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More Commissions and More Risk Part II: The Exits and Settlement

josipcausic
Josip Causic
Instructor

This article is a follow up to last week’s which explored the similarities and differences between 2 similar iron condors on the RUT and it’s exchange traded fund counterpart, the IWM.  Previously we discussed the entry.  Here we will focus on the outcome of the trades, comparing their bottom line rates of return. The second segment of this article delves into what could have happened if the RUT put leg had been left open and went sour.

The Exits

Once again both the RUT’s iron condor and IWM’s are looked at separately, starting with Figure 1 which shows the outcome on the Russell 2000 cash-settled index.

Iron Condor on the RUT Exit
BTO + 1 Apr wk A 850call @ 1.05
STO – 1 Apr wk A 845call @ 1.67 BTC + 1 Apr wk A 845 call @ 0.05
RUT on (3-29-12) $828.78  
STO -1 Apr wk A 795 put @ 2.34 BTC + 1 Apr wk A 795 put @ 0.05
BTO +1 Apr wk A 790 put @ 1.88
Max Profit = 1.08 Max Loss = 3.92 Actual Profit = 0.98
ROR = 28% minus commissions Actual ROR = 24% minus comm.

Figure 1: RUT’s Iron Condor outcome

On the left is the entry with the initial calculation of rate of return (ROR) being 28%. On the right, we see that two sold legs, the obligation call and the obligation put, were bought back for a nickel each; hence, reducing the original Maximum Profit by a dime. The credit kept also changes the ROR by about four percent; so the true ROR at the end of this trade is 24%. Again, commissions are not taken into account in this equation, but in real trading they are a significant part of the final calculation.

Next, let us move on to the outcome of the trade on the Russell 2000’s exchange traded fund, IWM, which trades at one-tenth of the RUT value.  Both products closed in the middle of the range and the iron condors would expire worthless. Yet, the decision was made to repurchase back the call and put legs with obligations, so that the capital could be re-utilized for trades expiring the next week. Buying back the obligation emphasized the point of truly comparing oranges with oranges.  That next week, April’s Week B by the way, was a special week because the market was closed on Good Friday and the sellers of premium benefited from Theta decay over the long Easter weekend.

Iron Condor on the IWM Exit
BTO + 1 Apr wk A 85call @ 0.12
STO – 1 Apr wk A 84call @ 0.28 BTC + 1 Apr wk A 84 call @ 0.05
IWM on (3-29-12) $82.25  
STO -1 Apr wk A 79 put @ 0.20 BTC + 1 Apr wk A 79 put @ 0.05
BTO +1 Apr wk A 78 put @ 0.13
Max Profit = 0.23 Max Loss = 0.77 Actual Profit = 0.13
ROR = 30% minus commissions Actual ROR = 15% minus comm.

Figure 2: IWM’s Iron Condor outcome

The above figure is laid out identically to the RUT’s Figure 1.  On the left is the entry discussed in the previous article, and on the right is the exit. Notice that the initial Max Profit was only 0.23 so when both the sold call and sold put were repurchased the actual profit was significantly reduced. This cut the IWM’s rate of return in half. So go ahead and draw your own conclusion, connect the dots. Is trading the IWM really identical to trading the RUT in this type of scenario?

RUT Settlement Prices

Buying back the obligations on the IWM caused a significant reduction in ROR.  This might lure an option trader into bending his rules and being passive and not buying them back.  Buying back the obligations on the RUT when the premium received was over a dollar was not such a big deal with regards to the ROR.  But what could happen if we didn’t buy back those RUT obligations prior to expiry?  Let us assume that instead of selling the Apr wk A 790 put, the 820 put was traded and was not bought back.  Keep in mind the fact that the RUT trades one day less than IWM and settles on the opening price the next day, Friday. April’s week A was especially unusual due to the shortened week.  The RUT’s last trading day was Wednesday, but the option settlement in cash was done based on the prices of the Russell 2000 on Thursday’s opening print.  The regular RUT closed above the 820 put on Wednesday, April 4, 2012.  To be exact the RUT closed at 820.39 and one would assume that the 820 put would go out worthless, but no! On Thursday, the RLS, the Russell’s settlement price was 815.79 due to the pre-market gap. In the case of the 820 put there would be a loss of 4.21 per share plus the 15 dollar settlement fee.

So where do we go to find the settlement price at no extra cost? The CBOE; where else?  http://www.cboe.com/ The Figure below shows the CBOE snapshot of the index settlement values. Anyone trading the cash-settled index should pay attention to these settlement prices and their respective tickers. To find these tickers select Index Settlement Values under the third tab QUOTES & DATA, then look to the left under Index Settlement Values and select, Weeklys Settlement Values.

Figure 3: Weeklys Settlement Prices

Look at the bottom three, relevant for the April 5, 2012 settlement. The NDX settlement ticker is the NDS, the DJX is the DJS, and the RUT is the RLS.

In conclusion, the purpose of this article was two-fold; first, to compare the outcomes of the rate of return on the iron condors discussed in last week’s article. Secondly, to make sure an option trader understands the possible ramifications of not buying back their obligations on a cash settled index, as well as where to find out the actual settlement prices for these atypical trading instruments like the RUT. A trader should do his or her own research before trading an instrument that has an unusual settlement. To learn more, contact the Education Counselor at your nearest Online Trading Academy to sign up for our Options Courses.

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.