Options Strategies.pdf

8/22/2019 Options Strategies.pdf

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Options Trading Strategies | Implied Volatility & Probability

Option's Anatomy

The anatomy of an option's value is made up of 6 elements with the corresponding"Greek" measuring the sensitivity/exposure to that specific element:

1. Underlying instrument's Price. Delta & Gamma (& Lambda).

2. Time to Expiration remaining. Theta.

3. Implied Volatility. Vega (not a "Greek", a.k.a Kappa).

4. Short-term interest rate. Rho.

3 Month (90 Day) Tbill is the default rate.

5. Strike price of the option (ITM, ATM and OTM). Mix of Greeks specific to strike.

6. Dividends (if relevant). No directly corresponding Greek(s).

Both Time to Expiration and Volatility have a DIRECT impact on the option's value

More Time to Expiration makes both calls and puts rise in value.

Less Time to Expiration makes both calls and puts fall in value.

Higher volatility makes both calls and puts rise in value.

Lower volatility makes both calls and puts fall in value.

The product's Price itself has its own varying impact on calls distinct from puts, fore.g.

As price rises, straight calls increase in value; but, puts decrease in value.

As price falls, straight calls decrease in value; but, puts increase in value.

Interest Rates and Dividends (if relevant) have opposite effects on calls versus puts

As Interest Rates rise, long calls rise in value; but, long puts decrease in value.

As Interest Rates rise, short calls decrease in value; but, short puts rise in value.

As Interest Rates fall, long calls decrease in value; but, long puts rise in value.

As Interest Rates fall, short calls rise in value; but, short puts decrease in value.
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As a company raises its Dividend, long calls decrease in value; but, longputs increase in value.

As a company raises its Dividend, short calls rise in value; but, short puts decreasein value.

As a company lowers its Dividend, long calls increase in value; but, longputs decrease in value.

As a company lowers its Dividend, short calls decrease in value; but, shortputs rise in value.

Listed options have no right to the dividend. The options just reflect what theproduct's price is expected to do. As a Dividend is raised, the drop in price will bemore, once the underlying goes ex-dividend. This makes calls decrease in value; butputs increase in value. As a Dividend is lowered, the drop in price will be less oncethe underlying goes exdividend. This makes calls increase in value; but, puts

decrease in value.

You may choose to trade European-style Indexes that are absent of dividends,to remove dividends out of the equation from the start.

Direct and opposing effects explain why calls and puts do not share identical values attheir common ITM, ATM and OTM strikes. Calls and Puts shift betweenasymmetricaldistribution curves,losing their symmetryremember at any given strike there willalways be a pairing of an OTM Call with an ITM Put, an ITM Put is paired off with anOTM Call, and an ATM/NTM Call is paired up with an ATM/NTM Put. Paired does notmean one is an identical twin of the other.

Which elements impacting an option's anatomy do you not have the choice ofaccepting or rejecting, when structuring a chosen option spread?

Federal Open Market Committee determines Interest Rate policy. Not your say.

Dividend policy is decided by the listed company. Not your say.

Price of the underlying product is marketdriven. Not your say.

Quote: Of a stocks move ...

31% can be attributed to the general stock market,

13% to industry influence,

36% to influence of other groupings, and the remaining

20% is peculiar to the one stock.
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Benjamin F. King, Market and Industry Factors, Journal of Business, Jan1966.

So, which elements of an option's anatomy is left for you to decide on? Strikes,Time to Expiration & Volatility.

AsTime is Synthetic Volatility and Volatility is Synthetic Time, for which both areunique to an option's strike,at minimum, 50% of your trading day's effort mustfocus on Volatility analysis.

Strikes

The exchange on which the product is traded decides the number of strikesand increments between strikes. For retail traders, to control the risks within limitsdue to smaller sized accounts, it is advisable to choose products with

$1 wide increments between strikes for Calendars. Maximum width would bea product with $2.50 increments between strikes.

$1 to $2.50 wide increments between strikes for Verticals, maximum of $5.

Are you too wide or slim? Not your waistline. But, are you exposing short positions totoo much credit margin at risk for a given strike width; and, you construct longpositions that are too cramped without room for the debit to expand? Reconfigure thestrike width.

Time to Expiration

You decide how much time to sell and buy. Advisable for retail traders to be

Short Net Credit spreads between 3050 days with an ROI of between 1%2% perday at minimum, at maximum 3%4% per day.

Long Net Debit Spreads between 6090 days up to a maximum of 120 days, withan ROI range between 150%200+% within 60 days of being in the trade, is considereda reasonable expectation.

VolatilityDebating Historical versus Implied & Which Options Pricing ModelApplies?

Much debate surrounds comparing both Implied Volatility (IV) and

Historical/Statistical Volatility (HV/SV) against each other. While IV and HV aremeant to converge at an option's expiration, it is not certain that convergence willoccur. Why? Various combinations of corporate action (e.g. takeovers/investigations),or variance in earnings guidance may prevent an assumed "over/underpriced" optionreaching convergence at expiry. Moreover, you cannot resimulate the macroeconomic parameters affecting the volatility specific to an Asset Class. The HomeOptions Trading process has chosen to remove the use of Historical Volatilityaltogether. HVIV crossover signals only cause visual confusion: no such crossover
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signals were used as trade entry criteria in generating theConsistent Resultsshown inthe model portfolio.

IV is a forward looking estimate, which explains why there are back/far monthexpiration intervals. So, for practical trading purposes,it makes sense toforecast IV 30-120 days forward. There is no reason to look backwards, as youcannot Theoretically Price Historical Volatility into the option/spread you planto be long/short in.

Of note, Vega measures the amount of change in the option price for a 1% change inImplied Volatility (not HV/SV). There is no "Greek" that measures HV/SV.

Here's the key difference between Historical Volatility and Implied Volatility.

HV is an annualized standard deviation of price changes expressed as a %.

It calculates how volatile the underlying was for X. number of past tradingdays (adjustable period), prior to each observation date in the data series, for thatgiven period. For HV you can adjust the period to be different from the option'sexpiration cycle; but not with IVthe expiration cycle is fixed.

HV measures how fast the underlying has been moving around in the past for thatgiven period. HV is not a substitute for IV. HV of an underlying may have benignvolatility behavior in the past but become extremely active suddenly, with nothing toanticipate this change in activity. Especially with volatility, history fails topredict future expectations based on past experiences.

Rather than rely on HV, it's more meaningful to look at Gamma, as howfast (acceleration) or how slow (deceleration) it can manufacturepositive/negative Deltas to propel/stabilise your position. A HV measure of "fast" isnot needed, as you can view Deltas live each trading day in your platform, as the"Speed or Rate of Change" + Gamma as "Acceleration/Deceleration". Also,remember Theta is the cost of embedding that Acceleration/Deceleration in yourDeltas, given the GammaTheta inverse relationship. Theta is the expensefor pushing the pedal to the metal.

IV is the collective forward estimate (forecast) of participants trading thatunderlying of its standard deviation of daily % changes in price from the present, until

the option expires. In the anatomy of an option's value, it is IV that needs attention.

Prices of an option's premium is entered into an options pricing model, to solve forIV. Depending on which of the3 most commonly used Theoretical PricingModelsused, the IV value is computed using various algorithmiccombinations, typically using both ATM/NearestTheMoney Calls and Puts.

It is the IV (not HV) of an option that is the required standard deviation inputwhen entered into a pricing model that makes an option's current Theoretical
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Price equal to the current market price. When you price to enter or exit trades fora particular day, you use the current spot prices to Theoretically pricethe intrinsic/extrinsic value of the ITM/ATM/OTM strikes of a spread'sconstruction, not a historical number.

The volatility variable is the only unobservable parameter in an option'spricing model. It is termed a "variable" parameter as volatility is not fixed butrises/falls to extreme levels; then, reverts to its mean, or is repulsed away from itsmean. There are upper and lower limits within which IV is contained or breaks out of.

The option price, the futures price, time to expiration, interest rate andstrike price(s) are all observable (i.e. known/measurable). So, these knownparameters can be entered into specific fields in most trading platforms, to solve forthe only unknown parametervolatility. As volatility is derived from knownparameters that is why it is called "Implied" Volatility.

In practice, what this means is toevaluate IV levels (Low, Medium or High in %

terms) first, then Probability. Finally, reconcile both pieces of analysis using theReward:Risk Ratio of the underlying's PRICE (with and without analysis ofchanging dates to simulate Theta as decay bought/premium sold separately), toaccept/reject the opportunity as an economically viable trade.

Now, let's look at probability. Delving into the intricacies of the maths of optionspricing models is not for everyone. Still, you must know which of the3 OptionsPricing Models: BjerksundStensland, Binomial and BlackScholes,matches theExercise Style (American or European) of the underlying product you are trading. Itaffects the outcome of your probability analysis.

