Bread & Butter Iron Condors

[Put_Master]

Quote from blueplayer:

<<< You seem to be thinking in terms of expiration day while my example was done on July 31, the day that the black swan occurred.
Of course if we let the contracts run to full expiration then the balances would be different. For instance for today Sept 18 2012 the credit spread seller would only have $6450 in his account (still not zero). But what kind of sane trader would keep an ITM credit spread for such a long time? >>>

Sorry, but gotta disagree again. If your credit spread is already a couple of points ITM, weeks or months before expiration day, you would have to be "insane" to close it.
You are already at max loss. Your $100,000 is gone,... give or take a few dollars for any time premium remaining.
Therefore, keep it open. You have time for it to potentially recover.
You have little to lose keeping it open, and potentially much to gain.


<<< Besides on July 31 the naked seller would be toasted so this point is irrelevant. >>>

Sorry, but still gotta disagree.
I may need to close a few contracts if the stock drops to $21, being that I'm on 40% margin. (Using $250,000 vs my initial $100,000).
But my naked put account is still intact.
And if I were on 38% margin instead of 40%, i would not even need to close any contracts with a drop to $21.
Of course, this assume all my stocks were fully marginable.

I'd like to hear from SLE , Atticus and others on this issue.

 

[blueplayer]

Quote from Put_Master:


Sorry, but gotta disagree again. If your credit spread is already a couple of points ITM, weeks or months before expiration day, you would have to be "insane" to close it.
You are already at max loss. Your $100,000 is gone,... give or take a few dollars for any time premium remaining.
Therefore, keep it open. You have time for it to potentially recover.
You have little to lose keeping it open, and potentially much to gain.

Hello Put_Master, disagreeing with me is fine, but there are certain facts that can't be argued against. I'll explain.

According to your logic, every single ITM vertical spread of any stock and any expiration month should be at its max value. That is, you are claiming that the value of any ITM vertical spread is the difference between the strikes no matter when they expire.

That my friend is an incorrect claim. Just a few examples that you can see with any platform that disprove your belief:

AAPL Nov PUT 710/705 spread. According to your logic it should be at $5.00 now because it is all ITM. However the value as quoted is $2.67 much less than $5.00. We are a couple months away from expiration.

GMCR Nov PUT 33/32 spread the value is at $0.67, not $1.00 as your logic claims.

GOOG Oct PUT 730/725 spread, again it should be at $5.00 according to you because is all ITM, but the value as quoted is $2.80 and we are one month away from expiration.

Finally, some action for September:

GOOG Sept PUT 730/725 should be at $5.00 according to you, however it is quoted at $3.90 And we are a few days away from expiration.

If you noticed, as you get closer to expiration day the value starts approaching the spread difference but not quite.

You can observe this with many ITM vertical spreads where the options strikes are not that far from the underlying price. In other words if they are not deep in the money, which has been exactly the case we have been discussing this whole time.

So when I said that in July 31 the FB Sept PUT 25/23 spread was at $1.40 I wasn't lying and the fact that it was not at $2.00 is the reason why the credit spread was superior to the naked put on margin on that particular day.

You seem to have this high level idea of vertical credit spreads as binary instruments that are either at max profit or max loss without any regard for the non-linear nature of the options that compose them. That my friend is a wrong understanding of the subject matter.

 

[Put_Master]

<<< According to your logic, every single ITM vertical spread of any stock and any expiration month should be at its max value. That is, you are claiming that the value of any ITM vertical spread is the difference between the strikes no matter when they expire. >>>

Blueplayer, I've never stated any such thing, In fact I've repeatly talked about the time value remaining in the contract, even when it's trading BELOW both strikes.

But you keep using examples of a black swan occuring on this or that particular day, which is somewhat ridiculus, as to which specific day,... as we are having a hypothetical discussion about a black swan.
Why?
You refer to a black swan, but the options bid/ask don't reflect any spike in IV or a change in bid ask price... or gap.
If anything the VIX and IV has been dropping over the past few months!
Those improving numbers are the examples you're using???

