Condor Options

In Part I of this Guide, I explained why the calendar spread is a good vehicle for generating income and looked at some of the risks. In Part II, I’m going to take you through the “how”, from the perspective of managing risk at every step in the process.

Step One – Position-Sizing

The first decision you have to make about trading any strategy is how to size positions—and that’s where the Calendar Options strategy starts:

• Size positions appropriately for your risk-tolerance – When learning a new strategy or technique, start small—or, better yet, just paper-trade at first. Even if you think you’ve mastered all the ins and outs of options-trading, never risk more than one-third to one-half of your total investment capital on options-trading strategies (not including options tied to long stock positions, such as covered calls and married puts). Note that “investment capital” does not include your house, your emergency funds, your kids’ college savings or, some would even argue, anything you’re absolutely counting on for retirement.
• Diversify risk among multiple options strategies – Whenever I see someone putting all of their capital into one strategy just because it had the highest return last quarter (or last year, or even over 10 years) it scares the heck out of me. Different strategies have different risks, and the risks of one strategy can offset those of another. My own options portfolio focuses on market-neutral strategies aimed at producing monthly income by selling premium, and mainly includes diagonal spreads, condors, calendar spreads and butterflies.
• Allocate capital to each strategy in proportion to risk– All my core options strategies are defined-risk, which means I know the maximum amount I could possibly lose whenever I enter a trade. But as we’ve seen, in the options realm there are several dimensions of risk, and it’s important to consider all of them in your diversification plan.

  With calendar spreads, we focus on what primarily distinguishes them from condors and butterflies: volatility risk. Vega, in proportion to capital at risk, for our typical calendar position is 60% to 100% greater than the (negative) vega of an average iron condor. That means if we want to balance volatility risk, we have to allocate no more than half as much capital to our calendar strategy as we’ve devoted to short-vega strategies (condors and butterflies), which translates to no more than one-sixth of total investment capital.

After deciding how much to set aside for calendar trades, we divide that up according to the Calendar Options Model Portfolio allocation.

• The Model Portfolio is based on a simple, equal-risk allocation method, with a portion of capital kept in reserve for hedge trades and adjustments – Because we open as many as three core positions in a given expiration cycle (more about this later), we divide total portfolio capital into four equal parts—one for each core position, with the last 25% (at least) remaining for hedging/adjustment.
• Risk does not always equal required margin – The margin needed for most Calendar Options trades is equal to the net cost, and that equals the total dollar risk of the trade. However, the strategy includes double-diagonal positions, for which FINRA rules require brokers to hold more margin than the real risk (unless the trader mismanages the position in the most inconceivably incompetent fashion). Model Portfolio allocation, for core positions, is based on real risk, not necessarily the margin required by your brokerage.
• Hedge trades typically are allocated a fraction of the core position size – Hedge positions focus on adjusting portfolio delta while minimizing additional risk, so they’re usually smaller, in terms of risk capital, than core positions. To make it easy for subscribers to determine trade size, we specify hedge trades relative to the number of contracts in an existing core position. Trade alerts make note of when we’re buying a specific number of contracts (again, in proportion to an open position), versus risking equal capital..
• Note that the Model Portfolio was developed as a convenient way to size positions and balance risk – It is not optimized for performance and is not intended as a recommendation. It is, however, the basis for our performance record, so anyone who wishes to track that performance going forward would use the Model Portfolio allocation.

Step Two – Diversify Risk Within the Strategy

Our approach to diversifying risk, within the Calendar Options Strategy, begins with trade entry. With the exception of time-decay, all the variables that affect option pricing are risks we have to carefully manage in calendar-spread trades, as in any “positive-theta” option strategy (where the net position gains value with time).

• We build a portfolio of positions across a range of strike prices to spread out risk – Each month we open as many as three different core positions as the underlying share price changes, using each new position to bring our aggregate portfolio risk profile back to our desired target.
• Multiple entry trades also help average out volatility risk – Calendar spreads are positive-vega, or “long volatility” positions, which means they typically rise in value when the market drives up option premium (higher implied volatility) and lose value when traders become more complacent. By building each month’s portfolio with a series of trades over time, we spread out volatility risk much like dollar-cost averaging smooths out some of the price risk in purchasing stocks.
• We typically use multiple strikes for each core position – Instead of betting that share price won’t move, or trying to predict where the price will be at some time in the future, we build tolerance for changes in share price into each individual position. Core positions typically start out as double-calendars rather than single-strike calendar spreads.
• Double-diagonals for volatility-neutral trading – If implied volatility remains above our target trade-entry range for an extended period, we have the option to use a double-diagonal spread instead of a double-calendar. As the name suggests, each side of a double-diagonal includes two different strikes as well as expiration months—like merging a double-calendar with an iron condor—to produce a position that’s closer to vega-neutral.

Step Three – Manage Risk Dynamically

After we’ve established one or more core positions, we apply a proprietary multi-dimensional dynamic hedging approach to correct for changes in delta and, at the same time, manage volatility risk:

• Hedge trades include calendar spreads, butterflies and double-diagonals – This allows us not only to increase profit potential while hedging delta, but also to avoid adding volatility risk—or even to reduce it—when implied volatility is relatively high and/or falling steadily.
• Adjustment trades – In addition to using various spread-trade strategies for hedging portfolio risk, we have a variety of “adjustment” techniques for altering the risk profile of an existing position in response to changes in underlying share price. Some of these are as simple as closing half of an open position to lock in a profit and/or reduce gamma. Others are a little more complicated, rolling a position, or part of a position, up or down to adapt to a trending market or a whipsaw reversal. Regardless of the adjustment, every trade alert specifies exactly what contracts we’re buying, what contracts we’re selling and, if appropriate, the type of trade we’re making (such as a butterfly or iron condor).

At this point it’s probably clear that you’re going to encounter a lot of different combination trades in this newsletter. True, even advanced options traders will probably see something new here—after all, when it comes to options, the possibilities are virtually unlimited (no pun intended).

But less experienced members needn’t let that scare them. Every trade alert is precise and includes everything you need to know about the order we’re placing. Trade alerts are followed up with analysis that explains what triggered the trade and its effect on our portfolio risk profile. And if you have any questions, you can just fire off an e-mail to frank@condoroptions.com, and I’ll do my best to clear up anything you don’t understand—within 24 hours, and if we have a trade working, immediately.

Nevertheless, some preparation would be helpful if you’re not familiar with the full range of three- and four-legged option trades. The third part of this Guide [to be published shortly] will include a catalog of trades used in the Calendar Options newsletter to help you visualize and comprehend the characteristics of each and how we use it to shape our profit/loss profile.