I've never traded options, spreads, or iron condors before. Will I be able to follow your trades?
Yes! The great thing about our system is that it is so flexible, and requires no prior experience with iron condors or options trading in general. For a more thorough overview of how we trade, see our Strategy page.
Do you recommend any books on options trading?
Yes, click over to our Recommended Reading List. If you have a book you'd like us to review, get in touch via the Contact page.
Why don't you trade iron condors on individual stocks?
Because indexes are less volatile than individual stocks, which gives us a tighter range to work with - and hence a greater probability of success. Individual stocks are almost always more volatile than any index, in part because they're subject to so much "event-driven" movement, like earnings reports, the actions and fortunes of competitors, management shakeups, etc. These sort of events can trigger an unexpected dramatic price swing at any time, and can easily push the price right past the range of a condor trade. So we only trade iron condors on indexes to avoid those kind of unforseeable shifts.
What about commissions?
We don't assume any particular commission structure in our performance numbers, for several reasons: 1) There a many different commission rates out there, and we're not going to arbitrarily pick one; 2) commissions have a much different impact on smaller accounts than they do on larger acccounts, in most cases, so there's no one correct way to assess the likely impact of commissions; 3) we're in the business of publishing our strategy and tracking its performance, not providing portfolio management services; our members are mature and responsible traders who are capable of managing their own accounts, including assessing the impact of commissions.
We stress the importance of execution, too: novice traders often get preoccupied with up-front transaction costs, and ignore the less obvious but equally importance issue of execution. If your broker charges an extra $40 in commissions on your 10-lot trade, but gets a better price by 0.05, they've saved you $50, for a net $10 gain. As a rule of thumb, you'll get what you pay for when it comes to execution, so be careful that you don't nickel-and-dime yourself into a low-commission, poor-execution situation. It's extremely important to get with an options-friendly broker if you aren't already - someone like Optionshouse, thinkorswim, OptionsXpress, or eOption (and there are others).
What's the minimum account size necessary to follow your trades?
We can't legally give any personalized advice about account size or what risk profile is appropriate for you. But we can say that an account with less than $5000 will face decreased percentage returns as commissions and slippage take a large portion of profits.
You trade 3-4 positions per month. Do you weight these positions equally?
Yes, our view is that positions should be equally weighted. There's no discernible edge that we're aware of in weighting positions based on entry date. And since the intent of putting on multiple positions is to smooth out the aggregate risk curve of our portfolio, it's important that subsequent trades have a similar or equal weighting in order to maximize the balancing-out effect.
My purpose in trading is to build the size of my account.
Option spreads like iron condors are a great way to build capital because they have two built-in features that you can't get by trading stocks alone: 1) leverage - every option contract is worth 100 shares of its underlying asset, which enables you to capture the price movement of an asset with a much smaller outlay of capital; 2) hedging - option spreads like iron condors enable you to define your maximum upside and downside before you initiate a trade, so you know right from the start exactly how much you will win or lose on any trade. Defined-risk trades like these protect you from the infinite downside/upside risk that is inherent when you buy/sell stocks.
My purpose in trading is to generate a steady monthly income.
Then you've come to the right place. As our Strategy page explains, the goal with iron condors isn't to hit homeruns every time we trade - instead, our goal is to make a lot of base hits that will add up over time. This is the same motivation behind bonds and income funds: to reduce risk and achieve consistent, measured performance.
My purpose in trading is to reduce the risk of my other longer term investments, like stocks, mutual funds, and ETFs.
Options spreads like iron condors can play a valuable role in any portfolio. Even if you only commit a small amount of capital to our strategy, you can use options to smooth out your returns and reduce the volatility inherent in investing. Let's say that over a three-month period, the S&P 500 Index loses 3% of its value. If your investment portfolio is long the S&P (through the SPX, SPY, or an index fund), you'll be fully exposed to that downside risk. But if you take that same portfolio and add our options spreads into the mix, you can still make money over that time period by profiting from the relatively range-bound nature of the index.
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In order to match our Model Portfolio return, it's important to participate in every trade in a given cycle. If you've joined mid-cycle, it's best to wait for the first trade in the next cycle. Before making any real trade, however, we strongly recommend reviewing the Strategy Guide, strategy-related posts and the past few months of trade analysis so you have a basic understanding of the strategy before risking any hard-earned coin. This means that even members who join right at the beginning of a new cycle would be well-advised to observe at least one cycle from start to finish before trading any real funds.
The Calendar Options Model Portfolio allocates equal risk (dollars) to each position and assumes a maximum of four positions per month. Therefore, traders who want to track our Model Portfolio returns would risk 25% of the capital devoted to the strategy on each initial trade. More important, the total capital risked on the strategy has to match each individual trader's risk-tolerance and overall portfolio risk profile.
