Bread & Butter Iron Condors

[blueplayer]

Quote from sle:

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)

Hello Sle, I won't object to the last two points, however, I am curious if you really think that (a) actually applies to the scenario being discussed, that is, a 30% fall on the underlying with a 15% OTM naked put strike before the fall.

Do you think that the naked put will prove better in terms of RR for that particular case?

I don't really see how it can be, but I would like to hear your arguments.

 

[Put_Master]

Quote from blueplayer:

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.

My only problem with this example is, this is a 4 month contract, and the "event' occured just a week later.
Thus you still had more than 90% of the time remaining of time premium.
Thus not a typical situation, as to when one would close the deteriorating spread.

My eyes need a rest, so I'll write back later or in the morning.
Again. Very good discussion for the entire board of readers.
Plenty for all to think about.

 

[blueplayer]

Quote from Put_Master:

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.

Well, I forgot about those two things, dividends and covered calls, so you got me there. It is very likely then that the naked put seller under your conditions will come ahead of the vertical spread seller. That it is hard to argue against once you consider the supplemental income you can bring.

Can at least keep the fact that the credit spread is not completely wiped out if the margin levels are similar?

 

[sle]

To achieve the same return, you need to sell a much smaller amount of naked puts. So your proportionate losses would be much smaller.

 

[blueplayer]

Quote from blueplayer:

Hello Sle, I won't object to the last two points, however, I am curious if you really think that (a) actually applies to the scenario being discussed, that is, a 30% fall on the underlying with a 15% OTM naked put strike before the fall.

Do you think that the naked put will prove better in terms of RR for that particular case?

I don't really see how it can be, but I would like to hear your arguments.

Well, I also forgot about dividends and covered calls, so you can take back my question Sle.

 

[Put_Master]

Quote from sle:

To achieve the same return, you need to sell a much smaller amount of naked puts. So your proportionate losses would be much smaller.

I Agree.
But the point of the exercise was not to compare profits, but to compare how a negative event might affect both type traders.
Thus, I added even MORE stress to my account then I should have,... because I wanted it to be a realistic stress test for me.
And thus a good comparative analysis and study of the 2 strategies.

Really gotta close my eyes.
Thanks to both of you for an excellent discussion. Hopefully others will benefit from it,...as I did.

 

[Put_Master]

<<< Can at least keep the fact that the credit spread is not completely wiped out if the margin levels are similar? >>>

Similar margin leverages are either not possible or not realistic for the comparison.
The issue is the TOTAL use of ones cash for the spread trader.
And the cash and margin for the naked put seller.

Thus, the severity of your loss will depend on when the black swan event occurs, how large a drop below your strikes, and how much time premium remains in the contract. And what kind of spike in IV and bid/ask you now face.
If it's late in the contract, while it may not be a 100% loss, I'm not sure 90% is much of an improvement.... excluding your credit received.
(Unless you used the credit to sell even more contracts).

If it's really late in the contract, a penny below your strikes will wipe you out.
if it's early in the contract, you can be even lower below your strikes, and still save some money, due to the time premium.
But that spike in IV is NOT going to be very friendly to your net worth.

 

[Put_Master]

<<< Similar margin leverages are either not possible or not realistic for the comparison.
The issue is the TOTAL use of ones cash for the spread trader.
And the cash and margin for the naked put seller. >>>


I just wanted to further explain why similar margin leverages between the 2 strategies are either unrealistic or not possible.
The average spread trader who uses all his cash, and who uses strikes in the $30 - $60 range, is on leverage of 10 times his account value.
The higher the strikes the higher the leverage. But that 30 - 60 range will put them at about 10 times their account value.

Thus, there is no way a naked put seller can be on that much leverage. It's unlikely the margined put seller will even be on 2 times their account value.
On the other hand if the spread trader reduced the amount of cash he put at risk, to amounts similar to what the leveraged naked put seller used,.... the spread trader would use LESS THAN 1/3 of his cash.
That is simply not realistic.
No way is a spread trader going to sit with MORE THAN 2/3 of his money in cash.

Thus, a reasonable and sensible way to stress both traders somewhat similarly during difficult times, is to have the spread trader use all his cash, and for the naked put trader to be on leverage of 2 times his account value.
That is a lot of margin. Way more than most naked put traders would dare be on.
Thus, more than a fair comparison.

 

[osho67]

Thanks fo the discussion. This thread is a good education.

Is it possible to put all the pages in pdf format so I can print them in one go?

Thanks

 

[Put_Master]

Quote from osho67:
Thanks fo the discussion. This thread is a good education.
Is it possible to put all the pages in pdf format so I can print them in one go? Thanks

I agree, it was a good discussion for the board.
I learned quite a bit myself.
It's these type discussions, arguments and debates, that make us all more intelligent, more safe and more profitable traders over the L-T.