Iron Condors 101: Part 2 – Why selling options beats buying options
I believe it’s impossible for anybody to accurately predict market direction in the short-run, so the only thing any of us can do is put probability in our favor and be consistent with our trading over long periods of time. To be a successful option trader we need to take the higher probability trades as often as we can, and let statistics and the passage of time be our biggest ally.
But which is statistically better? Selling options? Or buying them?
The answer is selling is better and it’s not close either, it’s by a landslide. Let’s take a look at what the results would be for all the possible outcomes for both a call buyer and a call seller:
For the Call Buyer, in at least 2 of the 3 possible outcomes they will lose money. For the Call Seller on the other hand, they will be profitable in at least 2 of the 3 possible outcomes. To determine profit or loss in the event that the underlying goes up, it depends on the magnitude.
This is because the Call Buyer had to pay a premium for the contract meaning the underlying not only has to go above the strike price, but it also has to increase by the value of the premium paid as well.
Call Buyers can be right on the underlying direction and still lose money
For the Call Seller though, they were paid the premium so even if the underlying goes up past the strike price, if it doesn’t also surpass the premium received they can still end up making money.
Call Sellers can be wrong on the underlying direction and still make money
Now that we’ve established that selling options is much better than buying options, we just have to determine what kind of options we will be selling. For me personally I always like to remain market neutral so Iron Condors are the perfect tool for that job. When we’re selling Iron Condors we’re selling implied volatility. Selling implied volatility rather than buying it has a huge built in advantage which we can call the volatility risk premium or VRP.
- Implied volatility is what the market expects to happen in the future
- Historical volatility is what has already happened in the past
It’s human nature for market participants to over price unknown future events which creates the volatility risk premium or the situation where implied volatility is usually substantially higher than historical volatility. Here is a chart of the S&P 500 as of today:
The bottom turquoise line which represents implied volatility is at 11.51% where as the middle pink line representing historical volatility is at 6.03%. That shows a significant volatility risk premium and gives the Iron Condor seller a significant statistical edge.
Now trading isn’t always so black and white and this isn’t always the case. There are rare times when volatility gets pushed to extremely low levels and the better trade is to buy an Iron Condor rather than sell it, but those are few and far between. The vast majority of the time selling options beats buying.
I don’t know any better than anybody else does where markets are heading in the coming weeks because nobody can predict market movements in the short-run. Looking at the consistent results below for our VTS Iron Condor Strategy though you’d think that I do.
Less than 20% of trading months were losers, how am I doing this? Well it’s not a crystal ball I assure you and it has nothing to do with predicting short-term market movement. It’s done through understanding statistics and probability theory, taking the highest probability trades as often as possible and then just managing risk over time.
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