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More Commissions and More Risk

josipcausic
Josip Causic
Instructor

This article will compare and contrast the RUT (Russell 2000 cash-settled index) with the IWM (ETF that tracks the Russell 2000). In order to do this justice, an identical option strategy, the iron condor, will be placed on each of them.  Next, we will focus on the similarities and then, the differences will be emphasized.

PART I: Lay of the Land

Figure 1 shows the weekly trades on the RUT & IWM that were placed on Thursday 3-29-2012.

Figure 1

The specifics for each of these two trades are listed below in the next two figures.

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

Figure 2: Iron Condor on the RUT

Let us move on to the Russell 2000’s exchange traded fund, IWM, which trades at one-tenth of the RUT value.

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

Figure 3: Iron Condor on the IWM

As Figure 2 and Figure 3 clearly show the RUT and IWM iron condor trades are very similar in terms of the rate of return (ROR). Hence, we are comparing apples with apples. Next, let us look at the similarities between these two trades.

PART II: Similarities

Within this section, at least two similarities need to be addressed: implied volatility (IV), and average true (trading) range (ATR).

The IV reading on the RUT at the time of the trade was 22.73. Similarly, the IV reading on the IWM was 22.42. Observe how similar they are.

Now let’s move on to the ATR, or the trading range for a week. Without showing the charts which anyone can pull up and verify, the weekly ATR for the RUT was 33 handles, while the weekly ATR on the IWM was 3.5 or about 1/10th of the RUT; another similarity.

PART III: Differences

Once again, there are at least two differences that need to be addressed: commissions and risk. Starting with the first one; if a trader’s aim is to earn the same amount of credit on the IWM iron condor as on the RUT, then what contract size are we looking at specifically? Rounding the total credit of the RUT to 1.00 instead of the exact 1.08, it is clear that on the IWM we would need to place four contracts, each about 0.25, to get one whole point. Those four contracts do not come free. So keep in mind that there would be three extra commissions that would need to be “pony-ed up” by the IWM trader versus the RUT trader.

Next, let us talk about the risk, which is the last but not the least important point of this article. The IWM product has American Style options, meaning it could get assigned or exercised at ANY TIME. The RUT has European style options. These settle in cash but only after the contract’s termination; they also trade one day less. Just like the options on the SPX, S & P 500, the last trading day is on Thursday. What does this have to do with risk? 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.

In conclusion, this article compared and contrasted the cash-settled index, RUT with its Exchange Traded Fund, the IWM. For simplicity’s sake, the same option strategy was used as well as the same duration, a weekly option.  The difference between the two on their ROR is almost nil, but the differences are much greater as we put these trades under deeper scrutiny.  Trading the RUT involves fewer contracts and less time sitting in the trade for virtually the identical ROR, though this wasn’t visible at first glance.  Contact the Education Counselor at your nearest Online Trading Academy to sign up for our Options Courses so that you can better know your trading products before you trade them.

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.