Some may dismiss minor probability differences in constructing constrained

Delta (& Gamma) rangebound strategies like Iron Condors and Calendars.

Calendars require a separate treatment of probability. But, for highly breakeven sensitive strategies like a Straddle/Strangle or Ratio Backspreads that mustbreak out of a range to be profitable, using a consistent model to beprecise with the Probability of Touching specific strikes is critical. While thesestrategies cited are all indifferent to direction, you need to reconcile the chosenstrategy with the relevant probability model.

ModelsHumps & Curves ... Probability Distribution, Skew & Kurtosis that is!

With any of the 3 Options Pricing Models, all have a common featurea DistributionCurve.

There are 4 measures associated with the Distribution Curve. These 4 measures inmathspeak are called "moments", a concept originated from physics expressingquantity. A moment represents the magnitude of force, measuring distance from anaxis of rotation.
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As a retail trader, do not get hung up about the mathspeak; but, understand how themechanics of these 4 measures apply to the Distribution Curve of the Option PricingModel you select in the trading screen. Taken all together, these 4 moments expressthe probability distribution of your constructed spread in relation to the underlyingproduct traded.

4 Moments

1.The Modeof the probability distribution of X, where X is the underlying's price.

Measures of central tendency ('"averages"): Mean, Mode and Median can be usedto describe what price could behaviourally do in a certain way around the live priceitself.

Most trading platforms use the "Mode" in their distribution curve to calculateprobability, as it's the most widelyaccepted central tendency measure for tradingpurposes. Back to basic statistics ... Mode is the most frequently occurring value in a data series. The numberof occurrences at a price point expressed as a probability is useful for trading. Theorder gets filled as price occurs at a particular point. Median is the value in a data series, where half the values are higher than itand half the values are lower than it. It doesn't help traders with the frequency ofprice occurring. Mean is calculated by adding all values in the data series, then dividing it bythe number of values in the data series. It is not an observable number in itself, asit derived from other numbers. To see the impact of price movements on youroption trade, there is no use in expressing probability with mean numbers, as itis composed of other numbers.

2. Variance, is expressed as a positive or negative interval away from the mean.The square root of which is the Standard Deviation (SD) or Standard Error, alsoreferred to as the "Probability Range". Most trading platforms have a +/ symbol("sigma") representing the SD, with a Probability Range field that can be set to 1(68%), 2 (95%) & 3 (99%).

3. Skew, is the measure of the shift ("lopsidedness") in the density of the probabilitiesof a distribution curve, as the MeanMedianMode separate from each other and areno longer equal to one another. See "Distribution Types: Normal, Positive & NegativeSkew".

Skews exist for the very reason that institutions are taking on/laying off the risks in

their underlying positions against that market they are trading in (a.k.a "hedging").Skews arise from institutional hedging needs and their requirement to limitunexpected arbitrage in the market(s) they are exposed to.

To hedge, institutions use large amounts of Calls and Puts in varying quantitiesand combinations, in turn affecting the supply and demand for options (ITM, ATM &OTM), reflected in changes of the underlying's Put-Call Ratio.
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A retail trader may say ... I typically only use ATM and OTM options, so what hasInstitutions taking ITM positions have to do with me?

Always remember at a given strike, there is an ITM Call/Put paired with an OTMPut/Call at that SAME strike. So, as Institutions drive Supply/Demand for ITMCalls/ITM Puts impacting the IV, on the flip side, your OTM Puts/OTM Calls getaffected. ATM/NTM options are not exempt from this Supply/Demand action either, asthey sit between ITM and OTM options.

Only when there is no skew (skew = 0), is the Supply/Demand of Calls exactly equal tothe Supply/Demand of Puts. Precise equilibrium of the fear of price rising matches offexactly against the fear of price rising. Perfect equilibrium is unlikely to last (a fewseconds maybe; but, not over days). Especially in highly liquid Index/ETF products,there is an inherent skew bias in the underlying. And zero skew conditions do notremain, as Supply/Demand of Puts/Calls must become imbalanced at some point, tocreate a twosided market with BidAsk differentials.

Other than a Zero Skew, there are 3 other types of Skews:

Positive Skew: As strike prices increase, Implied Volatility of both Calls & Puts riseshigher.Most prevalent in Agricultural Commodities (Corn, Wheat, Soybeans, Beanoil, meal), Orange juice, Coffee and Oil/Oil products.

Negative Skew: As strike prices increase, Implied Volatility of both Calls &Puts falls lower.Most prevalent in equity Indexes: S&P, OEX (XEO), bonds and livestock (cattle).

Dual Skew: product has both Positive and Negative skews, typically the

skew reverses around the Near-the-Money strikes or ATM.Most prevalent in Gold, Silver, Metals and Currencies/Currency ETFs.

Look on the right pagelets for examples of how to use Positive, Negative and DualSkews.

4. Kurtosis, measures whether the distribution is tall and thin or short and flat,compared to the normal distribution of the same variance, around the Mode (the LivePrice of the underlying traded). It suggests when and which options areover/underpriced.

A Normal Distribution curve has Zero Kurtosis.

Positive Kurtosis (Leptokurtic) hasA pointed peak around the live price of the distribution = higher probabilityor greater frequency than a normal distribution of future price occurrences tobe closer to the live price; and"Narrow shoulders" = higher probability or greater frequency than anormal distribution for price occurrences to have extreme moves within 1, 2 or 3


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Standard Deviations, as the body of the Leptokurtic midsection is narrower than anormal distribution.Narrower midsection = lower probability or less frequency of intermediatemoves compared to a normal distribution.Positive Kurtosis suggests OTM Calls & OTM Puts and ITM Calls & ITM Puts areunderpriced.

Negative Kurtosis (Platykurtic) hasA flatter rounder peak around the live price of the distribution = lower probability orless frequency than a normal distribution of future price occurrences to be closer tothe live price; and,"Wider shoulders" = lower probability or less frequency than a normaldistribution for price occurrences to have extreme moves within 1, 2 or 3Standard Deviations, as the body of the Platykurtic midsection is wider than anormal distribution.Wider midsection = higher probability or more frequency of intermediatemoves compared to a normal distribution.

Negative Kurtosis suggests OTM Calls & OTM Puts and ITM Calls & ITMPuts are overpriced.

Specifically, with Kurtosis, you will get differing views on how useful it is for retailtrading, especially from ex-market makers/floor traders. Namely, because with liquidproducts, options are never mispriced. The price of the an option is what you are ableto buy it marginally below Theoretical Price; or, sell it marginally above the TheoreticalPrice for that day. Though, you will get consensus with the value of using Skew forretail trading purposes. So, if you use a paid service that provides IV data, make sureat minimum the service provides measures of Skewness, as part of the package. If itprovides Kurtosis (without additional charges), it's a bonus and a clear differentiator.

Ranges and extremes of Implied Volatility, Skewness and Kurtosis act as magneticfields pushing/pulling price towards/away from its mean/mode, as measurabledimensions of price.

Conclusion: It is the Demand/Supply of Put/Calls, priced by Implied Volatilitythat shapes the Skew (and Kurtosis) of the underlying traded. In turn, formingthe Probability traits of how price occurrences are to be distributed from wherethe live price is trading. Always choose a higher probability and lower rewardtrade to control the risks. Want more on factoring the increase/decrease inforecasted IV to Theoretically Price an option or spread?

The Earliest Date Test for Credit Spreads and Latest Date Test for Debit Spreads...
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Most beginner traders are made aware of exiting Credit spreads 10 days to expiry toavoid Gamma risks and exiting Debit spreads 30 days to expiry to avoid accelerationin Theta decay.

Aside from the Calendar which needs specific treatment (see be low)

Credit spreads are +Theta and at the same timeVega trades, there is an Earliest DateTest (before 10 days to expiry) that can be worked out to assess the exact date when80% of the original Credit has been reduced to buy back the Credit spread for profit.

Debit spreads are Theta but at the same time +Vega trades, there is a Latest DateTest (before 30 days to expiry) that can be worked out to assess the exact date when aforecasted rise in IV is overcome by Thetas erosion, to exit the trade before thishappens, instead of incurring the Maximum Loss

Options Strategies | Trading Plan

Your Trade Plan specific to each spread type must include ...

Entry Criteria that is consistently re-applied as Stay In-Play and Exit Criteria for ... Market Ranges: Extreme, Normal & Dull Days.

Pure Price Technical Analysis: Point & Figure Patterns.

Greeks unique to the construction of each spread type.

Additional Criteria: VIX, Strike Width Intervals, Delta & Timeframe.Theoretical Pricing Models (choice of 3):applying the relevant model specific to theproduct. 3 Test Scenarios: 1. Construction Criteria, 2. Probability of Touching the strikes of

the spread's construction & 3. IV & Theta: Earliest/Latest Date Test (based on IVForecast). Reward : Risk Ratio. Implied Volatility Forecast: minimum of +10% IV for Debitspreads and10% IV in Credit spreads. Skew Forecast. Work the Entry Hard. Work the Exit Hard.