So again, my point is, once you are ITM, you are at max loss, minus any time premium that remains.
And the reason you are at max loss, is because you are unable to buy any of the stocks, even if you wanted to. All you can do is close the trade for a loss.
How much loss will depend on how deep ITM and how much time remaining. Given that we are talking about a black swan, there is no specific answer for that. Other than it will be a lot MORE than you assume.

In addition, the more narrow your spread gap, the less damage you will incur when closing a spread due to the black swan,... with subsequent spike in IV and changes to bid ask. (Not just the bid ask numbers.... but the bid/ask gap as well.)
The wider your spread gap, the more damage you will incur.
Narrow is always better when closing a spread.

Remember, the naked put seller can consider buying all or most of his shares. The spread trader can not.
And again, my example of 40% margin was a bit extreme, but I used it so I'll stick with it.

 

[blueplayer]

Quote from Put_Master:


Blueplayer, I've never stated any such thing, In fact I've repeatly talked about the time value remaining in the contract, even when it's trading BELOW both strikes

I see that we are reaching some form of agreement here. Just for reference this is what you actually said:

Sorry, but gotta disagree again. If your credit spread is already a couple of points ITM, weeks or months before expiration day, you would have to be "insane" to close it.
You are already at max loss. Your $100,000 is gone,... give or take a few dollars for any time premium remaining.

The give an take a few dollars is of vital importance here, as with the Facebook example I provided early we were talking about 38% of our capital still intact. And in many of the later examples I provided it is between 36% to 48% of your capital. I believe that you can agree that it is very far from a max loss.

But you keep using examples of a black swan occuring on this or that particular day, which is somewhat ridiculus, as to which specific day,... as we are having a hypothetical discussion about a black swan.
Why?

I picked July 31 for Facebook because it was actually just a few days after a black swan for the stock itself. If you paid any attention you will notice that it was a few days after the earnings report. I used the example to ground your theoretical discussion with an event that actually happened and allowed me to compute a comparison following your rules. It was fair and square.

So again, my point is, once you are ITM, you are at max loss, minus any time premium that remains.
And the reason you are at max loss, is because you are unable to buy any of the stocks, even if you wanted to. All you can do is close the trade for a loss.
How much loss will depend on how deep ITM and how much time remaining. Given we are talking about a black swan, there is no specific answer for that.

I think that max loss has a concrete and measurable meaning, and that is, the loss of all the capital invested. Is that not correct?

In the Facebook example, the loss on July 31 was 62% for the spread and 95% for the naked sell, what of the two do you think is closer to a max loss?

An there is always an specific answer, I picked a major event for Facebook, I could have easily picked another different time point, like the collapse of Lehman Brothers for instance. I just choose the collapse of facebook because it was a recent example that all here can relate to. I'll be more than happy to run the numbers for Sept 2008 if you want and you will see that the results won't change much for a certain set of stocks.

Remember, the naked put seller can consider buying all or most of his shares. The spread trader can not.
And again, my example of 40% margin was a bit extreme, but I used it so I'll stick with it.

Your example of 40% margin doesn't correspond with the reality of the requirements at your broker, which according to all that you have written is Charles Schwab. Their own Margin Handbook as of Aug 1 2012 contradicts you clearly on page 14. Please take a look at the link I provided and see it for yourself:

http://www.schwab.com/public/file/P-4193744/Margin_Handbook_FINAL_080112.pdf

The computations used in my Facebook example are correct and adjusted to Schwab requirements. Your 40% number on the other hand is pulled out of thin air.

Finally with $5K left in your account and a $65K margin call, how much facebook stock at $21.71 can you really afford?.

It really amazes me your denial in the face of the cold numbers, you are entitled to your own opinions but not to your own facts.

The fact of the matter which can be checked with very simple arithmetic (as I did) is that the naked put writer in a Reg T. margin account is exposed to tremendous risk and can be wiped out as easily as the credit spread writer, and in fact he can end up much worse under the same conditions.

An example with a real black swan event will follow.