First, never risk more than you can afford to lose—period. As infinitessimally unlikely as it is that we would take a 100% loss, no one should risk next month's groceries, utility bills or rent/mortgage on any investment strategy. Second, no more than 50% of your investment (risk) capital should be allocated to options strategies…but we like to devote the vast majority of that to market-neutral “income” strategies like calendars, condors and butterflies. Any option strategy that depends on a stock making a big move (up or down) should be considered speculative, and we keep our spec trades to less than 15% of investment capital.
Finally, watch your portfolio vega. Calendar spreads incur much more volatility risk per dollar than is offset by an equal-dollar iron condor. And unlike condors and butterflies, calendar spreads can lose value at expiration if implied volatility plummets. We devote no more than 20%–30% of our options “income” capital to the Calendar Options strategy, seeking a close-to-vega-neutral portfolio risk profile, with leanings one way or another depending on our short-term expectations regarding IV.
NOTE: The above allocation discussion is not a recommendation and should not be construed as investment advice. We're giving educational instruction regarding the general guidelines for an average investor's risk profile—members should consult a registered financial adviser for an assessment of the risk and allocation appropriate for their individual circumstances.
“Adjustments” are simply hedge trades. If our upside risk is too high, we add or roll a position up to get delta closer to our target range; if downside risk is a concern, we may either roll a position down or open a butterfly below the market for protection.
The key to being prepared for adjustments is keeping at least 25% of total capital allocated to the strategy free for hedging and adjustment trades. Butterfly hedges are a recent addition that offsets vega as well as delta risk. If we enter a fourth position in a given month, it's typically a partial-size hedge trade, and we try to keep the cost of subsequent adjustments below an additional 25%. Note, however, that our optimal trading windows often overlap, so in most months we open at least one trade for the next expiration cycle before closing the current cycle's trades.
We favor ETFs for their relative stability in the face of individual company events (such as earnings, upgrades/downgrades, dividends, etc.). Our core newsletter strategy uses SPY as the underlying vehicle; Supplemental Trades (optional positions that aren't autotraded) venture into sector ETFs and individual stocks. We like low-beta issues (beta < 1.0) because, typically, they're no more volatile than the S&P500. Regardless of the underlying, we avoid known event risk, such as earnings and dividends.
Another factor is implied volatility. If options for XYZ are trading in the middle of their three- to six-month IV range or above, the risk of losing money on the decline in premium for our long-dated contracts is too high. Volatility skew toward the front month is great, as long as there isn't a known event causing it.
Our average return per trade since inception has been almost 5%. Taking the cost of commissions into account, 2% would be a reasonable estimate. A 2% per month return works out to a 26.8% annualized return. Our latest strategy enhancements have backtested much higher—but it's important to remember that past results, real or backtested, are no guarantee of future performance. Please see the December 2010 Quarterly/Annual Performance Review for more details.
We typically make sure we can get test orders filled at the trade-alert price or better before sending out an alert. We rely on our autotrading partners to confirm fills at the stated price, and we keep a small lot aside to test whether the fill price is good at least 10 minutes after the trade alert goes out. But there's no guarantee that every member can be filled at the stated price.
It's entirely reasonable for members to give up a penny or two if they're getting in late or want to make sure the order is filled right away.
The base position, or “unit” as it's called by some of our autotrading partners, is the number of contracts needed to be make sure a position can be split for adjustments without ending up in unbalanced positions. For example, our adjustment strategy could lead to a single-calendar being split twice, into a double-calendar and then a triple-calendar; that requires four contracts to keep a whole-number contract allocation at each strike through both adjustments. We don't split double-calendars more than once, so two contracts is our initial base position for those opening trades.
Trading whole-number multiples of the base position ensures that a position won't have to be split unevenly. This is essential for autotrading, because brokers don't want to decide whether to roll, for example, 12 contracts or 11 contracts to represent “half” of the position. For members who trade manually, the base-position-multiple rule becomes less important for positions above about 10 contracts. If we roll half of an already divided 10-contract position (5–5), the difference in risk profile between rolling 2 or 3 contracts isn't terribly great. Members can use their own assessment of volatility and underlying price risk to choose between the two without incurring significantly more risk. Note that our Model Portfolio return assumes a position size large enough to safely buy the number of contracts closest to 25% of the portfolio value without regard to exactly matching base-position multiples.
Autotrading is based on multiples of the “base-unit” trade, which typically is not exactly in line with our Model Portfolio allocation, but usually is pretty close (see “What is a ‘base position’, and what does it mean?”, above). Brokers work closely with us on managing orders, and we make sure any firm order that we fill at least partially gets executed by autotrading, although not necessarily at the best price.
Usually it's pretty close, but we can't guarantee that autotraded results will match our reported Model Portfolio performance record.
What's more important is that we view autotrading as a convenient way for novice subscribers to see how the strategy works—what trades we make and how frequently—for members who aren't necessarily available to trade in real time during the day. We issue trade notices to give members who may be stuck in meetings at, say, 3:00pm Eastern, an alert that we're making a trade before the close, at a price we expect to be filled based on current technical analysis and options portfolio analysis. If autotraded orders go unffilled, after 10 or 15 minutes, we issue a trade alert update to establish the new fill price.