Automated Alerts to Monitor the Position: specific to each spread type set up acombination of Alerts to track the Rise/Fall of the price of the associated spreads Debit paid/Credit received atspecific +/% changes. Rise/Fall of Implied Volatility of the associated Debit/Credit spread at specific +/

% changes. Price movement based on preidentified P&F trading ranges for theUpside/Downside or Range-bound levels.

Watch the video below for a preview inside the comprehensive trade plan templateincluded in theOriginal Curriculum.

RIGHT Mouse Click on the video, choose Full Screen and click play.
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Or to get Full Screen mode, click on play and double click any corner of the video.

Staggering contracts as part of the trade plan, as the Skew shifts ...

Iron Condor: constructing a super wide wing span in response to difference in/+ Skew Changes

Recall the difference in Skew:

Positive Skew makes Calls more expensive than Puts.

Negative Skew makes Puts more expensive than Calls.

Due to the inherent Skew especially in Index Products, OTM Call spreads can trade forabout 20%30% higher in premium than equidistant OTM Put spreads.

For example, based on the money management rule of allocating 3% per trade out of60% of the Net Liquidating Value in the account, say it translates into 6 Iron Condorcontracts.

Instead of placing 6 contracts at once on the same strikes, stagger the allocation of2 contracts at the original OTM Call and Put strikes with Delta criteria cited above,45-50 days to expiry.

Then, after 5 days, if the Skew becomes increasingly Positive allocate another 2contracts to the left of the original Iron Condor, 40-45 days from expiry.

Then, after 10 -15 days, if the Skew turns Negative, allocate the remaining 2contracts to the right of the Original Iron Condor, 30-35 days from expiry.
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Staggering the allocation creates a giant Iron Condor with a super wide wing span toshoulder the +/Skew changes.

The Earliest Date Test for Credit Spreads and Latest Date Test for Debit Spreads...

Most beginner traders are made aware of exiting Credit spreads 10 days to expiry toavoid Gamma risks and exiting Debit spreads 30 days to expiry to avoid accelerationin Theta decay.

Aside from the Calendar which needs specific treatment (see below)

Credit spreads are +Theta and at the same timeVega trades, there is an Earliest DateTest (before 10 days to expiry) that can be worked out to assess the exact date when80% of the original Credit has been reduced to buy back the Credit spread for profit.

Debit spreads are Theta but at the same time +Vega trades, there is a Latest Date

Test (before 30 days to expiry) that can be worked out to assess the exact date when aforecasted rise in IV is overcome by Thetas erosion, to exit the trade before thishappens, instead of incurring the Maximum Loss.

Options Strategies | Trading Plan

This section specifically plans how to monetize the Greeks and Probability of Touchingstrikes criteria unique to each spread type for Entry, Staying In-Play and Exiting, totake Profits and limit Losses.

There is plenty of web-available information on the construction of the well-knownspreads discussed below. I wontunnecessarily repeat their definitions. Here, it is

about emphasizing the criteria for controlling the risks.

Design each trade template specific to the chosen strategy, planning that chosen set ofGreeks that adds to Profit; versus, which Greeks runs the Risks of incurring Losses.Reconcile the planned versus actual Greeks-based P/L criteria to determine the set upof Entries and Exits, for that particular spread traded.

Long Calendar (Debit Spread) Plan: Theta & Vega Affects Profit, Delta & GammaImpacts the Loss.

Both option legs in a Calendar share the same strike, making the intrinsic value in a

common strike the same, for the 2 legs. Effectively, this cancels out the intrinsic valuewith the Short option leg paired against the Long option leg, at the same strike.

With intrinsic value removed, only the extrinsic/time value of Theta and Vegaremains in the Calendar to make it profitable. This is why the term Time Spreads isused to describe Calendars.


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Characteristically of Index products, in comparing Call Calendars versus PutCalendars, the Volatility Skews favours Puts, more so if the market drifts or trendsdown with a low Volatility climate (i.e. VIX between 10-15). Unlike the currentsituation with the VIX trading near 40 and above. Typical of the trait of Indices is fortheir OTM Puts to carry higher Implied Volatilities compared to their correspondingOTM Calls on the upside. The market crashes down. There is no crash up. This

allows higher premium to be sold at the Short strike of the ATM Put Calendar makingit relatively cheaper than Call Calendars. With more embedded premium that can besold at the outset, Put Calendars can and do expand more in value to lower the initialDebit than Call Calendars. As the Calendar starts of initially as a Debit spread, it justmakes sense to give the position better odds in the first place of collecting more Crediton the Short leg to finance the Long leg. Thats why it makes sense to use PutCalendars for Downside protection; but, for the Upside use Call Diagonals (which is aShort Vertical to finance a Debit Calendar). From here on the term Calendarassumes the construction using Puts.

Greeks Profile:Delta (~0.00),Gamma, +Vega and +Theta

Profit from selling Theta to collect increasing amounts of premium to fund a risingVega (IV needs to increase from a lower range to a higher range).

Loss arises from sizeable Delta (and Gamma = Delta of the Delta) increasing.

You want Delta and Gamma to remain as small numbers, meaning limited directionalspeed and slow price movement signalling restricted range bound behaviour. You donot want these 2 Greeks to become larger numbers.

Theta is the highest when it is ATM (Delta 0.50). A Calendar is worth the mostmoney when it closes exactly on the ATM strike, at expiration of the Front MonthShort leg.

This is when the Front Month Short leg expires without any time value left (Theta ~0)and the Back Month Long leg is ATM with one full month (or more) remaining.

The Roll value of a Calendar, gets its highest value when the products price is ATMproducing the greatest amount of Theta to sell the Front Month option again.

Entry

Strike width intervals. A Calendar strategy, by definition needs the products price to

drift or inch up/down within a tightly confined range. So, choosing a product withstrike increments of $1 at minimum and $2.50 at maximum between strikes, in thefirst place, avoids the risk of using a product that has strike intervals that are too farapart (e.g. $5$10 intervals).

As there is no Profit to be made using intrinsic value, its not sensible to chooseCalendars using a product with wider strike increments. Typically, widening aCalendar from a $1 width to a $2 width is adequate. The need to widen a $1 widthCalendar to $3 is rare (i.e. 2 strikes away from the strike the Calendar is initiated


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from, typically ATM) and that would be the maximum width. Else, it would be invitingmore Delta & Gamma risk than is necessary to construct a viable Reward : Risk RollValue. In turn, destabilizing Theta & Vega and diluting the Roll Value.

If an exact ATM strike with Delta0.50 is not available, Near The Money strikes(Delta0.45 to0.55) may make sense, depending on the Reward : Risk Ratio of theTheoretical Prices at the NTM strikes. Deltas used here are negative, as the chosenconstruction is using Puts.

If the Delta of a product fails to have an ATM/Near the Money Delta between0.45to0.55; but, instead has an OTM Delta of0.40 (or less) jumping to an ITM Delta of0.60 (or more), trying to construct an ATM Calendar is pointless. Same rule if theDelta jumps from ITM into OTM, skipping the ATM/Near-the-Money range, reject theproduct as a non-directional Calendar candidate. A directional spread for a productwith such fast Delta characteristics is more relevant.

As Delta denotes directional speed, look at the spatial differences between the Delta of

the ATM strike and the Deltas of the subsequent OTM and ITM strikes moving awayfrom the ATM strike.

If the increments of 3-4 strikes towards the furthest OTM/ITM strike becomeincreasingly bigger per strike up/down, the product has faster Deltas. There is moredirectional speed in each strike the closer it gets to OTM/ITM.

If the increments of 3-4 strikes towards the furthest OTM/ITM strikes becomeincreasingly smaller per strike up/down, the product has slower Deltas. There is lessdirectional speed in each strike the closer it gets to OTM/ITM.

Increments in an ideal Calendar would maintain near equally spaced Deltas apartas it moves 3-4 strikes away from the ATM strike towards the OTM/ITM. In absence ofequally spaced Deltas, slow Deltas may be an acceptable alternative for a non-directional Calendar. But, if the product shows fast Deltas, choose another product toassess Calendar candidates.

There is no need to test the spatial increments of Deltas beyond 4 strikes up/down,as a non-directional Calendar has limited Profit potential, when the product moves 4strikes away from the ATM strike. Why? Because the extrinsic value to sell forcollecting Theta as premium diminishes, as strikes move away from the ATM striketowards OTM/ITM, given the ATM strike is highest in extrinsic value.

Theoretical Price. Peculiar to a multi-month Calendars construction, the ShortFront Month leg will always have a different expiry cycle from the Long Back Month leg(until the last month). This distinct difference gives the Calendar its Roll value,which is not present in Vertical Spreadsas both legs expire in the same month.

