What's wrong with Iron Condors

[Ghost of Cutten]

Quote from sle:



In any case, there is an economic explanation for why vols are structurally rich. Any seller of convexity will demand compensation for (a) increased dispersion in his returns and (b) for negative correlation of his returns with the general state of the world. You could use fancy math and utility functions to prove it, but the intution behind it is pretty simple.

How do you know those two assumptions are correct though? For example, an investor in a stock, or the producer of a commodity, can write a call at practically zero risk to himself - his returns become *less* volatile and *less* correlated with bad conditions as a result of selling premium (since he earns extra return without increasing his losses under any scenario). Similarly, with natural buyers of assets - writing puts reduces their risk, whilst increasing their return, compared to being flat.

If vol is structurally overpriced, why doesn't the market just sell it on moderate size and earn free money?

 

[Ghost of Cutten]

Quote from newwurldmn:

That would actually be an interesting study. Enter into a 1 month iron condor (with some set parameters) and see if the trade generally makes money.

That could be an interesting strategy for people who are able to predict when large price moves are more likely than usual. Simply enter iron condors when the risk of large price moves is not high, and be flat at all other times.

Any idea what kind of returns this kind of strategy might earn, relative to risk?

 

[sle]

Quote from Ghost of Cutten:

How do you know those two assumptions are correct though? For example, an investor in a stock, or the producer of a commodity, can write a call at practically zero risk to himself - his returns become *less* volatile and *less* correlated with bad conditions as a result of selling premium (since he earns extra return without increasing his losses under any scenario). Similarly, with natural buyers of assets - writing puts reduces their risk, whilst increasing their return, compared to being flat.

No, the returns for both will become more volatile.

Quote from Ghost of Cutten:
If vol is structurally overpriced, why doesn't the market just sell it on moderate size and earn free money?

There is like a million reason why people sell vol and why people do not. If I where you, I'd first figure out why your statement above is incorrect.

 

[Ghost of Cutten]

Quote from newwurldmn:



Additionally, people trade derivatives for many reasons and I can easily construct a derivatives trade where both parties can win.

A buywriter sells a call and the stock pins at his strike (he makes his premium). But the stock is incredibly whippy and The buyer of the call delta hedges and makes money on gamma.

Only if a third party loses - the buyer of the call can't delta hedge if the buy and holder is the only other player in the market. If they are the only two players, they can't both win, money just goes from one to another. Hence, the actual market price P&L of derivatives is zero sum.

Obviously since derivatives reduce actual risk in the real world, derivatives are hugely positive sum. But their P&L on the world's collective trading books will be zero minus commissions.

 

[Ghost of Cutten]

Quote from sle:

No, the returns for both will become more volatile.

Can you explain how are the returns for both more volatile? For example, in the case of the buy-writer, you are effectively saying that being short a put is more risky than being long the underlying.

 

[weewilly]

Whether or not covered calls/naked puts smooth out volatility of returns is a separate question from whether or not implied volatility of options tend to be persistently higher than realized volatility.

 

[newwurldmn]

Quote from Ghost of Cutten:

That could be an interesting strategy for people who are able to predict when large price moves are more likely than usual. Simply enter iron condors when the risk of large price moves is not high, and be flat at all other times.

Any idea what kind of returns this kind of strategy might earn, relative to risk?

I was thinking that there have been studies showing that systematically selling vol makes money if you are able to keep doing it despite high drawdowns. If iron condors don't work then the selling variance strategy only derives it's edge from the downside wing component.

When I get my data, I will probably do it.

 

[Ghost of Cutten]

Quote from weewilly:

Whether or not covered calls/naked puts smooth out volatility of returns is a separate question from whether or not implied volatility of options tend to be persistently higher than realized volatility.

I agree. But we're discussing the causes of that persistent value disparity, not its existence. Sle said that being short vol increased volatility of returns and correlation with existing risk profile, so if one or both those assumptions are not true, that calls the explanation into question.

 

[optionable]

Quote from sle:

Out of curiosity (I trade rate vol mostly anyway, so i am not gonna "steal" your super-system), what delta strangles do you general sell and what delta strangles do you buy for protection? Also, when you say a while, how many years is it?

umm, I have no idea how to answer the 'delta strangle' question, you'll need to dumb-down the question to common-speak for me.

I have tried to get into the greeks when I first got into option selling, but it quickly went way over my head and I haven't been remotely interested since. Though, conventional thought is that options traders need to understand greeks.

I've been profitably selling ICs for...this year is my third year.

Take care.

 

[newwurldmn]

Quote from Ghost of Cutten:

Only if a third party loses - the buyer of the call can't delta hedge if the buy and holder is the only other player in the market. If they are the only two players, they can't both win, money just goes from one to another. Hence, the actual market price P&L of derivatives is zero sum.

Obviously since derivatives reduce actual risk in the real world, derivatives are hugely positive sum. But their P&L on the world's collective trading books will be zero minus commissions.

That is correct, the total cost of derivatives is zero sum. But my point was that in the sea of derivatives trading two individuals with opposite trades can make money. And just because derivatives are zero sum doesn't mean one party isn't paying away edge in order to satisfy some other goal: hedging, accounting, etc.

Why is there risk premium in an option?
Suppose you know for a fact that an option is worth $1. What's the most you will pay for it and what's the least you will sell it for?
You should be willing to pay $1 (expected value flat) because there is an outside change you can make infinity dollars. You should be willing to sell it for 1.01 or higher (but never $1).
The risk premium exists because we are all not risk neutral (bankruptcy is generally worse than making a billion dollars).