Hi Friends and Students,
Before I am off to Kuala Lumpur tomorrow for my course tomorrow, let me do one more piece on myths of options trading. Let us see what happens in this particular seminar when a self-proclaimed options trainer is telling his students about selling an OTM put spread as part of a long iron condor.
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Trainer: When you sell a put spread, try to go as far OTM as possible.
Student A: How far should we go?
Trainer: Try to pick a 10 delta option to sell and as long as you get a decent credit, that’s what you need. No need to look at volatility or other greeks. Simply use a 10 delta rule and you can see how simple it can be.
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If this story sounds familiar to you or it has been the way you are selling an OTM put spread (and for that matter, an OTM call spread) as part of a long iron condor, you may have been ignoring one important thing – skew. What’s that? Why is it important to know? Essentially, skew describes the relationship between the implied volatility of each strike. In the case of a vertical, by studying the skew, we are actually looking at the implied volatility relationship between the long strike and the short strike. So, why is it important? It is because there are times the quotes may be mispriced. If you have been reading my blog, you should know that “talk is cheap and show me the proof!”. So, here is my proof:
Source: Thinkorswim
Using the options chain for SPX as an illustration, we are considering three verticals.
a) Selling an Apr 1190-1185 put spread at $0.35
b) Selling an Apr 1195-1190 put spread at $0.30
c) Selling an Apr 1195-1185 put spread at $0.65
Now, let us compare spreads (a) and (b). 1195 strike is higher than 1190 strike. So, logically one will say that 1195-1190 vertical should be able to command a higher credit compared to an 1190-1185 vertical. But look what happens here? The 1195-1190 vertical actually commands a lesser credit compared to 1190-1185. Why is that so? It is the skew.
So, if the trainer merely tells his students to sell as far out of the money as possible without talking about skew or why skew is important, it is tantamount to the students giving a discount for the spreads they sold.
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Let us look at another part of this seminar when the trainer is talking about the width of the spread.
Trainer – so when you have decided the strike to sell, you need to look at which strike to buy too, right?
Student – what should be the width? Should it be 10 points, 5 points or 20 points?
Trainer – what a good question? I like to do a 10 point spread and I don’t like a 5 point spread. In fact, I have been doing 10 point spread all the time and you just need to believe me and follow what I am telling you.
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Now, let us compare spreads (a) and (c). Earlier we have concluded that due to the mispricing of the quotes due to skew, (a) is more preferable than (b). Not only that, I will now say that (a) is better than (c) too.
First of all, the selling strike for spread (c) is 1195 while the selling strike for spread (a) is 1190. The underlying will obviously reach 1195 before 1190. From a premium writer’s perspective, 1190 is relatively safer to sell compared to 1195, true or true? Now for spread (c), one can only command $0.65 and it is a 10 point spread. If one has to risk this amount of money, why don’t he sell 2 times of spread (a) and in doing so, his total credit received will be $0.70 ($0.35 x 2). So, do you want to sell a spread that is slighter further away from the money and yet you can get a higher credit? You are the judge.
So, now you should realize whether you should simply take the trainer’s instruction (because trainers are supposed to know more about the students right?) and follow accordingly. Or should you ask the trainers to prove to you what they say? You have a choice. I know some of these trainers are offering very affordable options courses and the truth is that they are cheap for a particular reason.
In my case, what I will likely do is to discount what the self-proclaimed options trainers say because if they cannot even show me the proof, I know how good they are. If in the course of teaching iron condor or other single-term spread / multiple-term spread strategies and they don’t talk about skew, perhaps I will look for another person who will bother to talk about the concept in the simplest way it can be to ensure his students are able to understand and apply.
Hope some of you have “a-ha” moment after reading this post and I strongly believe that some of you will.
Best trading!
Jack:)
