Meet the Warriors: The Option Trader

Warrior Presentation: Who is behind Financial Analyst Warrior?

In order for you to get to know who is behind Financial Analyst Warrior, I thought it would be a good idea to explain part of what I do for a living. This could also give you a concrete example of how I apply the knowledge I gained from the CFA program to earn money in real life. To be honest, only a microscopic fraction of the knowledge I use was learned from the CFA and most of it online and in books but still…

I guess I should start by disclosing that I am a trader, not an investor, and the strategies I implement on a daily basis are trading strategies rather than investments. Typically, an investment will be made because of its intrinsic value, with the prospect of generating gains on a reasonably long horizon. Reasonably long could be ranging from 1 year to 5 years. The trader’s horizon can be much shorter than that, it could be seconds, days or weeks but can rarely be counted in terms of months. Periodical assessments and occasional adjustments are required from an investment while trading requires almost constant monitoring. I admit that in some situations, there can be a very fine line between trading and investing. My trading strategy stays far clear of that fine line. The strategies I implement are definitely in the trading category and require careful if not constant attention. Potential profits, of course, are much larger than that of a regular investor who builds a portfolio of stocks, which he hopes will outperform during his time horizon. However, it requires significantly more monitoring and adjustment and the probability of a large loss is higher than that of an investor who is long stocks.

I’m just realizing now that I built suspense before disclosing which strategy I am actually trading….. I trade an option strategy called iron condor which is basically a combination of a bear call spread and a bull put spread. These are also called credit spreads because it allows the trader to receive cash from the spread (credit). It is also known as a vertical spread because two options of the same expiry but at different strike price are traded. I will not offer an extensive description of how these work since I know that if you are smart enough to read this blog, you are also smart enough to Google “iron condor” and find a wealth of information that will describe the strategy way more eloquently than I ever could. Nevertheless, to spare you the nuisance of having to interrupt this delightful read and open another window to perform the search, I will outline in an example how it works.

By the way I did not implement that specific trade, nor do I recommend it.

Assuming we are on February 10th and the S&P 500 ETF (SPY) is trading at 131.93.

Further assume that I believe that SPY has a reasonable chance of staying between 126 and 138 for the next 5 weeks.  The following are current market prices for options expiring on March 18th (5 weeks from now):

CALL 138: $0.41

CALL 140: $0.19

PUT 126: $1.14

PUT 124: $0.87

As I said before, the iron condor is a combination of two credit spreads so let us create those spreads first.

BEAR CALL SPREAD

  • Buy CALL 140 @ $0.19
  • Sell CALL 138 @ $0.41

NET CASH = 0.41 – 0.19 = +0.22

The total risk of the trade is the “distance between the strikes” which is $2. In other words the trade will start losing if the price rises above $138 before expiry. I will not explain the basics of options here but shorting a call give the trader the obligation to sell the underlying for the strike price if the price rises above it. If the price rises to $139, he will have to buy the stock at that price and sell it for only $138, thus losing $1. In our scenario, the total risk of $2 is reduced by the fact that we just generated $0.22 by selling the spread.

This makes our net exposure (net risk): $2 – $0.22 = $1.78.

BULL PUT SPREAD

  • Buy PUT 124 @ $0.87
  • Sell PUT 126 @ $1.14

NET CASH = 1.14 – 0.87 = +0.27

Again the total risk of $2 is partly countered by the $0.27 we just pocketed so;

Net exposure (net risk):  $2 – $0.27 = $1.73

Here we start being in trouble when the price of SPY moves below $126 with maximum loss occurring when the ETF reaches $124.

Combining the Spreads

This is where you have to be careful, when simultaneously implementing these two strategies, the total risk still remains $2. That is because, at expiry, the price cannot both be above $138 and below $124, so we can only lose up to $2 on one side. The net exposure is therefore $2 less the total credits collected. In this case:

Net Exposure:  $2 – (0.22 + 0.27) = $1.51

In other words, the maximum of our original money we can lose is $1.51 and that will occur in 2 scenarios:

1)      SPY rises to $140 and above

2)      SPY falls to  $124 and below

To compute our return, we simply divide the cash collected by the our net exposure which is the amount invested. In this scenario:

Total return = ($0.22 + $0.27)/$1.51 = 32.45%

This means that, in five weeks, $100 invested in this strategy will yield $32.45.

But that of course is a fairy tale scenario which can hardly be expected to occur consistently. If someone could make this type of compoundable return, he would double his money every three months.

Once the iron condor position is open, this is where the real work starts. The risk management, adjustments, monitoring of delta and gamma required at this stage is what is really complex about this strategy. Understanding the trade and implementing it is relatively easy but managing it is a constant balancing act. Proper risk management is what will ensure longevity for the option trader. Unfortunately the managing of the trade is a topic for a full book and there is already a blog that does an incredible job at explaining iron condors and how to adjust and manage them.

I should note that although most of my trades are complete iron condor, I also trade directional credit spreads quite often. I avoid taking bold directional bets so I always leave what I feel is a comfortable distance between the current price and the short strike price. This gives me room for error and my experience is that it is easier to make money from credit spreads than iron condor. For this reason, I usually manage each side of my iron condors as a separate credit spread.

Underlying

Since option pricing is very sensitive to the underlying’s volatility, I try to avoid exposure to unsystematic risk. Hence, I prefer trading iron condors on index or ETFs. The price of the underlying must be sufficiently large so that many strikes are available and it is easier to implement a full iron condor position. Also, the option must be liquid so the bid/ask spread must be fairly small.

In Summary

My trading strategy uses front month or one month out options to construct credit spreads and iron condors. This is how I generate most of my trading income. I believe that properly managed, this is a viable strategy which has the advantage of not requiring a vast amount of capital. Although it is much harder to manage positions on many underlying, it offers some degree of diversification so I usually deal with many index or ETF. I guess my description of the strategy was more exhaustive than originally intended … sorry I got carried away but the point was to get to know who is behind Financial Analyst Warrior. We will introduce other members of our team in the near future so stay tuned! We also have an upcoming post on why pursuing the CFA designation so this article will be for you if you are on the fence about committing to the CFA!

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