Separately measure the IV differences in Theoretical Price between the Front Month tothe first Back Month, to estimate the Calendars payout ratio. Arguably, TheoreticalPrice will at best always be an estimate. Still, specific to the Calendar, as both legs


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expire at different months, it is critical to evaluate the Theoretical Price of the first Rollseparately. Then, repeat the test for the Long legs subsequent Back Months remainingas Rolls before the last month, which may not have any economic value left to Rollwith the onset of accelerating Theta decay in the last 30 days.

This is the key tool to gearing the payout ratio of Reward to Risk in the Calendar.

The trading platform of your existing broker should already have an in-builtTheoretical Price function in it for free.

IV. The lower the Back Months IV is to the Front Months IV, the cheaper the initialDebit of the Calendar. Remember, the Calendars Short /Sell leg is the Front Monthoption and the Long/Buy leg is the Back Month option.

For the Short/Sell leg, choose an option about 3-7 weeks away from expiration.

For the Long/Buy leg, choose between 2-3 months (1 Roll at minimum, 2 rolls at

maximum) away from expiration, to see which Back Month yields the lowest initialDebit.

Index products are ideal to trade Calendars, as their Back Month options typicallyhave an IV about the same, if not marginally lower/higher (within/+ 5%), than theirFront Month options IV.

An iVolatility IV forecast in the lower ranges (0.200.30 deciles; or, 0.600.80) movingup by +0.10 deciles representing an increase of +10% in IV is an ideal opportunity. IVforecasting tools from iVolatility.com have been blended into the Home OptionsTrading techniques.

Select a $1.5 Reward at minimum (ideally $2) to $1 Risk Ratio.

In a Calendar, the Reward is the Theoretical Prices estimate of the payout. And theMaximum Risk is limited to the Initial Debit.

So, to determine how many Back Months to embed into the Long option, assess thenumber of months that will yield the biggest difference between the Initial Debit andTheoretical Price. For example, compare a Calendar with

3 months apart, e.g. Apr-Jun with 2 rolls in it: Initial Debit is $0.70 andTheoretical Price payout is $1.05. So this is a $1.5 Reward : $1 Risk opportunity;

versus,

3 months apart, e.g. May-Sep with 2 rolls in it: Initial Debit is $0.90 andTheoretical Price payout is $1.58. So, this is a $1.75 Reward : $1 risk opportunity.

Choose the Calendar with the higher payout of Reward. You do not need to use all theRolls, especially if you have met the Roll Target of halving the initial Debit with the


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first Roll. How do you work out the exact Theoretical Price to target the first roll of theCalendar? Click here.

As it is the Long leg that generates the Profits, whereas the Short leg finances the Longleg, take the effort to evaluate the Long leg separately to make sense of the payout.

Remember to value the Long Calendar for its Theoretical Price, to buy this as aDebit spread below the market value.See Price Scout: Work the Entry Hard.

Open Interest.

For the Front Month Short leg, the Open Interest should be at minimum 1020times the number of Calendar contracts you plan to fill. (e.g. If you plan to do 4 ATMPut Calendars, the Open Interestnumber for the ATM Put strike needs be above 40).Same rule applies when rollingthe strike in the following Front Month that the Shortoption is being rolled to must have at least 1020 times Open Interest.

Same for the Back Month Long leg, check that Open Interest is between 1020times the number of Calendar contracts you plan to fill at that same strike.

Exit (versus Stay In-Play)

For a Calendar Exit always test

How much of a +/change in Price will cause zero change in the CalendarsTheoretical Price, i.e. Reward = Risk, a point of no Profit but also no Loss. Planbelow/above this price, as an Exit/Roll.

How much of a +/% change in IV (rush & crush) will cause zero change in theCalendars Theoretical Price, i.e. Reward = Risk, a point of no Profit but also no Loss.Plan below/above this IV%, as an Exit/Roll.

Specifically for IV, you must stress test the % change in IV of the Short leg separateofthe % change in Long leg. Why? Breakdown the construction of the Calendar. TheShort leg needs to make money from the Credit collected (premium from Theta sold),as well as IV falling. IV rising in the Short leg wipes out the Theta collected aspremium. The Long leg only makes money as IV rises while suffering the Loss ofTheta decay. But as the Short legs IV falls, at the same time, the Long legs IV will alsofall; but, at different rates. The analysis is flawed if you assume IVs fall on the Shortleg shares the same trajectory as a rise in IV on the Long leg, simply because both legs

share the same strike. Remember the Short leg is in a Front Month while the Long leghas multiple Back Months built into it.

Forward the date to each expiration cycle (1 or 2 rolls) to note the dates beforeexpiration of when Thetas premium contribution of the Short leg fails to compensatethe Long legs accelerating Theta decay, especially in the final expiration month of theCalendar. Take note of the date/specific week when Reward = Risk, when no Profit butalso no Loss is made. Plan the week(s) of these dates to watch for an Exit/Roll.
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Plan each Exit scenario independently. Then, keep the worst case scenario of the Pricechange, add the worst case scenario of the IV% change and combine the remainingdays discounted with forward dates for a complete and robust stress test of theCalendars Exit plan.

Any change that adds to Profits, re-evaluate the Roll value. Any change that incursLosses, consider an Exit. A Roll may or may not be 10 days from expiration. It maybe sooner. Though, never Roll a Calendar inside expiration week, as it leaves the Longleg unhedged in that week itself. Always, give priority to Theoretical Price to guide youon timing the date or the week for an Exit/Roll.

Base the Break Even Exits of the Calendar on the strikes above/below where theCalendar is initiated (typically ATM) and Theoretical Price conditions.

Increase/decrease the products price up/down to a point where the TheoreticalPrice of the Calendar is not making Profit or incurring a Loss. These are the specificpoints where the Calendar can move up/down to with zero Roll value remaining

points where the Calendar loses its ability to generate a Profit.

As IV changes, this impacts the value of the Back Month(s) option. Subsequently,affecting the Calendars Theoretical Price Payout, which makes it mandatory to re -assess the trend of the Probability of Touching the Break Even strikes on a weeklybasis.

Remain in trade, to Roll the Front Month Short option, if the $1.50 Reward : $1Risk ratio holds up and is Supported by an increasing/progressively modest rise in IV.

About 5 days before the 10 days to the Short options expiry, look for highest/higherRoll values as products price drifts between Deltas of 0.45 to0.55. At these Deltaranges, Theta produces higher/the highest time value to sell the Roll for. Once withinthe 10 day period before expiry, you are unlikely to get higher Credit premiums to sell,mechanically Roll the Calendar if the Roll can at least lower the initial Debit by 10%15% for the minimum economic justification to proceed onto the second roll.Otherwise, exit entirely.

The higher the Front Month Short options IV is compared to the Back Month Longoptions IV, the higher the Credit you will receive for selling the Short month, to lowerthe cost of the initial Debit more than you would otherwise get.

Monitor the Calendar more vigilantly if the $1.50 Reward drops down to a $1.25

Reward : $1 Risk ratio, with an increasing/mild rising trend in the Probability ofTouching the Break Even points.

Exit the entire Calendar if the ratio drops below $1.25 Reward : $1 Risk, with arising trend in the Probability of Touching the Break Even Points and a flat IV trend.Do not wait to lose 50%-100% of the Initial Debit before exiting entirely. Losing100% of the Initial Debit is the Maximum Loss.


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Use Point & Figure charting techniques: Look left at the last 3 columns of Xs andOs. Take the Longest column of Xs and Longest column of Os (widest trading ranges)as the worst-case test for a price move in either direction in evaluating a non-directional Calendars Probability staying ATM/Near The Money.

An Exit at Maximum Profit is obvious.Maximum Profit occurs when the products priceremains at the strike of the Short leg at expiration. The Front Months Short optionexpires worthless, while the Back Month retains the highest Theta (extrinsic timevalue) as it remained ATM.

If the products price fails at expiration to stay precisely at the strike of the Shortleg, there is zero intrinsic value left. Remember, the Short leg and Long leg share acommon strike, eliminating any intrinsic value.

An ATM Calendar is worth approximately the same, if price closes an equaldistance ITM or OTM from the ATM strike.

Close out the Calendar entirely, once you have rolled to the final month beforeexpiration of the Short option. Else, all that is left is a Long naked option exposed toDelta and Gamma risk, plus accelerating Theta decay.

Back Ratio Spread (Credit, Even Money or Debit Spread) Plan:Delta, Gamma & Vega affects Profit, Theta Impacts the Loss.

A Back Ratio Spread is essentially a Short Vertical Spread, plus buying 12 moreoptions at the Long strike. Hence, the ratio of 1 Short option: 2 Long options or 1Short option : 3 Long options. Regardless of the ratio, the position is always Net Longoptions. Remember you need to be Net Long for the directional bias you haveforecasted: Calls being Bullish and Puts are for a Bearish outlook.

