Our trading topics in December have focused on common delta-neutral strategies such as buying (debit) straddles and selling (credit) strangles. While both approaches have merit, the latter is far more likely to produce a profitable outcome in the majority of market conditions. Unfortunately, this high (statistical) probability of success comes with a major drawback: the potential for large losses. One way to overcome this disadvantage is through the use of a "hedging" technique, such as a spread or combination position.
A Limited-Risk Approach
A spread is a strategy that involves the buying and selling of simultaneous but opposing positions in different option series. When the cash received from the sold option exceeds the cost of the option that was purchased, the resulting position is called a "credit" spread. A credit spread is a popular technique among professional traders because it allows time (premium) decay to work in their favor while maintaining a limited-risk outlook. The objective is for both options to expire worthless, so the spreader can keep all of the credit (profit) in their account. Normally, a credit spread trader uses front-month options only, as their time value evaporates most rapidly in the final few weeks prior to expiration. This erosion effect benefits credit spreads, assuming no change in the other variables that affect option pricing such as the underlying security's price, option volatility, dividends, or interest rates.
- Manage your spread risk with stops and trailing stops.
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By combining two out-of-the-money credit spreads, a trader can participate in a relatively conservative, neutral-outlook strategy known as the credit-spread strangle. For those who enjoy more dramatic titles, the technique is also sometimes called an "Iron Condor." The strategy is generally used with range-bound issues or broad-market indexes and it is a limited-risk, limited-profit position that offers a wide range for success. Another benefit to this technique (over selling "naked" options) is that most brokers require less collateral for the combined position, as only one spread can lose money at expiration. Here is an illustration of the profit-loss potential for an Iron Condor: