How do I know if a stock is going to stay range-bound or neutral?
In most cases our underlying assumption for nearly all the trading that we do is that stocks remain within a defined range of one standard deviation (or 68% confidence) based on current implied volatility. This has been historically proven to be true, and in fact, implied volatility always overstates this expected move giving us our "edge" as an options seller. Having the ability to sell options far out on either end of the stock price provides us with a huge range of confidence and ample area for the stock to move and still profit. Whenever we have conflicting signals, whether we use technical analysis or charting techniques, we will always decide to stay with a neutral trade over making a directional assumption.
What are the best options strategies when you are neutral on a stock and IV is low vs. high?
When implied volatility is low and you don’t have an opinion on the direction of the stock, the best option strategy is not to make a trade. If you don't know the direction of the stock and you don't have an assumption on where implied volatility is going to go you're simply best off to sit on your hands and not make a trade at all. When implied volatility is high and you're neutral on the direction of the stock, you can choose between a couple different strategies. All of these strategies focus on the option selling and include straddles, strangles, iron condors and iron butterflies. The latter two are going to be best when you have an IRA account or a retirement account that restricts trading undefined risk positions.
How do I select strike prices on a short strangle?
One of our favorite strategies is the short strangle and strike price selection starts with knowing what probability level you want to target. For example, if you want to make a 70% probability of success trade that means that each side of your short strangle will need to be placed at the 15% probability of expiring ITM level (because 15% on each side is a 30% chance of losing in both directions together). This would also equate roughly to a 0.15 delta on each side.
How do I select strike prices on a short straddle?
Because short straddles are very high implied volatility strategies, strike selection is very easy as you will sell both the ATM put and ATM call option. If the closest ATM options are not near the current underlying stock price then choose to play the strategy a little bit directional and select a centered strike price either just above or just below the market.
How do I select strike prices on a short iron condor?
Strike price selection on an iron condor is virtually identical to that of a short strangle. You want to place the short strikes of your iron condor at the targeted probability levels that you are looking for and from there you can buy further out options for protection and a reduction in capital requirement to hold the trade.
When should you choose to do a strangle over an iron condor?
Choosing to do a strangle over an iron condor starts first with your account size. For most smaller accounts (less than $20k) we do not suggest trading strangles because they take up a lot of margin requirement to hold a position which ends up being too much risk. With larger accounts where you have the capital to do either one, it comes down to a question of return on capital and overall availability of funds in your account. Iron condors by their nature have a higher return on capital but also offer a lower total dollar profit potential long-term. In most cases you are better off, total profit-wise, to trade strangles in larger accounts. Here’s our suggestion; if you currently have a lot of available capital in your account you might opt to go with the strangle and if you have a lot of positions on already and don't have that much capital available to trade then you might consider the iron condor.
Given high implied volatility rank - when do you use a credit spread vs. an iron condor?
Since iron condors are created out of two separate credit spreads you can use them interchangeably whenever you want. We preferred to use iron condors when we want to be neutral on the direction of the underlying stock versus using a credit spread when you want to go bullish or bearish on the stock by trading only one side of the iron condor.
What is a skewed iron condor?
These types of iron condors have unbalanced strike spreads which creates skew in one direction or another. For example, you could have the put spread side 5 points wide and the call spread side 10 points wide. This would create skew to the bearish side because that side has the smaller strike spread. The call side would also carry more risk should the stock rally because the strike spread is wider. To skew the condor to the bearish side you would simply do the reverse of the above and make the put spread side wider.
How do I select strike prices on a short iron butterfly?
Think about a short iron butterfly as basically a straddle over where the stock is trading right now with protection on either side. So, you'd want to sell both an ATM call and put and then buy options a predefined distance out on either end. You’ll want to go fairly far out on either end to buy your protection as you'll want to pay a very cheap price for these options since the cost will be coming out of the short option premiums you collected selling the ATM contracts. Notice that we didn't say you should try to pay almost nothing for these options. You still want to pay money for these to give you protection and to make sure that you're even and balanced on both sides. Our suggestion is always to go out the same distance on either end. For example, if the stock is trading at $50 and you sell the $50 strike calls and puts, you might want to purchase the $45 strike puts and the $55 strike calls. Each end would be $5 wide and 100% balanced.
What is a broken wing butterfly spread?
A broken wing butterfly is when you skip a strike on one end of the spread. A regular butterfly would have for example the 10/11/12 calls. A broken wing butterfly would have 10/11/13 where you skip over the 12 strike and buy a further out strike. This should typically be done for an overall credit so that you don't have risk to one side of the trade and they work better in high implied volatility markets.
If implied volatility is low and you don't have a directional preference on a stock what strategy is best to use?
In this case, the best strategy is not to make a trade at all. There is no point in forcing a trade into the market when volatility is low and our edge is minimized when you don't have a directional preference on the stock. Full disclosure, here at Option Alpha we often find that this is the "trade" we make more often than not as we are very picky and choosy about our trades. We always want to ensure we are not trading just for the sake of trading and that our overall portfolio maintains the highest probability of success possible.