Due to the embedded Vertical, you need a sizeable movement in the expected pricedirection (Delta & Gamma) and IV to rise as forecastedthese are the Greeks to planfor to generate Profits. Remember, the entire position has to fight against the extraLong options increasing Theta decay. The Short Vertical (choose ATM to ITM strikes)is embedded deliberately to subsidize the purchase of the Long options (which sharesthe same strike of the Long leg of the Short Vertical). Being Net Long options, requiresIV to take the central role in increasing the value of the Long legs. Hence, the BackRatio Spread is often called a Volatility spread.

Greeks Profile for a Back Ratio Call: +Delta, +Gamma, +Vega andTheta

Greeks Profile for a Back Ratio Put:Delta, +Gamma, +Vega andTheta

Profit from increasing +/Delta, +Gamma and +Vega (IV needs to increase from alower range to a higher range). The Net Long position depends on increases in these 3Greeks to make money.


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Loss arises from Theta decay. The Short ITM options Credit is used to finance thedecay of the Long ITM/ATM or Near The Money (NTM) leg. While Theta is highest ATMwhere the sale of the Short leg here collects the highest possible Creditpracticallyspeaking this may not be the logical strike to construct the Short leg. As price willneed to move pas 1 Standard Deviation for the Back Ratio to begin breaking even andcloser to 2 Standard Deviations to generate a Profit. This overburdens Delta & Gammato make such a huge move, effectively lowering the odds of making Profit. It makesmore sense to sell the Short leg deep ITM to collect adequate credit to almost offset thecost of buying the Long legs ITM/ATM or NTM options.

A positive Vega means IV must rise as forecasted from a lower range to a higherrange, for the Long legs ITM/ATM or NTM options to increase in value.

Entry

Choose a ratio of 1 ITM Short option: 2 ITM/ATM/NTM Long options at aminimum; and, 1 ITM Short option: 3 ITM/ATM/NTM Long options at maximum.

Select the ratio that buys you the most Long OTM options, with the total cost of theentire position near zero (or a small debit below $0.75).

The way to look at the Credit of the Short ITM option in subsidizing the Longoptions, is to ask how many Long ITM/ATM/NTM options can the Short ITM optionfinanceis it 2 or 3?; before, it becomes an outright Debit spread where you wouldtypically pay up to 1/3for the strike width of a Debit Vertical? Choose thecombination (2 or 3) that is closest to placing the entire Back Ratio Spread for ~$0.00(even money). Typically, it is unlikely that the one Short options Credit can subsidizecompletely the purchase of more than 23 Long options.

If the construction allows for a Credit, at maximum, leave $0.01 to $0.10 Credit inthe position. Use up as much of the Short options Credit to finance the Long options,as it is the Long legs of the Back Ratio that generates the Profits. The Short leg merelyacts as a subsidy for the Theta decay working against the Delta and Gamma of theLong legs that are fighting against the decay to increase in value, as IV rises.

While price may move in the direction forecasted, the size of the move may lacksufficient Delta and Gamma to adequately increase the value of the LongITM/ATM/NTM option(s)as the Long options are further away from the productsprice compared to the Short leg being deep ITM which is more likely to increase invalue, being closer to the products price. As all options are in the same expiry month,the nearer it is to expiration, there is more pressure on the size and directional speed

of Delta and Gammas velocity to move the Long option(s), as the Short ITM optionsGamma becomes smaller.

The Back Ratio spreads risk is characterized by its Valley of Loss. It is the size ofDelta plus Gammas move that needs to overcome the Valleys width. And the Valleysdepth is a battle between how much Profit a positive and increasing Vega cancontribute against how much Loss a negative and increasing Theta takes away witheach day of decay. This is why it makes sense to construct the position to fill at near


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even money or a small Credit to begin with to make the Valley of Loss as shallow aspossible from the first day of entry.

Vega must rise to supplement the inadequacies of Delta & Gammas move. Thepositive Vega in a Back Ratio Spread means IV must increase for the position tobecome profitable.

As the position will always be Net Long more naked options, it is not prudent toplace a Back Ratio Spread for an large Debit at the start. Do not give up theopportunity to subsidize the Long naked option(s) with as much credit as you can sellin the Short leg. If you are absolutely certain of the products price direction, get aLong straight ITM call/put option and pay the Debit. At the same time, do not lowerthe number of Long options just to get a Credit, as it is the Long legs that areresponsible for generating the Profit.

Given the Net Long feature of these spreads, construct a

Back Ratio Call spread to be Net Long at the ITM/ATM/NTM Higher Call strike, for$0.00 or a Credit between $0.01$0.10.

At minimum, the Probability of the Call Back Ratio spread Touching its Higherstrike should be 30%50% more than the spread Touching its Lower strike. Morethan 60%, you may well consider a straight ITM call.

Back Ratio Put spread to be Net Long at the ITM/ATM/NTM Lower Put strike, for$0.00 or a Credit between $0.01-$0.10.

At minimum, the Probability of the Put Back Ratio spread Touching its Lower strike

should be 30%-50% more than the spread Touching its Higher strike. More than 60%,you may well consider a straight ITM put.

In both scenarios, if you are unable price the spread at $0.00 or a minimum Creditbetween $0.01$0.10; and, the preferred range of the Probability of Touching the 1Standard Deviations boundary towards the profitable strike fails to be met, reject theBack Ratio opportunity and evaluate another product.

Strike width intervals. In constructing the Back Ratio Spread for a minimalCredit/even money ($0.00), you will have to widen out the strikes. Effectively,stretching the horizontal width of the Valley of Loss.

Choose a product with strike increments of $1 at minimum and $2.50 at maximumbetween strikes. Choose products with tighter strike intervals in the first place, as youwill need to widen the strikes apart to price the spread at near $0.00 or a Credit.

Avoid a product with strike intervals of $5$10, as you will end up with a Valley ofLoss as wide as $30 (or more) apart between the lower and higher strikes to price theposition near $0.00. This places overreliance on Delta and Gamma to move violently


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in your forecasted price direction, to bridge such a large gap before the position caneven start to break even, let alone become profitable.

The Valleys depth is determined by how many more Long options there are thanthe one Short option. The more Long options there are, the deeper the Valley. Always,choose a ratio that keeps the Valleys depth shallow to limit the risk. Work on thewidth of the Valley first. Then, if needed, adjust the ratio of Long options to the Shortoption to change the depth of the Valley.

As Delta denotes directional speed, look at the spatial differences between the Delta ofthe Short ITM strike and the Deltas of the Long NTM strikes moving away from theATM strike.

If the increments between strikes towards the NTM strike becomes increasinglybigger per strike, the product has faster Deltas. There is more directional speed ineach strike moving towards the furthest OTM strike. Fast Deltas moving to the LongNTM strike is favourable for the Back Ratio Spread signalling more directional speed

towards the Break Even Point and the outer boundary of 1SD. What is not favourableis fast Deltas towards the Maximum Risk point, when price moves in the oppositedirection it was forecasted to move.

If the increments between strikes towards the NTM strike becomes increasinglysmaller per strike, the product has slower Deltas. There is less directional speed ineach strike moving towards the furthest OTM strike. Slow Deltas moving to the LongNTM strike is not favourable for the Back Ratio Spread signalling lack of directionalspeed towards the Break Even Point and the outer boundary of 1SD. What isfavourable is slow Deltas towards the Maximum Risk point, when price moves in theopposite direction it was forecasted to move.

IV. Placing a Back Ratio spread at lower IV levels helps price it closer to $0.00/nearevenmoney. At lower IV levels, the ITM Credit received from the sale of the Shortoption to fund the purchase of more Long options is lower than if IV were in the mid-levels; but, the IV of Long options has less to rise if they have already risen to the mid-levels. This is the trade-off.

An iVolatility IV forecast in the lower ranges (0.200.30 deciles; or, 0.600.80)moving up by +0.10 deciles representing an increase of +10% in IV is an idealopportunity. IV forecasting tools from iVolatility.com have been blended into the HomeOptions Trading techniques.

Currency ETFs/UltraShort Pro Shares & Commodity Indexes are suited for Back Ratiospreads, as their IV characteristically behaves in an explosive manner.

Target a $1.5 Reward to $1 Risk Ratio, at minimum.

The Maximum Risk is the width of the Back Ratio spread (difference between Long andShort strike), minus the Credit received; or, plus the Debit paid.


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Work the entry hard, it makes sense to value the spread for its Theoretical Price, to fillit slightly above market value if the Back Ratio is to be done for a credit; or marginallybelow market value if the Back Ratio is to be done for debit.See Price Scout: Work theEntry Hard.

Evaluate the Reward in context of 1 Standard Deviation (+1, 1). For a

Back Ratio Call spread, the Probability of Touching the Upside Exit within +1from the live price needs to be 60% or more. This leaves a 50+% Probability of Pricereaching the Upside boundary of +1.

