By: Steve Smith
This option strategy has an 80% probability of delivering a 40% return in one month. As we get through earnings season and the ECB event uncertainty should subside bringing volatility levels lower.
The stock market has experienced some wild days over the past two weeks causing the CBOE Volatility Index (VIX) to raise 30% to $21 so far this year. For those that view volatility as an asset class it is one of the best performing in 2015. But for option traders that view it as statistic that tends to revert to the mean the recent rally represents an opportunity to sell some juicy premiums and generate income.
One of the best strategies for taking advantage of inflated premiums is an iron condor. An iron condor consists of four strike prices all with the same expiration date to create both a put and call spread. Both are out-of-the money. If one sells the iron condor you are selling both spreads and collect the premium. The premium collected represents the maximum profit and is realized if the underlying security is between the higher strike put and lower strike calls that are sold short.
The strategy benefits from both time decay and a decline in implied volatility and works best in a relatively range bound market.
Clarity Coming into Focus
During the first three weeks of the year the SPY has traded as low as $198 and as high as $206, a 4% range. It currently resides right near the middle at $201 per share.
But within this relatively narrow range we has alternating up and down days with very large intraday price swings, the largest being a 3.2% swing on January 13th.
Along with these swings and lack of trend that there are also economic uncertainties that is propelling the VIX higher. First and foremost is the macro picture particularly the tumult in the currency market. The surprise move by the Swiss National Bank to uncap the Franc from the Euro caused severe market dislocation putting several firms out of business as the Franc surged nearly 30% in a single day. A true black swan event that has everyone on edge.
But with the European Central Bank meeting set for Thursday we’ll get clarity on their highly anticipated QE programs. Also, there is a Greek election coming this weekend that will help determine whether it remains as part of the Eurozone. Once these unknowns become known the market jitters should calm down.
On the micro level we are just entering the meat of earnings season and thus far it has been disappointing. Retail sales have been lackluster, homebuilders have warned of lower margins on lack of pricing power and banks have suffered from low interest rates. And of course earnings from energy companies will be terrible.
But now most of this news is pretty much priced into the market. I think the SPY will now be range bond for coming weeks and volatility levels will subside.
SPYing an Iron Condor
Let’s dive right into the trade I’m looking to make in the options of the SDPR 500 (SPY). I want to create a position that has both a high probability of turning a profit and a good return on capital. This is what will help me choose my strike prices.
I want at least a 75% probability of a profit; that means choosing the inside or short strikes that have less than 25% probability of expiring in-the-money. While many option chains will provide probabilities of expiration a basic rule of thumb is to look at delta. I’m using strikes with a 0.20 delta, meaning they have only 20% chance of being in-the-money on expiration.
That leads me to selling the $190 put and the $209 call options.
I also want to achieve a 30% return on my risk capital over the one month holding period. That leads me to buying $186 puts and $213 calls with the February 20th expiration. This will define my risk to a maximum of the $4 between strikes minus the premium collected.
The trade specifics with the SPY trading at $201 are:
-Bought February 186 puts at $1.05 per contract
-Sold February $190 puts at $1.60 per contract
This is a $0.55 net Credit for the put spread.
-Sold the February $209 calls for $0.80 a contract
-Bought February $213 calls for $0.20 a contract
This is a $0.60 net Credit for call spread.
The total credit is $1.15 for the iron condor. This represents the maximum profit that can be realized if SPY is above $190 and below $29 on expiration. The maximum loss is $2.85 and would be incurred if SPY is below $186 or above $213 on expiration.
That translates into a 40% return over the one month holding period. One important note, while there is an 80% probability this position will result in a profit there is a 40% chance that one of the inside strikes, $190 or $209 will be touched at some point prior to expiration. This means we could get a scare or two. But given this is a limited risk position there will be no need to panic.
I’ll go with the odds that we turn a nice profit one month from now.