OPTION TRADING TIPS: 2021-10-10

Saturday 16 October 2021

What is the Iron Condor?

The Iron Condor is a strategy used for trading in options. It combines two other tactics, a bull put spread and a bear call spread, meaning the investor holds a total of four positions in the same financial asset, such as a company stock. The name of the Iron Condor comes from the shape of a graph showing the effect of a change in the asset's market price on the investor's overall profit or loss.

The basis of the Iron Condor is options trading. This involves an investor paying an agreed fee up front that buys him the right to buy or sell an agreed quantity of a financial asset at an agreed price on a set future date, regardless of what the market price for the asset is on that date. The investor will hope to correctly guess the future price movement, and then buy or sell the asset as required to profit from the difference between the agreed price and the prevailing market price. As the deal is an option, the investor does not have to go through with the agreed transaction if the market price has gone against him. This is a significant benefit, usually reflected in the initial fee the investor pays to set up the deal.

Some investors use more sophisticated tactics with options, such as a spread. This involves setting up two options deals that cover the same asset, but contrast with one another. For example, an investor might set up an option to buy an asset at a low price, while also selling another trader the option to buy the same asset at a higher price. Exactly if and how the investor goes on to make or lose money depends on the asset's price movement. The key is that the money he paid to set up one deal will be different than the money he received in setting up the other deal. This is because one option is more likely to turn out to be profitable than the other.

There are a total of four possible ways to combine two options in a spread strategy. A spread can be described as either a call spread or put spread, depending on whether the investor's own option to buy carries a higher price than the option to buy that he offered to the other trader. A spread can also be described as either a bull spread or a bear spread, depending on whether the investor profits from the market price of the asset rising or falling. This thus creates the bull call spread, the bull put spread, the bear call spread and the bear put spread.

The Iron Condor combines two of these spreads — the bull put spread and the bear call spread. This means the investor sets up four options, all for the same asset. The name comes from the fact that a graph showing the trader's potential profit or loss starts out flat as the asset price rises, then increases through to a profitable level before flattening out again, and decreases back to a loss-making level before again flattening out. The name is derived from the way this shape resembles a large winged bird such as the Iron Condor.

Thursday 14 October 2021

What are Straddles and Strangles?

A call option is the right to buy a given asset at a fixed price on or before a specific date. A put option is the right to sell a given asset at a fixed price on or before a specific date. Calls increase in value when the price of the underlying asset goes up; puts increase in value when the price of the underlying asset goes down. Straddles and strangles are options trading strategies that combine both puts and calls to create positions that do not depend on the direction of the market movement for their profitability.

A long straddle position is constructed by purchasing both a put and a call at an exercise price at or near the current price of the underlying asset. To become profitable, the underlying must have a change in price greater than the total cost of the straddle, and the price change must occur prior to expiry. If it doesn't, the straddle expires worthless. Since a straddle can never be worth less than zero, long straddles have limited risk and unlimited profit potential.

A short straddle position is constructed by selling both a put and a call at an exercise price at or near the current price of the underlying asset. Because the options are sold rather than bought, the position is initially as profitable as it can be. To remain profitable at expiry, the underlying price must move less than the combined price obtained by selling the straddle. Short straddles carry unpredictably large risks and limited profit potential.

A long strangle position is constructed by purchasing both a put and a call at exercise prices some distance from the current price of the underlying asset. In terms of profit and loss, it acts very much like a long straddle. The advantage over straddles is that it costs less, and therefore has a lower maximum possible loss. The disadvantage is that it requires an even larger move to become profitable.

A short straddle position is constructed by selling both a put and a call at an exercise price some distance from the current exercise of the underlying asset. It has the same limited-gain, unlimited-loss characteristics as a short straddle, but it requires a greater price change for the position to lose money.

As a general rule, traders prefer to sell straddles and buy strangles when the expiration date is far in the future; conversely, they prefer to buy straddles and sell strangles when expiration is in the near future.

What is the Butterfly Option Strategy?

A call option is the right to buy a given asset at a fixed price on or before a specific date. A put option is the right to sell a given asset at a fixed price on or before a specific date. Calls increase in value when the price of the bankbaroda asset goes up; puts increase in value when the price of the bankbaroda asset goes down. A butterfly strategy is an options strategy using multiple puts and/or calls to make a bet on future volatility without having to guess in which direction the market will move.

A long butterfly strategy is constructed from three sets of either puts or calls having the same expiration date but different exercise prices (strikes). For example, Bankbaroda trading at 100, a long butterfly strategy can be built by buying puts (or calls) at 95 and 105, and selling (shorting) twice as many puts (or calls) at 100.

If the bankbaroda does not change price by expiry, the puts at 95 and 100 will expire worthless, and the puts at 105 will be worth 5 (from 105-100). If the bankbaroda is greater than 105 at expiration, all the puts expire worthless, and the initial cost of the butterfly is the amount of the loss. If the bankbaroda is less than 95 at expiration, the gain from the purchased put at 105 will offset the losses from the shorted puts at 100, and the loss is again limited to the initial cost of initiating the butterfly strategy. In essence, this is a limited-risk, limited-gain approach to shorting the volatility of the bankbaroda , as the maximum profit comes when the bankbaroda has no volatility at all.

A short butterfly strategy is the converse; a limited-risk, limited-gain approach to being long (betting on an increase in) the volatility of the bankbaroda . By buying the inside strike and selling the outside strikes, the position has its greatest loss when the bankbaroda does not move, and its greatest gain when it moves beyond either of the outside exercise prices. A short butterfly strategy profits as equally from a large move up as it does from a large move down.

A regular butterfly strategy uses either all calls or all puts. A long iron butterfly sells a put and a call at the inside strike, and buys a put at the lowest strike and a call at the highest strike. A short iron butterfly buys a put and a call at the inside strike, and sells a put at the lowest strike and a call at the highest strike. In terms of profit and loss potentials, iron butterflies look very much like regular butterfly built from either all puts or all calls.

In general, the only time there is an advantage to choosing one type of butterfly strategy over another is if there is a pricing disparity in puts and calls making one of them cheaper to purchase or more profitable to sell.