Back Ratio Put spread, the Probability of Touching the Downside Exit within1from the live price needs to be 60% or more. This leaves a 50+% Probability of pricereaching the Downside boundary of1.

Determine at what price, after +1 or 1 is passed that a Reward of 1.5 times therisk incurred can be made. Then, test if the Probability of Touching this price point is

at least 40%. Also, raise Volatility by +10% to see how much more the Probabilityincreases. Reject any opportunity that fails to yield a 40% Probability of Touching theprice point at which a $1.5 Reward per $1 Risk is generated.

Likewise, evaluate the Risk in context of 1 Standard Deviation (+1, 1). Takenote of the price at the lowest point in the V shape of the Valleys bottom evaluatethe Probability of Touching this price pointit is where the Maximum Risk of thespread occurs.

Within +1 or1, fora

Back Ratio Call, compare the Probability of Touching the Maximum Risk pointagainst the Probability of Touching the Upside Exit.

Back Ratio Put, compare the Probability of Touching the Maximum Risk pointagainst the Probability of Touching the Downside Exit.

In both cases, the Probability of Touching the Upside/Downside Exits should be atminimum 10% (ideally 20%) more than the Probability of Touching the point of theMaximum Risk. If there is no material edge in the Upside/Downside Exits havingobviously higher odds than the Maximum Risk point of being touched, consider aStrangle/Straddle instead.

Remember to value the Back Ratio Spread for its Theoretical Price, to fill it close tonear even money or as a Credit spread between $0.01 to $0.10 above the marketvalue.See Price Scout: Work the Entry Hard.

Open Interest & Days to Expiry
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For both the Short and Long legs, choose strikes with Open Interest between 10-20times the number of Back Ratio spread contracts you plan to fill. This ensuresadequate liquidity, especially when its time to exit the trade.

Look to fill the spread between 80-90 days at minimum to 100-120 days at

maximum before expiration.

Exit Criteria for Profit/Loss (versus Stay In-Play)

Maximum Profit is finitethe product can drop to zero, in a Back Ratio Put. A CallBack Ratio Call Spreads Profit is unlimited (in theory).

The guideline to exit the Call or Put Back Ratio spread is when the Profit is 1.5-2.0times the original Risk (which could have been a small Credit or $0.00).

If price has violently shot past the Long legs strike, it is unlikely to movefavourably much more. The price movement would have gone past 1 StandardDeviation and is 1/3rd to half-way towards the boundary of 2 Standard Deviations,which is a rare event. Profit at this level is an obvious signal to close out the entirespread.

Once the Profit Target is met, there is an alternative to closing out the entirespread. Sell off only the additional Long option(s). Meaning, the Short Vertical Spreadremains in playin losing its maximum Credit premium, you have drained the Crediteffectively to finance the Long options. If price reverses in the opposite direction of theBack Ratio Spread, the Short option of the Vertical remaining in-play becomes evencheaper to buy, increasing its Profit contribution. Mechanically close out the Vertical710 days before expiration. Do not leave it inplay inside expiration week. Price may

have dropped/risen to a Support/Resistance level within the expiration week. Do notrisk a reversal against the Verticals position with limited days to recover, as there is aremaining Short option in the spread with an obligation to settle it.

As IV changes, this impacts the value of the additional Long option(s). Remember, in aBack Ratio spread the Long leg has 12 more naked options which needs a rise in IVto become profitable. Subsequently, affecting the spreads value, which makes itmandatory to reassess the trend of the Probability of Touching the Upside/DownsideExits against the Probability of Touching the Maximum Risk point, on a weekly basis.

Stay in play, if the Probability of Touching the Upside/Downside Exits exceeds theProbability of Touching the Maximum Risk by 10% or more.

A positive trend is when this difference in Probability of Touching theUpside/Downside Exits increases every week progressively beyond 10% (without abreak across weeks where it falls below 10% for a sustained 23 days), in favour ofTouching the Upside/Downside Exit. The Probability of Touching theUpside/Downside Exit should increase from the original 50% (which was an entrycriteria) towards 60%. Consequently, the Probability of Touching the Maximum Riskpoint should fall by a near equal %.


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Exit the trade, if the Probability of Touching the Break Even Exit falls below theProbability of Touching the Maximum Risk by 10% or less.

A negative trend is when this difference of Probability of Touching theUpside/Downside Exits decreases every week regressively below 10% (without abreak across weeks where it rises above 10% for a sustained 23 days), in favour ofTouching the Maximum Risk point. The Probability of Touching the Break Even Pointitself fails to increase from the original 50% (which was an entry criteria); but, isreduced towards 40%. Consequently, the Probability of Touching the Maximum Riskpoint rises by a near equal %. This signals the Probability of price Touching theUpside/Downside Exit has lost its edge to move away from the Maximum Risk point.Do not wait to incur 50+% of the Maximum Loss before exiting entirely.

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

Shortest column of Xs (tightest Upside range) as the worst-case test for afavourable price move up of a Bullish Back Ratio Calls Probability. Use the Longest

column of Os (widest Downside range) as the worst-case for price moving in theopposite direction of a Bullish Back Ratio Calls Probability.

Shortest column of Os (tightest Downside range) as the worst-case test for afavourable price move down of a Bearish Back Ratio Puts Probability. Use the Longestcolumn of Xs (widest Upside range) as the worst-case for price moving in the oppositedirection of a Bearish Back Ratio Puts Probability.

Exit on price drifting with 3540 days before expiry. With 12 weeks before 30 daysremaining, if price fails to move past 1 Standard Deviation; but, inches up/down ordrifts within the Upside/Downside Exit of the Long strike and the boundary at1and +1, exit the position that shows a marginal Profit or Loss. Close out the entirespread to avoid incurring the Maximum Risk.

With 510 days before 30 days to expiry, while the Credit of the Short option isfunding the additional Long options, there is not much Delta, Gamma & Vega can doto generate Profit in the Long leg. There is only Theta decaying at the square root oftime (days) that is certain, accelerating exponentially with 2123 days remainingbefore expiry. This Theta decaying as premium collected only acts as the subsidy forthe Long options, it does not generate the Profit.

Alternative Exit for directional failure. Price moves in the opposite direction to thatoriginally planned for the Back Ratio Spread: Call = Bullish, Put = Bearish. Other

than closing out the entire spread, buy back only the Short option if possible, for$0.20 or less; but, leave the additional Long options in play. The absence of the Shortoption takes out the Valley in the Maximum Risk, should price reverse back towardsthe original direction forecasted.

Short Iron Condor (Credit Spread) Plan: Vega & Theta affects Profit; Delta &Gamma Impacts the Loss.


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The reason behind constructing the 2 Short OTM Verticals (a Call Vertical + a PutVertical) of a Short OTM Iron Condor equidistant from the products price, is toneutralize the risk of movement in Delta and Gamma. For entry, do not leg into theposition as 2 separate Verticals. Enter into the position as a whole Iron Condor.

While the wing span of a typical Iron Condor appears equally balanced in termsof the left and right distance apart from where price is trading, the price dispersion ofthe product is unlikely to take the form of a normal bell shaped curvewhere the lefthalve is the exact mirror image of the right halve. The Skew bias in the productmost notably in certain Index products, can flip between being positive and negative,throughout the expiration cycle.

Greeks Profile:Delta (~0.00),Gamma,Vega and +Theta

Profit from increasing amounts of Theta decay and descending Vega (IV needs todrop from a higher range to a lower range).

Loss arises from sizeable Delta (and Gamma = Delta of the Delta) increases. Youwant Delta and Gamma to remain a small number, meaning limited directional speedand slow price movement signalling restricted range bound behaviour. You do notwant these 2 Greeks to become large.

While Delta is not exactly equal to an options Probability of Expiring ITM, in essence it ismore a proxy, Delta is valid to use it as the starting point in constructing the wingspan ofthe Iron Condor.

As the aim is to retain nearly all of the Credit sold within the 2 Short Verticals oneither side, a Credit Iron Condor is typically constructed around where the Delta forCalls is between +0.20 to +0.30 and the Delta for Puts is between0.20 to0.30.

Selling an Iron Condor within the Delta range of +/0.20 to +/0.30 gives the ShortVerticals on both sides a ~65%-75% Probability of success for the Credit received toexpire worthless. At maximum, tighten the wing span to choose Calls and Puts with aDelta of +/0.35 for a 60% Probability of success but no tighter. You want more than50:50 odds of retaining the credit collected as premium.

Entry

Strike width intervals. An Iron Condor strategy, by definition needs the products priceto drift or inch up/down within a tightly confined range. So, choosing a product with

strike increments of $1 at minimum and $2.50 at maximum between strikes, in thefirst place, avoids the risk of using a product that has strike intervals that are too farapart (e.g. $5, $10 intervals). An alternative is to widen the $1 strike intervals to $2;or, widen out the $2.50 strike intervals to $5.

