly less than its maximum value of $15.

However, at expiration, the stock price was only slightly above the long call spread’s breakeven price. As a result, the long call spread trader didn’t make or lose any money by holding the trade to expiration.

However, the trade would have been profitable if the trader sold the spread when it was worth more than the entry price of $9.24. To close a bull call spread before expiration, the trader can simultaneously sell the long call and buy the short call at their current prices. As an example, if the trader closed the spread when it was worth $12, they would have realized $276 in profits: ($12 closing price – $9.24 purchase price) x 100 = +$276.

Since the long call is in-the-money at expiration, the trader would end up with +100 shares of stock (per contract) if they did not sell the long call before expiration. Upon selling the long call portion of a bull call spread, it’s wise to buy back the short call. Otherwise, the trader will expose themselves to unlimited loss potential.

Next, we’ll look at an example of a long call spread trade where the stock price moves against the position.

Unprofitable Call Spread Example

In this example, we’ll look at a situation where a trader buys an out-of-the-money long call spread. An out-of-the-money long call spread is constructed by purchasing an out-of-the-money call while also selling an out-of-the-money call at a higher strike price.

It’s important to note that purchasing out-of-the-money call spreads is a low probability trade because the breakeven price is above the stock price at entry. Additionally, the profit potential is greater than the loss potential.

Here’s the setup:

Initial Stock Price: $569.92

Strikes and Expiration: Long 575 call expiring in 35 days Short 635 call expiring in 35 days

Net Debit Paid: $32.45 paid for the 575 call – $11.00 received for the 635 call = $21.45

Breakeven Stock Price: $575 long call strike price + $21.45 debit paid = $596.45

Maximum Profit Potential: ($60-wide call strikes – $21.45 debit paid) x 100 = $3,855

Maximum Loss Potential: $21.45 debit paid x 100 = $2,145

As you can see, the long call spread’s breakeven price is more than $25 higher than the stock price when entering the trade, which means the stock price must increase more than $25 for the position to breakeven at expiration.

Let’s take a look at what happens:

Bull Call #2 Results

This example demonstrates that a significant stock price increase results in healthy profits for a bull call spread trader. Unfortunately, the stock price ends up dropping just as quickly. With the stock $45 points below the long 575 call at expiration, the long call spread expires worthless. The resulting loss for the call spread buyer is $2,145 ($21.45 debit paid x 100).

As mentioned before, a spread can always be closed before expiration if a trader wishes to lock in profits or losses. For example, if the trader in this example wanted to cut their losses when the spread traded down to $15, they would lock in $645 in losses: ($15 sale price – $21.45 purchase price) x 100 = -$645.

Alright, you’ve seen long call spread examples that break even and realize the maximum loss. In the final example, we’ll investigate a long call spread trade that winds up with its maximum profit potential.

Profitable Call Spread Example

In the final example, we’ll examine a long call spread example that ends up with its maximum profit potential.

Here are the specifics of the final example:

Initial Stock Price: $57.47

Strikes and Expiration: Long 49 call expiring in 82 days. Short 70 call expiring in 82 days.

Net Debit Paid: $11.10 paid for the 49 call – $1.85 received for the 70 call = $9.25

Breakeven Stock Price: $49 long call strike + $9.25 debit paid = $58.25

Maximum Profit Potential: ($21-wide call strikes – $9.25 debit paid) x 100 = $1,175

Maximum Loss Potential: $9.25 net debit paid x 100 = $925

Let’s see what happens!

Bull Call #3 Results

In the first 30 days of the trade, the stock price stagnates around the breakeven price of the long call spread. However, with around 45 days to expiration, the stock jumps 30% to $80 after an earnings announcement.

With the stock price $10 above the short call strike, the long call spread is worth around $20. With $21-wide strikes, the spread’s maximum value is $21. So, even though the position has around 45 days to expiration, the long call spread is worth near its maximum potential value.

When the call spread is worth $20, it’s likely that the long call spread trader closes the position for a profit because there’s only $1 left to make and $20 to lose.

If the trader did sell the spread for $20, the realized profit would be $1,075: ($20 sale price – $9.25 purchase price) x 100 = +$1,075.

Finally, if the spread was held through expiration, no stock position would be taken on because the exercise/assignment of the long and short call options cancel each other out. However, it’s possible that the spread trader is assigned on the short call when it’s deep-in-the-money before expiration.

Final Word

Congratulations! You now know how the bull call spread works as an options trading strategy. In summation, here is what we learned:

In a bull call spread, risk is limited to the net debit paid.
Bull call spreads can allow for less risk than just buying straight calls.
In the bull call spread, both upside and downside are capped.

* Want to make a little extra income from your bull call spread? Read our article on the bull call ladder strategy here! But be careful, this strategy introduces traders to great loss potential!

