The following is a guest post by John Douglas, who enjoys intelligent discussions around writing and focuses on portfolio enhancement through options.
In a recent article, I discussed an approach to trading and investing which underscores critical analysis as well as a refined philosophical perspective. In this article, I will discuss a very recent option strategy, which handled the volatility of the market quite profitably.
Given time and space, I must assume some basic level of competency in trading options. Otherwise, I would be forced to repeat material available in any options textbook.
WHAT’S IN A NAME? A GENETICALLY MODIFIED IRON CONDOR
Options traders are very familiar with the iron condor strategy. An analogy I use is a tennis match, where two players battle it out, within fixed boundaries. Technically, one would select a stock or index, and establish a combination which consists of a bear call spread and a bull put spread. In very general terms, one creates opposing forces, and confines the playing field to desired parameters. The mindset is such that one has no preference as to the “winner”, but simply hopes to charge a fee for renting out the playing field. Ideally, the game is “rained out” and there are no winners or losers.
This concept, in and of itself, is difficult for most people to understand. It means that you don’t have a dog in the fight-you are, in essence, the casino. You will always prevail on one side or the other-that’s the worst case. The management and adjustment of the uncooperative side tests the skill and imagination of the trader.
Just recently, I established an iron condor, utilizing BIDU spreads. Now, the purist might argue that iron condors are best used on boring, low volatility stocks. That’s because such stocks, at least in theory, offer a higher probability of having both sides of the trade expire worthless. Thus one would pocket the premium accruing from both sides.
Been there, done that and I don’t blindly follow textbook convention. I tend to take another road and seek out high volatility stocks, recognizing upfront that I will have to manage one side or the other. Furthermore, I don’t concern myself with someone else’s nomenclature. So I use the term “iron condor” merely as a reference point. In practice, I will alter the DNA of the iron condor molecule, often creating an amorphous, mutated animal. My bank account could care less how the strategy is classified.
THOUGHTS AND ANALYSIS OF INITIAL STRUCTURE : PORTFOLIO DIVERSIFICATION VS. STRATEGY DIVERSIFICATION
BIDU presents an interesting case study, as the subject trade is very recent-in fact it is still in play as of this writing.
To set the stage, the trade was established by:
- Selling the ATM calls/puts (145 at the time)
- Using the 150/140 strikes as the “wings.”
- The objective is to have both sides expire worthless
- Or take profits on one side, and adjust the other side, or trade against it.
July expiration options were used. Almost immediately, the market experienced a sell-off, presumably in response to an Ireland downgrade. More likely, however, the budget ceiling debate probably played an important role as well. So, in less than 24 hours the short call side was profitable, with roughly 80% of the maximum gain available. The short puts were, of course, running in the other direction. Note that when the position was established, it was delta neutral ( or reasonably close). Ten positions were initially established.
Given the quick move, the decision was made to capture all of the profit accrued in the short calls. The next move, however is most instructive, as it reflects an individual trading philosophy that traditional structures can-and should-be modified in such a way that fundamentally changes the entire trade.
Specifically, an immediate decision was to short 2,000 shares of BIDU, and then reducing that position in increments of 500 shares. Note that the decision was made to push the “petal to the metal” early in the sell off phase, and then lighten up. This is the complete opposite tactic of the novice, who will short an initial small amount, discover to his delight that he is making money, and then decide to add to the short position. This is, as indicated, totally wrong. The novice will now be whipsawed, and is likely to surrender his gain (and will probably retreat at a loss), simply because he lacked the courage of his conviction-at precisely the moment he should have gone for the jugular. Remember that the short position is now covered by three components:
- The profit already booked via closing the short calls
- The upside long calls remain as ultimate buffers
- The short puts are still decidedly in the negative.
The fairly quick trade in shorting BIDU resulted in a gain that would exceed the maximum downside position, which was reflected by the short put side of the iron condor. When the profitable short call position was added in, the strategy was extremely profitable. As to the short put position, there was absolutely no downside to leaving them in place, and await the GOOG earnings announcement.