You can sell $0.25-$0.35 out of $1 strike intervals, just as you can sell $2.50-$3.50out of $10 strike intervals. Though its not identical.


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Choosing an Iron Condor from a product with $10 strike intervals does notguarantee that you can collect more Credit in selling the same fraction within thewidth of the strikes in a product with $1-$2.50 strike intervals. The reason the strikesare set that far apart in the first place, represents the propensity of the product tomove at those intervals, which poses the Delta and Gamma risks that you do not wantfor a Credit Iron Condor.

Lowering the initial Credit received (i.e. increasing the wing span) raises theprobability ofretaining the Credit that was sold. The entire wingspan of the Credit IronCondor should stay within 1 Standard Deviation of where live price is trading,otherwise the Iron Condor is not collecting adequate premium to economically justifythe construction in the first place. In other words, do not construct Short IronCondors spanning 2 Standard Deviations wide.

Using a product with $10 strike intervals, invites more Delta and Gamma risk than isnecessary for Theta and Vega to cope with, diluting the amount of Profit contributedby these 2 Greeks.

Of note, in general because the interest rate component is built into Calls plus theinherent Skew which is typically more pronounced in Index products, the OTM Callscan typically trade 30%-40% higher in Credit premium to sell than the equidistantOTM Puts. Within a Short period (less than 30 days), the richer premium on the Callside is driven by the inherent +/Skew of the product and less to do with the interestrate.

With richer premiums on the Call side, it is often easier to get filled on moreaggressive mid-price fills by Shorting an Iron Condor when the product is going into asmall to moderate rally; but, less so with a sell-off. So, use theFutures to gauge pre-market open trading activity,to see if the major broad-based Indices are opening

higher that day to sell the credit at marginally higher prices (up to +0.10 above theTheoretical Price of the Credit Iron Condor) and work the order hard to fill within 60-90 minutes of the markets opening.

If the Delta of a product fails to have an ATM/Near the Money Delta between +/0.45 to +/0.55; but, instead has an OTM Delta of +/0.40 (or less) jumping to anITM Delta of +/0.60 (or more), trying to construct an equidistant Iron Condor with amissing ATM strike as the centre that joins the Short Vertical Put together with theShort Vertical Call, as one positions adds Delta risk in price movement.

Deltas skipping the ATM/Near The Money strikes represent unstable Delta and

Gamma, which is not the required criteria for an Iron Condor. Same rule if the Deltajumps from ITM into OTM, skipping the ATM/Near-the-Money range, reject theproduct to construct a non-directional Iron Condor on. An unbalanced/ratioed IronCondor for a product with such Delta characteristics may be more relevant.

Other than directional risk, Delta also denotes directional speed. So, look at thespatial differences between the Delta of the Short ATM/ITM strike and the Deltas ofthe Long OTM strikes moving away from the ATM strike.
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If the increments between strikes towards the OTM strike becomes increasinglybigger per strike, the product has faster Deltas. There is more directional speed ineach strike the closer it gets to OTM. Fast Deltas moving to the Long OTM strike isnot favourable for the Iron Condor signalling acceleration towards theUpside/Downside Exits and the outer boundary of1 and +1.

If the increments between strikes towards the OTM strike becomes increasinglysmaller per strike, the product has slower Deltas. There is less directional speed ineach strike the closer it gets to OTM. Slow Deltas moving to the Long OTM strikeis favorable for the Iron Condor signalling deceleration towards the Upside/DownsideExits and the outer boundary of1 and +1.

Increments in an ideal Iron Condor would maintain near equally spaced Deltasapart as it moves 3-4 strikes away from the ATM strike towards the OTM strikes bothon the Call and Put side. In absence of equally spaced Deltas, slow Deltas may be anacceptable alternative for a non-directional spread. But, if the product shows fastDeltas, choose another product to construct an Iron Condor on.

There is no need to test the spatial increments of Deltas beyond 4-5 strikesup/down, as a non-directional Iron Condor has limited Profit potential with pricemoving 4-5 strikes from the ATM strike, price will almost be Touching the Exits oneither side.

Never sell options (be it an Iron Condor or Vertical) in the Front Month. In the last21-23 days before expiration, the negative Gamma risk outweighs the Theta premiumcollected. With 10-15 days to expiry, Gamma explodes at the ATM options. Even ifDelta stays flat (~0.00), the negative Gamma risk (measuring in/stability) expandsexponentially at an acute curvature that is in multiples of Theta decaying alsoexponentially (at the square root of time). Do not initiate an Iron Condor with lessthan 20 days before expiry.

Point & Figure charting techniques: Look left at the last 3 columns of Xs and Os.

Use the Longest column of Xs and Longest column of Os (widest trading ranges) asthe worst-case test for a price move in either direction in evaluating a non-directionalIron Condors probability of price staying within the wing span.

IV. While at higher IV levels, you get to sell 2 Short Verticals combined as one IronCondor for more Credit, the risk of IV making a higher high increases. IV forecastingtools from iVolatility.com have been blended into the Home Trading techniques.

An IV forecast in the decile ranges of 0.700.80 falling or 0.300.40 decreasing by0.10, i.e. a drop of 10% helps drop the credit further in addition to the Theta collectedas premium in a Credit Iron Condor, given its Vega and +Theta profile.

If IV is in the decile range of 0.000.10, IV could fail to fall lower and rise instead.IV increasing raises the Iron Condors Credit value, when we want it to fall to buy itback cheaper than when we sold it.


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If IV is in the decile range of 0.901.00, IV could rise to make a higher high. Again,IV increasing raises the Iron Condors Credit value, when we want it to fall to buy itback cheaper than when we sold it.

Broad based Indexes (e.g. DIA/DJX, QQQQ/MNX, SPY/XSP) are ideal to trade IronCondors, because within 50 days their Front Months composite IV is often marginallyhigher than their Back Months composite IV. This gradual decline in IV together withprice drifting collecting positive decay, improves the odds of trading Iron Condors.

Even with an inherent Skew bias unique to specific Index products, its very rare tofind more than a 3%-5% difference in the composite IV between the near and farmonth in most tracking Indexes/ETFs. Do not expose Iron Condors unnecessarily tospikes in an IV rush, hoping to gamble on an IV crush after the rush to make itprofitable. Other strategies using other products are better suited for sudden and largechanges in IV differences. Within the stipulated time frame to trade Iron Condors, thepractical IV testing range of an Iron Condor of most major tracking Indexes for an IVrise/fall is between +/5% to +/10%. Any more will not be a realistic simulation.

The major broad-based and tracking Indexes/ETFs are absent of single event-relatednews (peculiar to a stock) that spikes the IV within any individual month.Indexes/ETFs are more conducive to trading Iron Condors as they contain VolatilitySkews within acceptable limits that do not add Volatility risk.

High IV is not a license to sell it. IV must fall below its high. Neither is Low IV alicense to buy it. IV must rise above its low.

The core gauge of the broader markets propensity to buy/sell 30-day IV is theVIX. It makes more sense to identify Short Iron Condor opportunities when the VIX isat a higher trading range versus when it is at a lower trading range. The higher theVIX is, the IV levels improves the odds of collecting higher premium. The historicaltrading ranges of the VIX ranging between 10-20-30 was broken, since October 2008.And a year of trading under the new ranges needs to happen, to comment on what thenew ranges would be.

The Reward : Risk Ratio of the Iron Condor needs to be analyzed differently.

Sell at minimum 25% up to a maximum of 35%, of the strike width of the Verticalsmaking up the Iron Condor. So, for an Iron Condor with ...

$1 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at +/

Delta 0.250.35 to receive between $0.25 to $0.40 of credit in total.

$2.50 strike intervals for the Call and Put Short Verticals, sell the OTM strikes at+/Delta 0.250.35, to receive between $0.65 to $1.00 of credit in total.

If you have clear reasons to sell higher Call/Put Deltas, stop at +/- 0.35 Deltas as themaximum. Otherwise, the edge in the odds of expiring ITM becomes unfavourabletowards the OTM Short strike.


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Selling these consistent fractions of the width of the Verticals making up the IronCondor, regardless of the different strike intervals, exposes the edge of Iron Condorswings to ~40% (or less) of being touched by price movement. In turn, giving the IronCondors outer wings a minimum of ~60% (or more) probability of price not touchingthem, for the position to retain the Total Credit received.

At maximum, choose OTM strikes that give the entire Iron Condor a 30%probability of both outer wings being touched by price movement, i.e. 70% probabilityof not being touched. Lowering the probability beyond 30% is margining capital on acredit spread beyond what is efficient that could have been used for another strategy.