Additional Resources

What Is A Bull Call Spread? – Fidelity Investments

Bull Call Spread Definition – Investopedia

Bull Call Spread Debit … – The Options Industry Council (OIC)

Next Lesson

Option Exercise and Assignment Explained w/ Visuals

Posted on January 14, 2022February 11, 2022 by Mike Martin

Last updated on February 11th, 2022 , 06:38 am

Buyers of options have the right to exercise their option at or before the option’s expiration. When an option is exercised, the option holder will buy (for exercised calls) or sell (for exercised puts) 100 shares of stock per contract at the option’s strike price.

Conversely, when an option is exercised, a trader who is short the option will be assigned 100 long (for short puts) or short (for short calls) shares per contract.

TAKEAWAYS

Long American style options can exercise their contract at any time.
Long calls transfer to +100 shares of stock
Long puts transfer to -100 shares of stock
Short calls are assigned -100 shares of stock.
Short puts are assigned +100 shares of stock.
Options are typically only exercised and thus assigned when extrinsic value is very low.
Approximately only 7% of options are exercised.

The following sequences summarize exercise and assignment for calls and puts (assuming one option contract):

Call Buyer Exercises Option ➜ Purchases 100 shares at the call’s strike price.

Call Seller Assigned ➜ Sells/shorts 100 shares at the call’s strike price.

Put Buyer Exercises Option ➜ Sells/shorts 100 shares at the put’s strike price.

Put Seller Assigned ➜ Purchases 100 shares at the put’s strike price.

Let’s look at some specific examples to drill down on this concept.

Exercise and Assignment Examples

In the following table, we’ll examine how various options convert to stock positions for the option buyer and seller:

As you can see, exercise and assignment is pretty straightforward: when an option buyer exercises their option, they purchase (calls) or sell (puts) 100 shares of stock at the strike price. A trader who is short the assigned option is obligated to fulfill the opposite position as the option exerciser.

Automatic Exercise at Expiration

Another important thing to know about exercise and assignment is that standard in-the-money equity options are automatically exercised at expiration. So, traders may end up with stock positions by letting their options expire in-the-money.

An in-the-money option is defined as any option with at least $0.01 of intrinsic value at expiration. For example, a standard equity call option with a strike price of 100 would be automatically exercised into 100 shares of stock if the stock price is at $100.01 or higher at expiration.

What if You Don't Have Enough Available Capital?

Even if you don’t have enough capital in your account, you can still be assigned or automatically exercised into a stock position. For example, if you only have $10,000 in your account but you let one 500 call expire in-the-money, you’ll be long 100 shares of a $500 stock, which is a $50,000 position. Clearly, the $10,000 in your account isn’t enough to buy $50,000 worth of stock, even on 4:1 margin.

If you find yourself in a situation like this, your brokerage firm will come knocking almost instantaneously. In fact, your brokerage firm will close the position for you if you don’t close the position quickly enough.

Why Options are Rarely Exercised

At this point, you understand the basics of exercise and assignment. Now, let’s dive a little deeper and discuss what an option buyer forfeits when they exercise their option.

When an option is exercised, the option is converted into long or short shares of stock. However, it’s important to note that the option buyer will lose the extrinsic value of the option when they exercise the option. Because of this, options with lots of extrinsic value remaining are unlikely to be exercised. Conversely, options consisting of all intrinsic value and very little extrinsic value are more likely to be exercised.

The following table demonstrates the losses from exercising an option with various amounts of extrinsic value:

As we can see here, exercising options with lots of extrinsic value is not favorable.

Why? Consider the 95 call trading for $7. Exercising the call would result in an effective purchase price of $102 because shares are bought at $95, but $7 was paid for the right to buy shares at $95.

With an effective purchase price of $102 and the stock trading for $100, exercising the option results in a loss of $2 per share, or $200 on 100 shares.

Even if the 95 call was previously purchased for less than $7, exercising an option with $2 of extrinsic value will always result in a P/L that’s $200 lower (per contract) than the current P/L. F

or example, if the trader initially purchased the 95 call for $2, their P/L with the option at $7 would be $500 per contract. However, if the trader decided to exercise the 95 call with $2 of extrinsic value, their P/L would drop to +$300 because they just gave up $200 by exercising.

7% Of Options Are Exercised

Because of the fact that traders give up money by exercising an option with extrinsic value, most options are not exercised. In fact, according to the Options Clearing Corporation, only 7% of options were exercised in 2017. Of course, this may not factor in all brokerage firms and customer accounts, but it still demonstrates a low exercise rate from a large sample size of trading accounts.

So, in almost all cases, it’s more beneficial to sell the long option and buy or sell shares instead of exercising. We like to call this approach a “synthetic exercise.”

