I want to talk about risk/reward of the non-directional trading.
I got the following email from a novice options trader:
"Non-directional strategies offer very limited returns while still have sizable risks in my opinion. I am not sure the risk-return profile is attractive enough."
This is a common misconception. In fact, it is up to you to set your own risk/reward of the trade.
I like to trade Iron Condors. In fact, this is one of my favorite trades. There are many ways to setup those trades. Lets check what we can do if we want to trade RUT August Iron Condor. RUT is trading around $795
Trade #1 - short strikes have deltas of ~10
- Buy RUT August 2012 700 puts
- Sell RUT August 2012 710 puts
- Sell RUT August 2012 860 calls
- Buy RUT August 2012 870 calls
Total credit: $1.35
Maximum gain: 15%
Downside protection: -11%
Upside protection: +8%
Probability of success (based on the short strike deltas): ~80%
Trade #2 - short strikes have deltas of ~25
- Buy RUT August 2012 745 puts
- Sell RUT August 2012 755 puts
- Sell RUT August 2012 830 calls
- Buy RUT August 2012 840 calls
Total credit: $4.70
Maximum gain: 88%
Downside protection: -6%
Upside protection: +5%
Probability of success (based on the short strike deltas): ~50%
Trade #3 - short strikes have deltas of ~40
- Buy RUT August 2012 770 puts
- Sell RUT August 2012 780 puts
- Sell RUT August 2012 810 calls
- Buy RUT August 2012 820 calls
Total credit: $7.40
Maximum gain: 284%
Downside protection: -3%
Upside protection: +3%
Probability of success (based on the short strike deltas): ~20%
All gains and probabilities are based on holding until expiration. The maximum gain or loss for the Iron Condor trade is always realized only if held through expiration.
So if you are going to make one of those trades, you can choose the strikes based on your belief where the stock will be trading by August expiration. To realize the maximum gain, the stock has to trade between the short strikes, so all options expire worthless.
As we can see, probability of success is directly related to the potential gain. You can have better risk/reward but lower probability of success. If you want higher probability of success, you need to settle for lower potential gain.
This is the beauty of those trades. You can structure them based on your risk tolerance and your belief where the stock will be trading during the life of the trade.
I personally like to trade 25 delta condors. For me, they offer the best balance between risk/reward and probability of success. Those trades require more adjustments than 10 delta condors, but when the underlying cooperates, the gains can be very significant. Like Dan Sheridan likes to say, "make the stock prove it can move".
Kim Klaiman
