Option Spreads and Positive Expectancy

Thu, Feb 19, 2009 | Jared Woodard


Reader Peter T. writes in with a very good question:

Then are several places on the site where you mention that you prefer to let the probabilities play out and not adjust condors. I calculated the expectation of the latest IWM trade based on the probabilities. I did some minor rounding to make it easier to read.

There is a 65% probability of making $50 which comes to $32.
There is a 35% probability of losing $150 which comes to $52.

So the net expectation for this trade seems to be a loss of $20 before commissions. I realize you don’t hold all the way to expiration but I don’t see how that would change the net expectation to positive.

I assume I’m missing something here.

To which we said:

Any option trade in an efficient market will have flat-to-negative expectancy: you should see similar results with any other iron condor trade you examine, but also for other spreads, simple long or short options, etc. etc.  Were that not the case, arbitrageurs would move in and take the positive expectancy trades until that market was priced efficiently.

The profitability of volatility-based strategies depends on the accuracy of the volatility forecast (rather than, say, price forecast) at the inception of the trade.  The reason we don’t “adjust” iron condor trades is that there’s really no such thing as adjusting: you’re either exiting an existing position entirely, or exiting an existing position and entering a new, somewhat similar position.  That’s not to say we don’t spend most of our energy on risk management; it’s just that the notion of “adjusting” or “fixing” a losing trade is most often a recipe for merely taking on undue additional risk.

Just to put another example out there: say you purchased a put spread on AAPL today, the March 80/85 vertical for $1.25 with the stock at 90.70 (this is by no means a recommendation – just an example).  With at the money implied volatility at about 54%, you have about a 33% chance of making money on this trade at March expiration.  In other words, you could expect to make $123 ($375*0.33) and lose $82 ($125*0.66) for a positive net expectancy of $41.

That looks go so far, but we haven’t factored in the effects of time decay and changes in volatility yet.  Assume that AAPL stock just sort of drifts for a week or two, and that implied volatility consequently comes in a tad, say 2%.  Suddenly, two weeks later the same trade has a less than 25% chance of being profitable at expiration, with a negative net expectancy.  Conversely – and to finally answer Peter’s question – what switches the expectancy of an iron condor position to positive is a decline in implied or realized volatility and/or the passage of time.

Ultimately, no one trades anything if they think it’s fairly priced.  You wouldn’t buy that AAPL put spread if you thought the stock was going to drift or rise, just as you wouldn’t sell an iron condor on IWM if you thought volatility was cheap.  The key point to take away here is that any options trade is about volatility, whether one wants it to be or not, even if the original motivation for the trade had only to do with the price of the underlying.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More


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