 

[Put_Master]

<<< Your example of 40% margin doesn't correspond with the reality of the requirements at your broker, which according to all that you have written is Charles Schwab. >>>

You are correct about the 40% example.
Like i said I was just talking off the cuff and used an extreme example. That extreme example was my error, and i appreciate you bringing it to my attention.
A more realistic statement I should have used would be,.... if I leveraged my naked put account to twice the value of my account net worth, and all the stocks were put to me a penny under my strikes, i would then be at 50% margin.
That being, I could own stocks worth $200,000 and be at 50% margin a penny under those strikes.

Those stocks could then drop to where i would be at 30%. At which time I would need to raise cash, if I wanted to continue holding the stocks..... assuming all the stocks were fully marginable.
But I'm ok until I hit the 30% mark.
Is that a more accurate statement?

 

[Put_Master]

<<< I picked July 31 for Facebook because it was actually just a few days after a black swan for the stock itself. If you paid any attention you will notice that it was a few days after the earnings report. I used the example to ground your theoretical discussion with an event that actually happened and allowed me to compute a comparison following your rules. It was fair and square. >>>


FB was an attempt at a reasonable example, but wasn't the IV already inflated in FB, when it dropped on earnings?
Wasn't the stock already dropping almost from day one of it's creation?
When we talk about a black swan, aren't we really talking about a "surprise" event that drops the market in general and a stock in particular?
A black swan, is when IV is in the low or normal range for a stock and then the hit occurs.
Thus the shock of the spike in IV, with subsequent bid/ask spiking and the bid/ask gap widening.

Thus, I'm not sure FB is a realistic example of a black swan event.
There would have been a bigger % spike in it's IV and subsequent bid/ask numbers and gap.
I think most investors were expecting something similar to what occured. No real shock to investors.
Disapointment yes. Selling yes. But shock?
With a shocking % spike in IV that day.....???

A black swan is NOT just about stocks dropping. It's about a sig spike in IV.
That IV spike is what kills option traders, who have to close their trades,.... because they can't buy their excessively leveraged stocks.

Thus your examples of closing stock spreads, whose IV have been dropping for months, are not very realistic examples.

 

[blueplayer]

Quote from Put_Master:

<<< Your example of 40% margin doesn't correspond with the reality of the requirements at your broker, which according to all that you have written is Charles Schwab. >>>

You are correct about the 40% example.
Like i said I was just talking off the cuff and used an extreme example. That extreme example was my error, and i appreciate you bringing it to my attention.
A more realistic statement I should have used would be,.... if I leveraged my naked put account to twice the value of my account net worth, and all the stocks were put to me a penny under my strikes, i would then be at 50% margin.
That being, I could own stocks worth $200,000 and be at 50% margin a penny under those strikes.

Those stocks could then drop to where i would be at 30%. At which time I would need to raise cash, if I wanted to continue holding the stocks..... assuming all the stocks were fully marginable.
But I'm ok until I hit the 30% mark.
Is that a more accurate statement?

I see that now we are even closer to an agreement. I completely understand your explanation and it is clearly your personal preference but not a feature of the margin requirements of your broker. In other worse is an arbitrary "margin" that you build in case of major disaster and I am fine with that.

However I hope that you also see that the new, more clear statement contradicts the conditions you set for the analysis which were:

Lets say the market suddenly drops 25 - 30%.
Lets also assume the credit spread trader and the naked put seller are both 100% invested. Both have a $100,000 account.

The way I read it I assumed you meant that both accounts were maxed in terms of the margin required for the particular transactions i.e credit spread and naked put. Which is clearly not what you had in mind, at least in terms of the naked put.

So far so good, but now you must also allow me to use the same advantage that you are taking for yourself. That is, you are leaving yourself a margin of safety that was not originally afforded to me. If you allow me to take that margin of safety myself I can quickly run the numbers again and compare. That sounds fair to you? I certainly hope so.