Regardless of the strike width chosen, the typical method of constructing an entireIron Condor position is to contain its entire wing span within 1 Standard Deviation (1 to the Downside/left of the Live Price and +1 to the Upside/right of the Live Price).Outside the range of1 and +1 makes it difficult to collect sufficient credit premiumto justify the return on probabilities of initiating a 4legged, 2ways nondirectionaltrade.

However, beyond the typical method and unique to trading Iron Condors is the methodof staggering the number of contracts allocated for the entire trade, across anincreasing number of strikes.

See pagelet on the right for depiction of staggering contracts within a given %allocation per trade.

Remember to value the Short Iron Condor for its Theoretical Price, to sell it as acredit spread above the market value.See Price Scout: Work the Entry Hard.

Open Interest & Days to Expiry

For the entire position, choose strikes with Open Interest between 1020 times thenumber of Short Iron Condor contracts you plan to fill. This ensures adequateliquidity, especially when its time to exit the trade.

Look to fill the Iron Condor more than 35 days at minimum up to 50 days atmaximum before expiration. Below 30 days, the Credit collected is insufficient toreward the position for the Delta & Gamma risk going into the 5-10 days before expiry.Above 50 days, exposes the Iron Condor to too much IV uncertainty and possiblychanges in interest rates.

Exit Criteria for Profit/Loss (versus Stay In-Play)

Exit criteria for Profit

~10 days before expiry, exit all 4 legs; or

If the Short Call Vertical or Short Put Verticals value has dropped to $0.10-$0.15,buy back the Vertical to close out the Short side that is closer to where price is
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trading. Do not risk the possibility of price retracing in the opposite direction to hiteither side of the Short Verticals in the week of expiration itself.

For Long options in the Verticals trading near $0.05, do not close these legs out.Buy back only the Short options in the Verticals. This leaves you with Long optionsshould price bounce back unexpectedly.

Always observe the closing rule of 10 days before expiry. Only if favourable pricingconditions occur as stated above, then use the variation in closing just the Short legand leaving the Long option of the Vertical untouched. Otherwise, mechanically exitthe entire Iron Condor. Some more experienced traders choose to hold the Iron Condortill 57 days within the expiry week itself, to close it out. Namely, this is what theyhave consistently done as a routine. Stay consistent with the number of days to exit:if its 10 days stick to it, if the decision to exit is between 57 days stick with it.

Before 1015 days expiry, when 70%80% of the Iron Condors credit has beenreduced, exit the trade entirely. For e.g., an Iron Condor sold for $1.00 decays down to

$0.20, close out all 4 legs. The remaining 20% of Profit is marginal and not worth theDelta and Gamma risk of remaining in play. Its not logical to risk the entire $1.00 (ofwhich youve already gained ~80%) for less than 20% more Profit to milk in 2+ weeks.Guard against the greed and let sensible fear prevail.

Stay In-Play, with 20-30 days before expiry

If the Probability of Touching the Upside/Downside wings is between 30%40%;but, watch the position when the Probability of Touching the wings drifts highertowards 45%55%.

Watch the Iron Condor more closely, if the iVolatility Hi/Low Indicator driftsaimlessly between the 0.450.55 decile without a clear signal, if IV will drop further orstay range bound. For example, if IV has already dropped from the 0.80 decile down tothe 0.60 decile, i.e. IV has fallen 2 full deciles = 20%, it may be bouncing againstSupport for the IVs mid-range between the 0.450.55 decile range and fail to fallfurther.

Be vigilant when the original Deltas of the short OTM Calls (+0.25 to +0.35) of theCredit Call Vertical grows larger, as price moves towards the Call Vertical side. Andwhen the original Deltas of the short OTM Puts (0.25 to0.35 ) for the Credit PutVertical grows larger, as price moves towards the Put Vertical side.

In either case, this signals the original OTM strikes are at risk of becoming morecostly to buy back, which reduces the Profit of the trade.

Exit Criteria to Limit Losses

Exit the entire trade before/during economic or political news that violentlyincreases the overall markets Volatility. i.e.VIX shoots up above its daily volatilityrange.
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The Probability of Touching the Exit on either the Upside or Downside of the IronCondor increases from the original 40% to 60%70% with 5-10 days before expiry.

IV rises to raise the Iron Condors original credit by ~125%, making it more expensive tobuy back, instead of decreasing the premium collected, which is what is needed to makeit cheaper to buy back.

An Iron Condor needs to maintain a negative Vega, representing a drop in IV tostay profitable. The negative Vega needs to become an increasingly larger number forthe forecasted fall in IV to add to Profit. If the negative Vega number gets progressivelysmaller towards ~0.00, IV is rising and without sufficient positive Theta decay to offsetthe IV increase, the position starts incurring Losses. Theta collected as premium iswiped out by a rising IV, and there may be insufficient days remaining to collect theadequate amount of premium to restore the drop in the credit spread. Remember, justas you can only lose 1 days worth of decay in a debit spread, you can only effectivelycollect one days worth of premium per day in a credit spread.

Straddle/Strangle (Debit Spread) Plan: Delta, Gamma & Vega affects Profit, ThetaImpacts the Loss.

In terms of construction, there really is only one material difference between aStraddle and a Strangle. For any given product, if there is no +0.50 Delta Call with acorresponding exact0.50 Delta Put, there is no ATM Straddle. ATM by definitionrequires a precise 50:50 Delta for the Call and Put. Construct a Strangle insteadusing a Near-The-Money Call and Put strike.

For a Straddle/Strangle, a price

Rise in the product, increases the Theoretical Price of the Call. Simultaneously,lowering the Theoretical Price of the Put.

Drop in the product, increases the Theoretical Price of the Put. Simultaneously,lowering the Theoretical Price of the Call.

This increase in Theoretical Price is necessary to generate a higher sale price thanthe original Debit paid, to make a Profit.

Greeks Profile: (/ +)Delta, +Gamma, +Vega andTheta

Profit from increasing amounts of/ + Delta, + Gamma and a rising +Vega (IV

needs to increase from a lower range to a higher range).

The Straddle/Strangles risk is characterized by its V-shaped Valley of Loss. It isthe size of Delta & Gammas move that needs to overcome the Valleys width. And theValleys depth is a battle between how much Profit a positive Vega indicating a risingIV can contribute against how much Loss a negative and increasing Theta takes awaywith each day of decay.


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The sum of a Calls Delta and Puts Delta is mean to approximate ~1.00. It seldomequals 1.00 exactly because of the inherent Skew bias towards the Put/Call side, inany given product. At any given OTM/ATM/ITM strike, the sum of the absolute valueof a Call Delta plus the corresponding Put Delta is typically equal to between ~0.951.05 (i.e. no exactly 1.00). Absolute value means removing the + sign in front of theCall Delta and sign in front of the Put Delta.

Specific to a Straddle/Strangle, an increase in the Call Delta results in a near equaldecrease in the Put Delta; and vice-versa.

Loss arises from sizeable Gamma reduction, Vega reduction and increasing Thetadecay.

Specific to a Straddle/Strangle, it is the Gamma and Vega that needs to work togetherto overcome Thetas decay. Gamma is at its highest ATM. Theta is also at its highestATM.

So, as the products price moves towards being more ITM on the Call side(consequently, more OTM on the Put side), IV must rise to supplement the Loss inGamma to overcome Thetas acceleration. Conversely, if price moves towards the moreITM strikes on the Put side (consequently, more OTM on the Call side), IV needs to riseto bridge the gap of Gammas reduction to battle the increasing time decay.

Gamma and Theta are irreconcilable enemies.

A Straddle/Strangle needs Gamma to hold out against Theta, until Delta moves theprice outside either the Call or Put strike forming the boundary of the Valley of Loss.

With any of the 3 Theoretical Pricing models,the mathematical expression of Gamma(same for Calls and Puts) will show it does not share a 1:1 linear relationship withTheta (as Calls are expressed differently from Puts, with the interest rate built intoCalls).

So, a Straddle/Strangle needs multiples of +Gamma to offset the exponentiallyincreasingTheta, with additional +Gamma left over to add to the acceleration ofDeltas directional speed of movement. In a Straddle/Strangle, Gamma has 2 jobs:fight Theta and Support Delta. This also, why IV needs to rise to Support an ever-exhausting Gamma.

Think of Theta as the necessary cost incurred to pay for the much needed explosion in

Gamma to push price outside the Valley of Loss.

Entry

Strike intervals. A Straddle/Strangle strategy, by definition needs the products priceto explode outside 1 Standard Deviation (1 or +1) and move into 1/3rd to a half ofthe 2nd Standard Deviation (2 or +2) to make a reasonable Profit.
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So, choosing a product with strike increments of $1 at minimum and $2.50 atmaximum between strikes, in the first place, avoids the risk of using a product thathas strike intervals that are too far apart (e.g. $5, $10 intervals). Tighten the Valleyof Loss - make it narrow in the first place, by us

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