Even though the performance difference may not be great, we discourage members from using autotrading in place of active capital management. Autotrading is a convenient tool for learning, but it should not be used for capital-allocation purposes.
Brokers work with us on managing autotraded orders, and we make sure any order that we fill at least partially gets executed by autotrading, although not necessarily at the best price (our performance history reflects average fill prices).
Depending on implied volatility, time to front-month expiration, and the number of days between front- and back-month expiration, a Calendar Options base-position unit could cost as little as $350 or as much as $600. A rough estimate of the average monthly dollar allocation required to trade one unit is about $2000. For autotraded accounts, we recommend a minimum of $3000 per Calendar Options unit for members who aren't able to monitor their daily margin balance and want to minimize the possibility of receiving margin calls.
Well, we do—but only on a very small percentage of our total allocation. If there's a stock going down, we might buy a calendar spread below the market; if there's a stock going up, we might buy a butterfly above the market. Options trading is not as simple as most of our competitors would make it seem—we want to give you the real bottom line. Any directional trades are considered speculative, and we clearly identify them as “Bonus Trades”.
But our strategies—both Condor Options and Calendar Options—are based on gaining income from selling options in the same way that insurance companies profit from selling policies. We don't have an actuarial department, but the market does a pretty good job of pricing risk. If we sell insurance policies (options) month after month with the probabilities in our favor, we can generate a steady stream of income (with an occasional “disaster” loss—but unlike insurance companies, we can manage our losses by hedging or buying back the policy anytime it becomes too risky and/or before our losses become catastrophic).
To continue the insurance company analogy, we don't so much try to predict when and where the next hurricane will hit, as try to take advantage of the odds that three category 4 hurricanes won't hit at the same time. An experienced stock trader could have an additional advantage in his/her ability to boost earnings by speculating on the directional movement of stocks and ETFs—and there's a place for such trades in any portfolio—but for the income-generating, insurance-business-type trades, we take at most a slight directional bias and let the odds, coupled with good risk management, work in our favor over the long-run.
Two reasons: 1) Options based on the S&P 500 index show a consistent advantage in premium relative to historic volatility, and 2) SPY options are more liquid and have tighter bid/ask spreads than SPX cash index options. Nevertheless, the strategy can be applied to any underlying, and we do trade other instruments in our "Supplemental Trades" portfolio...but in that case we look for a specific set of characteristics.
First, we avoid any known event risk—most important, earnings, and to a lesser extent, dividends (the latter don't affect the stock price unpredictably so much as the options pricing). Second, we like stable stocks that tend to go through periods of sideways trading. Beta is one objective measure of a stock's volatility relative to the market (S&P), but there can also be a subjective component to the choice of an underlying based on historic chart patterns.
Equally important, we look for implied volatility that's on the low side of its past (3- to 6-month) range and, ideally, still above the stock's historic volatility. Volatility skew is also important—if we can't sell front-month options at an implied volatility that's at least 90% of IV for the back-month contracts we're buying, we'll usually look for a better risk profile. There's one important caveat to this rule: if IV is skewed heavily toward the front month, that usually means there's some risk that option buyers are protecting against and/or speculating on...so we just walk away.
In contrast to the conventional “wisdom” that condors and calendars only profit in sideways markets, both of our options newsletters have proven that they can be very profitable in trending and volatile markets. The key is dynamic risk-management. We stagger entries across multiple strikes and times to spread out delta and vega risk. If a trend or increased volatility persists, we've developed proprietary ways of adjusting our positions to compensate.
Once we've opened three positions in an options cycle, if market conditions increase our risk, we employ hedge trades to reduce risk without having to give up all our profit potential. Depending on the circumstances we may open a fourth calendar-spread position to hedge our delta, roll contracts from one strike to another to flatten out delta without increasing volatility risk (vega), or open a butterfly hedge as a way to offset both delta bias and vega.
Make no mistake: this is no “couch-potato” strategy. We've spent years trying to improve the strategy while reducing trading frequency, and we think the effort required at this point is well worth the extra gains compared to conventional investment strategies. But if you want something for nothing, I've got a bridge over the East River I can let go for a steal (or an options newsletter claiming “We booked a 4653% return in just two days!”).
At some point, we'll probably have to limit the number of subscribers—but more because we want to be able to give every subscriber personal attention than because of liquidity issues. Nevertheless, we're quite cognizant of the potential drawbacks to sparking orders for thousands of contracts at once, and we'll limit our membership the minute we see any problems getting filled at a reasonable price.
Nevertheless, commission costs have a significant effect on real returns, so we tell subscribers it's essential to negotiate a commission structure that works out to no more than $1/contract at the lot size you're trading. That could mean a ticket charge of $7.99 plus $0.75/contract on a 40-contract calendar trade, or $0.95/contract with no ticket charge. Either way, the best options brokers are flexible with customers who are serious about actively trading and/or have sufficiently large accounts.