Fortunately, GOOG hit a homerun, and the short puts that were negative, turned substantially positive. The initial 10 positions had remained in place, and the decision was made to close all positions at .50. The reason is that this action provided a substantial gain, but it was anticipated that a modest spike back up in pricing would afford another opportunity to trade the short puts. As it turned out, 10 puts were sold at .90, and held until .12, creating a bit of cream to top off a profitable few days of trading.
Note that BIDU has weekly options, so the decision was made to establish a new hybrid or modified iron condor, by bumping up the short put parameters, and doing likewise with the short calls. However, the condor “flock” was altered by setting the strategy or formation with a 2:1 short put/ short call ratio. BIDU continued to perform in a rational manner over the next few days-especially for a Chinese internet stock. It demonstrated a continued daily rise, with little volatility. The decision was made to clip half the profitable short puts, bringing the ratio back in line with 1:1. Now, the total profit was exceptionally high, as well as secured, so the decision was made to simply await the earnings announcement. (Incidentally, we correlated a 154.60 stock price with our option parameters, and closed half the short put position at that point).
BIDU’s earnings announcement closely tracked GOOG, with the stock surging in after- hours trading. The positions open at this juncture were the 150/140 short put spread. As the after- hours closed, the stock made a 6.7% increase to $167.06. The short puts were closed after the market opened. Note that prior to the earnings announcement, implied volatility kept the 140 long puts from eroding, and the short puts at 150 remained somewhat constant as well. This behavior is typical for option prices as earnings announcements approach. Some option traders avoid earnings, but perhaps the decision should depend on the entire historical context, and the profit (or loss) incurred to date.
If one simply looked at a recent chart of BIDU (located above), it would be difficult to understand how a substantial profit could have been made by shorting the stock. Yet, the iron condor allowed a quick exploitation when the market engaged in one of its PIIG tantrums. Once the profits derived from the short positions were realized, it became much easier to play for the whipsaw.
Bear in mind that the post-short strategy never gave BIDU a chance to recoup-by selling off yet again. The short puts that were established to play earnings, i.e. the 150/140 strikes, still protected against an Armageddon scenario. The 150 puts were closed for a substantial profit as indicated, but the decision was made to establish a bear call spread using the 160/170 strikes. Ten positions were opened, with a maximum profit of $4,600, and loss of $5,400. Simultaneously, 20 of the July 29 160 puts were sold (and closed within a couple of hours). Part of the dynamic with the 160 puts recognized two factors: (1)volatility collapse, which relates to post-earnings deflation, and (2)the expiration of weekly options on July 29-just a few days away. Note also that the existing long puts were left in place for both margin and hedging purposes. Further, the new bear call spread also served as a hedge. It is anticipated that the 160 puts can be traded until expiration, and that the September bear call spread will be part of an evolving strategy-one that recognizes the mean regression interplay of volatile stocks and macro turbulence.
Textbook concepts, although absolutely essential to fundamental understanding of option basics, are challenged by the age of program trading and artificial intelligence. Large hedge funds, in their quest to design the optimal strategy, can trigger extraordinary waves of fluctuations and volatility. It is not clear whether this type of volatility is priced in the typical option. Further, a host of new trading instruments, and the complex equations needed to support these esoteric creatures, are not adequately accounted for in typical textbooks. Even cutting edge academic papers have yet to address some of these issues. Of course, much of this is playing out in real time, and is so new, that it may be too early to offer much substantive research.
Yet, the small retail trader can prosper in this environment. Much as a survivalist is trained to live off the land, and take advantage of sudden opportunity, so it is with the small-but flexible-trader. But, it is absolutely necessary for the “survivalist trader” to be mentally prepared. This article, although brief, is an attempt to examine traditional concepts, and to foster innovative approaches that can quickly recognize and seize fleeting discontinuities.