As the days rolled into March, I had no open trades. The death of a relative in one town and a pending surgery date for another relative in a different town persuaded me not to enter any March trades. What do you do if you're not in any live trades? You live real life and, also, you learn all you can about options.

If you're like me, sometimes you learn by spying on other people. While I'm not usually the sleuthing type, you can spy on other traders by watching the spread book on your online brokerage, if you have that capability. If not, you go to "COBWeb," the CBOE Complex Order Book on the Web, available during market hours on the CBOE's site.

Portion of the Think-or-Swim Spread Book for the SPX on March 4, 2015:

Someone wanted to sell a 5-contract iron condor in the April expiration period. This trade did not fill during the market hours on March 4, but the trader put in a GTC (good till cancelled) order. By checking the option chain on March 4, I determined that the date was still 43 days out to expiration of the APR 15 options. The trader obviously was willing to wait to attempt to get the desired price rather than lower the ask to the mark or below. We can see that the mark or mid-price for this iron condor was at $1.25.

How might this trade have looked if it had filled on March 4?

Graph of the Trade from the TOS Spread Book:

We know from the spread book (and a look at the market depth, too, which I also studied) that the current mid-price for this iron condor was $1.25. The theoretical profit shown here was reflective of the difference between the price the trader wanted and that mid-price: ($1.50 - $1.25) x 5 x 100 multiplier = $125.00. Think-or-swim was showing a theoretical profit of $124.59, not including commissions. That theoretical profit was a fake profit for the time being.

What else do we notice about this trade? I don't want to take up too much room with another graph when several others are already going to follow, but I noted on a different (not shown) page that the sold 2170 call would currently have had a delta of 0.14 and the sold 1975 put, -16. In both cases, the absolute values of those options' deltas were higher than those at which I used to enter iron condor trades. There's nothing wrong with choosing higher-delta options to sell if the trader knows how to manage such trades. However, the trade may get into trouble faster than when further-out options are sold.

There's usually more premium to work with when these closer-in options are sold, however. In this case, selling options closer in may have been the only way to collect enough premium to make this trade viable. When implied volatilities are low, as they were early in March, traders have to sell closer-in options in order to get much premium at all. That can cause a problem.

If you look again at the expiration graph, you notice that light blue horizontal band? That marks a standard-deviation move in either direction from the then-current price until the expiration of the options involved in the trade. Most traders consider a one-standard-deviation move to be the regular "noise" of trading, sort of a to-be-expected move. What if the SPX were to move to the upper boundary of the light blue band during the course of the trade? We can see that a one-standard-deviation move to the upside would bring price well outside the upside expiration breakeven for the trade, with big losses accruing. This setup, selling the higher delta options in this case, increases the chance that the upside boundary could be overrun sometime during the trade. Adjustments or stop-loss levels would have to be determined before the trade was entered.

The Greeks of the position are shown in the middle price slice under the graph, the one at the then-current price of 2098.53. Which of the Greeks (delta, theta, vega) for the whole position has the biggest absolute value? Examining the one with the biggest absolute value tells us something about which one will impact the trade the most at that time. The biggest influence on the trade among the Greeks will be the vega, with vega at -99.56. Vega tells us about how much the trade will gain or lose if implied volatilities change. When vega is negative, rising implied volatilities hurt the trade's profit. A vega of -99.56 means that for every 1 percent rise in the implied volatilities, this trade will lose approximately $99.56. Is that a problem?

It's not a problem if the implied volatilities stay flat, go up or go down only slightly. But which were they likely to do? The VIX is one rough measure some people use to determine whether volatilities for the SPX are near historical lows, highs or somewhere in the middle of the two.

OptionNET Explorer Graph of VIX versus SPX Price:

On March 4, the VIX (black line) was approaching the trendline (blue) from which the VIX has tended to bounce. Can the VIX go lower? Certainly it can. It can, and it has. Just thinking logically or statistically about the trade, though, should this trader have felt safe if this trade was filled, with the VIX below 13 and headed down to retest that trendline?

Let's ratchet the volatilities up about 4 percent and see what theoretically happens with the risk graph of this trade, if it had been filled at $1.50 and little time had passed and little price movement had occurred. Remember that these articles are roughed out ahead of publication, and this exercise was performed as of March 4.

Trade with Volatilities Higher by Four Percent:

Notice how this change has theoretically impacted the profit-and-loss line? Instead of a theoretical profit of almost $125 (due to the mismatch between the asked price and the actual mark or mid-price), the profit-and-loss line now shows a loss of $209.16 plus two-way commissions. The loss would be even greater without those false profits due to that mismatch. (As a follow-up, implied volatilities did rise but price also dipped and time passed, with both of those changes helping the trade's profit-and-loss. By the close of trading on March 11, the trade was showing a theoretical profit of $191.50. We can and should forward test our trades, but that doesn't mean that the theoretical changes become the actual changes in all cases.)

Given that our hypothetical trader couldn't see into the future and had only the type of testing that we've done here, what's the conclusion? There's no single answer as to whether the trader should be selling premium in an iron condor or other type of premium-selling trade when volatilities are at or near historical lows. Recognizing the risks becomes important.

Perhaps this hypothetical trader usually trades 20 contracts or even 50. A trade of five contracts then represents a significant reduction in typical risk for this trader. Such a trader might be seasoned at trading iron condors in an expanding volatility environment and feel that handling five contracts in such an environment is a breeze, compared to the trader's usual 20 or 50 contracts.

Conversely, the hypothetical trader might be a trader with a $5,000 account, and the $1,750 plus commissions risk might represent a significant portion of that trader's account. Moreover, that trader might never have traded an iron condor during a sharp downturn and might have no idea how the trade behaves during such a downturn. Such a trader might be taking on too much risk in a low-volatility environment when the volatility might expand.

A trader worried about too much risk in the case of a price downturn and a rise in implied volatilities might add a volatility hedge in the way of an extra out-of-the-money put. A trader worried about a relentless push to the upside might hedge with a call debit spread or by simply selling fewer call credit spreads than put credit spreads, creating an unbalanced iron condor.

Not trading for a time doesn't mean you have to stop learning. Here's another potential trade from the spread book on March 4 from a trader who put in an order to buy 40-contract MAR1 15 2130/2135 call debit for $0.05, two days before expiration. The trade didn't fill, but what do you think the trader hoped for? The spread book doesn't say whether the order was to buy-to-close a 40-contract call credit spread or to buy-to-open a 40-contract call debit spread, of course.

Leaving You Guessing:

Sometimes, it's fun to spy and speculate, isn't it? Fun or not, don't underestimate the value of spending non-trading days by learning from others. Not trading doesn't necessarily mean you're not advancing your trading skills.

Linda Piazza