Now, what you are really saying is that in the worse case scenario of an assignment you want to be able to buy 2 stock for the price of 1, that Is you want to be able to control $200K of stock with the $100K that you have now. Because the strike price of your put is $25, then the maximum number of shares you can buy is:

max shares = 200000/25 (allow me to use the whole number for easy calculation).

max shares = 8000

So in fact what you are really saying is that you are willing to sell 80 FB Sept 25 PUT contracts. This is something that you are doing to be on the safe side. So far so good.

Now, lets compute the margin req from Schwab for that sale:

Margin = 0.25*29.11 - 4.11 + premium
Margin = 3.1675 + premium per contract

That means that your margin req is $25340 (3.1675*80*100) of your original 100K (we don't include the premium as you can't do anything with it), in other words only 25% of your whole capital is being used to maintain this trade (and not 100% as I incorrectly supposed).

With that number lets see how the credit spread seller do. Having a margin of $25340 means that I can sell:

Max contracts = $25340/(1.55*100) = 163.48

Lets round up and sell right there 164 FB Sept 25/23 Put for $0.45 credit.

So right now, you and I are under equal conditions, both have sold enough contracts to use $25340 or margin req.

Lets fast forward to July 31 and check the P/L for both accounts.

Naked Put P/L : -$24400
Credit spread P/L: -$15580

None of the accounts has been wiped out, which is natural given the small number of contracts that we sold. However it is clear that the loss for the credit spread was substantially smaller than the loss for the naked put.

With Facebook at $21.71 you now need more margin to hold those contracts but that it is just around $18K of additional margin not of much consequence for the account. Although not only you have lost $24K so far in paper, but you now have an additional $18K tied on margin until Sept 21 where you will be assigned and presumably will roll into a paper loss of around $32K If facebook closes around $21, and of $24K if facebook closes around $22. Then you keep the stock around until you can unload it at a profit. Also by now you realize that you account is effectively frozen as all of your assets were used to buy the assignment and you are under strict margin now. You cross your fingers that some day you can unload those shares at profit or perhaps you finally decide to realize the loss.

I, in the other hand, would let my spread run one day in case of a dead cat bounce for the stock, but absent one then I will take the loss of $16K and live another day. There is not a sane trader out there that will keep an ITM credit spread running as the negative Tetha will kill you day by day. Also, after realizing the loss of $16K in July 31 I could use the $84K that I have left to keep trading. You in the other hand can only use $58K to trade because the rest is tied to your contracts and if assigned the whole account will be frozen for all practical purposes.

I understand your thinking, you will hold the stock until some day it goes over $23.95 and you make money, or perhaps you minimize the loss. But while that day comes you can't really do anything with this hypothetical $100K account.

I rather take the loss and keep trading, ah and also I wasn't wiped out in this case either

 

[blueplayer]

Quote from Put_Master:

<<< I picked July 31 for Facebook because it was actually just a few days after a black swan for the stock itself. If you paid any attention you will notice that it was a few days after the earnings report. I used the example to ground your theoretical discussion with an event that actually happened and allowed me to compute a comparison following your rules. It was fair and square. >>>


FB was an attempt at a reasonable example, but wasn't the IV already inflated in FB, when it dropped on earnings?
Wasn't the stock already dropping almost from day one of it's creation?
When we talk about a black swan, aren't we really talking about a "surprise" event that drops the market in general and a stock in particular?
A black swan, is when IV is in the low or normal range for a stock and then the hit occurs.
Thus the shock of the spike in IV, with subsequent bid/ask spiking and the bid/ask gap widening.

Thus, I'm not sure FB is a realistic example of a black swan event.
There would have been a bigger % spike in it's IV and subsequent bid/ask numbers and gap.
I think most investors were expecting something similar to what occured. No real shock to investors.
Disapointment yes. Selling yes. But shock?
With a shocking % spike in IV that day.....???

A black swan is NOT just about stocks dropping. It's about a sig spike in IV.
That IV spike is what kills option traders, who have to close their trades,.... because they can't buy their excessively leveraged stocks.

Thus your examples of closing stock spreads, whose IV have been dropping for months, are not very realistic examples.

Fine, lets use a better example.