Congrats! You’ve learned the basics of exercise and assignment. If you’d like to know how the exercise and assignment process actually works, continue to the next section!

Who Gets Assigned When an Option is Exercised?

With thousands of traders long and short options in the market, who actually gets assigned when one of the traders exercises their option?

In this section, we’ll run through the exercise and assignment process for options so you know how the assignment decision occurs.

If a trader is short a single option, how do they get assigned if one of a thousand other traders exercises that option?

The short answer is that the process is random. For example, if there are 5,000 traders who are long a call option and 5,000 traders who are short that call option, an account with the short option will be randomly assigned the exercise notice. The random process ensures that the option assignment system is fair

Visualizing Assignment and Exercise

The following visual describes the general process of exercise and assignment:

If you’d like, you can read the OCC’s detailed assignment procedure here (warning: it’s intense!).

Now you know how the assignment procedure works. In the final section, we’ll discuss how to quickly gauge the likelihood of early assignment on short options.

Assessing Early Option Assignment Risk

The final piece of understanding exercise and assignment is gauging the risk of early assignment on a short option.

As mentioned early, only 7% of options were exercised in 2017 (according to the OCC). So, being assigned on short options is rare, but it does happen. While a specific probability of getting assigned early can’t be determined, there are scenarios in which assignment is more or less likely.

The following scenarios summarize broad generalizations of early assignment probabilities in various scenarios:

In regards to the dividend scenario, early assignment on in-the-money short calls with less extrinsic value than the dividend is more likely because the dividend payment covers the loss from the extrinsic value when exercising the option.

Final Word

All in all, the risk of being assigned early on a short option is typically very low for the reasons discussed in this guide. However, it’s likely that you will be assigned on a short option at some point while trading options (unless you don’t sell options!), but at least now you’ll be prepared!

Next Lesson

Additional Resources

Exercise and Assignment – CME Group

Learn About Exercise and Assignment – CME Group

What is Rolling?

Rolling an Option

When Do You Roll Up the Put Spread?

What Does Rolling Up the Put Spreads Accomplish?

#1: Collect More Option Premium

#2: Neutralize Your Position Delta

What’s the Risk of Rolling Up the Put Spreads?

Concept Checks

Iron Condor Options Adjustment: Rolling the Short Call

Iron Condor Options Strategy Explained | Trade Examples & Stats

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

Study Methodology

Short Call Trade Management

Management Example: 50% Profit or -200% Loss

Metrics We’ll Analyze

Win Rates: 16-Delta Short Calls

Win Rates – Breakeven Win Rates

Average P/L Per Trade

10th Percentile P/L

Average Time in Trade

Short Call Performance by VIX Level

Short Call Win Rates by VIX Level

Win Rates – Breakeven Win Rates by VIX Level

Short Call Average P/L by VIX Level

10th Percentile P/L by VIX Level

45-Day Adjusted Average P/L by VIX Level

Checklist

Next Lesson

Short Put Option Payoff Results from 41,600 Trades [Study]

Short Call Option Strategy: Guide With Visuals Graphs

The Vertical Spread Options Strategies: Beginner Basics

Additional Resources

Understanding Implied Volatility: What Do Option Prices Represent?

The #1 Driver of Option Price Changes

Market Volatility vs. Option Prices

Comparison: Option Prices in High vs. Low Volatility Markets

Implied Volatility and Earnings

Next Lesson

Implied Volatility Explained

CBOE Volatility Index Guide

High Dividend, Low Volatility ETFs

Additional Resources

What Is Vega In Options Trading?

Basic Option Vega Example

Which Options Have the Most Vega?

Option Vega vs. Strike Price

Vega vs. Time to Expiration

Vega Calculation Using Black Scholes

Option Vega FAQs

Next Lesson

What is Option Delta? Ultimate Guide w/ Visuals

Delta Hedging Explained (Visual Guide w/ Examples)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

Basic Option Gamma Example

Gamma of Calls and Puts

Option Gamma and Probabilities

Which Options Have the Most Gamma Risk?

Option Gamma and "Moneyness"

Option Gamma vs. Time to Expiration

At-the-Money Option Gamma Near Expiration

ITM & OTM Option Gamma Near Expiration

Next Lesson

What is Option Delta? Ultimate Guide w/ Visuals

Delta Hedging Explained (Visual Guide w/ Examples)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources

What is Delta Hedging?

Basic Delta Hedging Example

Delta Hedging in Detail

Visualized Delta Hedging Examples

Trade Example #1: Hedging Long Stock With Long Puts

Trade Example #2: Hedging Short Stock With Long Calls

Delta Hedging FAQs

Next Lesson

What is Option Delta? Ultimate Guide w/ Visuals

Long Gamma and Short Gamma Explained (Best Guide)

Option Greeks Explained: Delta, Gamma, Theta & Vega

Additional Resources