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More Commissions and More Risk: Final Part

josipcausic
Josip Causic
Instructor

In the first part of this series on the topic of More Commissions and More Risk, the following claim was made: “One less trading day can make a big difference. The shorter the duration of having a credit spread exposed to market fluctuations, the better and the safer.” This article, the final one on this topic, will show how true that claim actually can be.

Once again iron condor trades were placed on the RUT and IWM. The specifics for each are listed below.

The Entries

Iron Condor on the RUT
BTO + 1 Apr wk B 850call @ 0.41
STO – 1 Apr wk B 845call @ 0.64
RUT on (4-05-12) $818.18
STO -1 Apr wk B 800 put @ 3.12
BTO +1 Apr wk B 795 put @ 2.36
Max Profit = 0.99 Max Loss = 4.01 ROR = 25% minus commissions

Figure 1: Iron Condor on the RUT for the second week of April 2012

The figure above shows fine tuning of the vertical spread by using five point wide strike increments on the RUT. When we move to the Russell 2000’s exchange traded fund, IWM, which trades at one-tenth of the RUT value, we see a difference. Look at the strike price involved on the IWM and compare them to the strikes on the RUT.

Iron Condor on the IWM
BTO + 1 Apr wk B 85call @ 0.07
STO – 1 Apr wk A 84call @ 0.14
IWM on (4-05-12) $81.58
STO -1 Apr wk A 80 put @ 0.41
BTO +1 Apr wk A 79 put @ 0.25
Max Profit = 0.23 Max Loss = 0.77 ROR = 30% minus commissions

Figure 2: Iron Condor on the IWM for the second week of April 2012

An attempt to place the RUT’s equivalent of a 795 put or an 845 call would result in a 79.50 put or an 84.50 call. But wait! The IWM does not have those strikes; hence the 80/79 put spread on the IWM would equal a ten point wide spread using the RUT’s 800/790 put strikes. There is a big disparity between having five-point wide wings and ten. Could that cause a problem? Certainly. However, the focus of this article is that extra trading day on the IWM versus not having an extra trading day on the RUT.

The Exits

First let us look at the outcome on the Russell 2000 which is more complicated. The last trading day for the RUT was Thursday (4-12-12) and the RUT closed at 808.59 but it did NOT settle until the next day, Friday’s opening print. As the previous article has pointed out, the ticker for the Russell 2000 settlement is the RLS. The opening print was 805.03, which means that there was a gap down below where the RUT closed on Thursday. Nonetheless, all of the traded legs went out worthless; the main concern being the sold 800 put. The settlement price was still five points higher than the sold 800 put obligation.

Iron Condor on the RUT Exit Thurs close 808.59
BTO + 1 Apr wk B 850call @ 0.41 Expired worthless
STO – 1 Apr wk B 845call @ 0.64 Expired worthless
RUT on (4-05-12) $818.18 Fri open 805.03 on the RLS
STO -1 Apr wk B 800 put @ 3.12 Expired worthless
BTO +1 Apr wk B 795 put @ 2.36 Expired worthless
Max Profit = 0.99 Max Loss = 4.01 Actual Profit = Maximum Profit of 0.99
ROR = 25% minus commissions Actual ROR = 25% minus commissions

Figure 4: RUT’s Iron Condor outcome for the second week of April 2012

While the RUT was trading above the 800 strike, the IWM was correspondingly above its 80 level. Yet as the last day of April week B options dragged on, the weakness accelerated towards the day’s close.  By Friday’s close the IWM was trading below 80. As for the sold 80 put, it had to be repurchased. Figure 5 shows the specifics.  The 80 put was bought back for fifty cents while the intrinsic value was (80-79.55) 0.45, so 0.05 was fluff. The cost to repurchase the single leg meant that the entire credit from the Iron Condor was given back plus some. The actual outcome was: 0.50 debit minus the 0.23 credit for a 0.27 loss.

Iron Condor on the IWM Exit Friday close 79.55
BTO + 1 Apr wk B 85call @ 0.07 Expired worthless
STO – 1 Apr wk A 84call @ 0.14 Expired worthless
IWM on (4-05-12) $81.58  IWM on (4-13-12) $79.55
STO -1 Apr wk A 80 put @ 0.41 BTC + 1 Apr wk A 80 put @ 0.50
BTO +1 Apr wk A 79 put @ 0.25
Max Profit = 0.23 Max Loss = 0.77 Actual Outcome = 0.50 – 0.23 = 0.27 loss
ROR = 30% minus commissions Actual ROR was negative

Figure 5: IWM’s Iron Condor outcome

In conclusion this article has demonstrated that holding on to a short credit spread trade until the very end can make a huge difference due to that extra day of market exposure. Often the reason why some option traders talk themselves out of trading the cash settled indices, which have one price as the closing price and another as the settlement, is that discrepancy during which a gap in either direction could occur.  But the point is, that trading the “safer” instruments that go an extra day might turn out to be even more dangerous than trading the instruments with atypical settlements, so make sure to know your risks no matter what.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.