What about Herbalife on April 24 2012? that was a quiet day, The stock was around $70 and the Aug 65 Put had a price of $4.25 and an IV of 39.26%

The Aug 65/62.5 Put spread was priced at $0.90 and had an IV of 39.84%

Now lets go to April 30 2012, earnings are announced and they come strong, beating the street, and the outlook is very positive. However, someone called David Einhorn is on the conference call and asks 3 questions. The next day, May 1 the stock drops more than 15% to $59.70, by the end of that week on May 4, the stock is at $46.94 a whooping 33% drop from April 30 and the implied volatility of the Aug 65 Put is now 68.97% (a gigantic spike) and the IV for the Aug 65/62.5 spread is 69.41% (equally huge spike). I think those conditions are the ones you are looking for.

Under those conditions the Aug 65/62.5 spread (which by now is deep in the money) is now $2.05 and the total loss per contract, if we buy them back, is -$1.15 or just 48% of the capital at risk. Very far from a max loss event don't you agree?

At some point I hope you can do your own homework and run your own numbers and see how using a hedged option position (vertical spreads in this case) always comes ahead of a naked one in terms of risk.

 

[sle]

Quote from blueplayer:

At some point I hope you can do your own homework and run your own numbers and see how using a hedged option position (vertical spreads in this case) always comes ahead of a naked one in terms of risk.

Actually...
(a) without considering any particular stock, in terms of sheer Sharpe and draw-downs in Sd-terms, I am pretty sure naked puts would prove to be a better strategy (in terms of risk/reward).
(b) a put spread is more of a binary bet while a naked put is a bit more of a distributional bet. On average, you have to have a much stronger view on the stock for the first one.
(c) selling a put spread is intuitively inconsistent, if you feel that the higher strike put is rich, the lower strike should be even richer (unless the skew is inverted)

 

[Put_Master]

I also didn't realize we were both operating under 2 different assumptions. I had no idea you had me at max margin.
However, just a couple of minor issues.

You mentioned if I owned the stock I can only sit and wait for recovery.
When in fact, i can collect dividends, which reduces my margin, and I can sell covered calls, which also reduces my margin,.... as well as lowers my break even price.

So I really don't have to wait for the stock to return to my original buy price.... if I so choose.
And in fact, i can select a covered call strike even lower than my original strike, for an even higher potential credit,... , depending on where I think the stock will be trading during that unit of time.

HOWEVER, while you may not think it fair, I actually was assuming you used your $100,000 for credit spreads.
I used my $100,000 and you used yours.
I then added 40% margin for me, just to make it more "fair", in terms of the "stress" of managing both accounts.
But I should have been specific about how many dollars of margin I was putting myself on.
I had no idea you assumed I was at max margin.

The reason I was assuming you used your entire $100,000 account, is because we were comparing leveraged naked put sellers to leveraged spread traders.
Both with the same $100,000 account.
And in reality, you really should assume you used the entire $100,000.
WHY?
Because if you were a pure spread trader, most spread traders are NOT going to sit on 30% cash, or what ever % you assume, and collect zero % interest.
If you are a spread trader you are going to use your cash.
As will a naked put trader.

The entire point of the exercise was to evaluate which trader might get into trouble easier.
Thus I attempted to use a realistic and comparible scenerio, that both traders might naturally find themselves in.
If anything, I made it harder on myself than I should have, as I would never leverage a margin account double my net worth.
But to make it equally stressful, that is what I did.
Turns out, you actually had me at triple my net worth.... or more.
So a big misunderstanding there. I should have stated specific dollars of margin.

I beleive a situation where the margined put seller worth $100,000 is on double his net worth of naked puts, and the spread trader uses all his cash is both realistic and a fair comparison.
And also to be fair and realistic, it is reasonable to assume a spike in IV and subsequent changes bid/ask and the bid/ ask gap,.... in the event of a black swan.
HOWEVER, I really don't know if that situation can be accurately or realistically evaluated.
So we may have to leave it for others to ponder.
A very good discussion. Thank you.