From the October 01, 2011 issue of Futures Magazine • Subscribe!

Eliminating risk with the iron cockroach

Option Strategy

Question: How can we eliminate all risk in one direction on our iron condor?

Answer: Turn our iron condor into an iron cockroach.

Equity indexes have seen a spike in volatility since mid-July and the heat of the debt ceiling debate, though a bottom — at least temporarily — appears to have been set. Fear is still high as the Chicago Board Options Exchange’s Volatility Index (VIX) reached a 14-month high in August. Options traders love this because they can sell option premium at elevated levels even in strikes well out-of-the-money.

Many traders sell option premium via short straddles, short strangles or iron condors. These strategies are non-directional. They will sell an at-the-money straddle or strangle and wait for volatility to collapse, hopefully realizing a profit in the meantime.

Because the market has to sell off dramatically for volatility to spike this high, the only thing that would cause an equally dramatic collapse in volatility would be a strong rally.

When selling a straddle, strangle or a traditional condor, any dramatic move will create a loss. Thus, we need a strategy that could withstand a large move to the upside while still benefiting from a short volatility approach.

To understand the benefits of the iron cockroach, let’s examine a traditional iron condor. An iron condor is the simultaneous sale of a vertical call and vertical put spread in the same expiration month with the same size spreads ($1, $2.50, $5 and so on).

An example would be selling the S&P 100 (OEX) 550-545 call spread and the 515-510 put spread. Using the option chain below, we see that we would take in $1.85 ($7.90 - $6.05) for the call spread and $1.50 ($15.45 - $13.95) for the put spread. This gives us a credit of $3.35 for the sale of two $5 verticals.

We want the market to close between $545 and $515 so that both spreads expire worthless and we keep the $3.35 premium as a profit. Should the OEX close below $510 or above $550, we would lose $1.65 ($5 on one of the spreads minus the $3.35 in premium).

Remember, we believe that volatility will collapse and a bounce higher will be the probable cause. With the OEX roughly at $525 (as of Aug. 25) our upside breakeven is at $548.35 (short call strike + premiums), so we only are 4.5% out-of-the-money. In other words, if OEX rallies more than 4.5%, we will sustain a loss. One way around this is to play with the put strikes and twist this trade from an iron condor to an iron cockroach.

An iron cockroach is the simultaneous sale of a call spread and a put spread in the same expiration, with one spread being wider than the other. We will use the same 550-545 call spread from our iron condor, but we will sell a 525-515 put spread.

We know that the 550-545 call spread sale yields $1.85. The 525-515 put spread is wider and brings in $3.90 ($19.35 - $15.45). The two spreads combined will bring in $5.75. So if the stock runs past our short call spread and we lose $5, we still are up $0.75 on the trade (See "A better roach motel").

Yes, we have more risk to the downside with the iron cockroach than with the condor, but we went in with a bullish bias, took in more premium and have no risk to the upside.

The iron cockroach can be set up with a bullish (as in our example) or bearish bias. To change the trade into a bearish position, we could sell the $10 wide 530-540 call spread at $5 and the 515-510 put spread at $1.50 for a combined $6.50 credit. Then, even if it broke and we lost $5 on the short put spread, the $6.50 we took in from the sale would yield a net $1.50 profit.

Edward LaPorte is an independent contractor for Random Walk, LLC. Their website, RandomWalkTrading.com, features options education material that is updated constantly.

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