Iron Condors 101: Part 4 – Longer dated option contracts are safer

by | Feb 13, 2017

 

There are several ways to leverage trades, many of which are regularly practiced within the financial industry.  By now most have read articles about how some of the biggest fund managers out there are at times leveraged as much as 30 to 1.  When they are right of course the potential profits are huge.  Obviously if they are wrong the opposite is true.

I think we can all see the obvious pitfalls of this type of strategy and I hope nobody out there is actually trading on leverage.  You may look like a hero in the short run but it’s only a matter of time before leveraging blows up your trading account.

There are different ways to gain leverage.  The most common is just to trade on margin and increase the size of trades, but another equally dangerous method that is often implimented by option traders and that is leveraging through time, essentially shortening the time interval of trades.

By shortening the expiry length of the option contract you can essentially add leverage to your trades. 

The profit potential is the same for short and long dated contracts, but since it takes place in a short period of time you can get many more trades done within the same time period which multiplies your annual returns.  This style of trading unfortunately isn’t as easy to identify as clearly dangerous which is why so many option traders get themselves into trouble doing it.  It’s not until after they lose more money then they were comfortable with that they realize the inherent dangers of shorter dated option contracts.

Let me illustrate why this is more dangerous with the following two graphs.  The only difference between the two is the contract time length.

This trade has 53 days to expiry:

 

This trade only has 25 days to expiry:

First lets talk about the similarities of these two trades:

  • They both have the same 90% probability of success
  • They both have the same potential gain of 209$ and potential loss of 1991$.
  • They are both delta neutral, theta positive, vega negative.

 

So an inexperienced trader may look at these two trades and ask:

Why wait 53 days to capture my 209$ when I can risk the same amount of money and capture the same profit in just 25 days?  Isn’t the 2nd trade twice as good because it allows profit twice as quickly?  (essentially leveraging the trade through a shorter time interval)

 

Well the answer to that question is right there in the charts.  Do you see that white line I placed at a price of 160.44$?  This line represents a 3% drop in the price of the SPY from the day I opened the trade.

Notice how a 3% price change has a much more dramatic effect on the shorter dated contract?

  • The 53 day contract would be down 139$ if the SPY dropped 3%
  • The 25 day contract would be down 274$ from the same 3% drop in the SPY

 

As you can see shorter dated contracts are far more vulnerable to price changes than longer dated contracts making them more risky to trade.  Since markets make big price movements several times a year that both traders are going to have to deal with, the person who trades longer dated contracts is going to come out ahead because the effects of those big price movements are far less severe making it easier to manage trades over time.

 

Trading Iron Condors is a life long strategy where patience and consistency are valuable virtues.  At Volatility Trading Strategies we focus on risk management and safely growing our long term portfolio’s.  We aren’t going to allow out-sized short-term gains to influence our trading style.  Shorter dated contracts are inherently more risky and in the end they just aren’t worth it.

 

 

 

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