condor Archives - Data Driven Options Trading

Underlying Security vs Risk Permission

What level of option risk goes best with what type of underlying security? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes.

What level of option risk goes best with what type of underlying security? Most people reading this might wonder what in the world is the point of this topic and why should I care? Depending on the option strategy, your choice of underlying security type can have a big impact on your outcomes. This might get a little deep, but hang with me and I think it will be worth your time.

4 risk levels, 4 underlying types

Brokers typical allow customers to trade options at four different levels of risk. I’ve written about how the risk compares between these levels. As a reminder the four levels are:

Level 0: Covered options- cash secured puts and covered calls
Level 1: Buy options
Level 2: Option spread trades- buy an option, sell an option
Level 3: Naked option selling

There are also four general types of underlying securities for trading options. With each comes different advantages and disadvantages. As a reminder the four types are:

Individual Stocks of Companies
Exchange Traded Funds (ETFs)
Index Options
Futures

For example, there are three different classes of underlying securities for trading options on the S&P 500 index: ETF options like SPY, Index options like $SPX, and Futures options like /ES.

So the question and point of this post is to examine which risk permission levels work best with which types of underlyings. It’s not an obvious question or an obvious answer. Most traders would say it doesn’t really matter- more risk is more risk, and less risk is less risk. But some underlyings are better built for certain strategies more than others. It doesn’t mean you can’t trade a strategy for a certain underlying, it is more of a question of what is optimal for the type of risk and potential return you are seeking in a trade.

The Matrix

I made a sixteen square matrix to evaluate each combination. I rated each pairing based on how well the option risk matched with the characteristics of the underlying. My conclusions are simply my opinions, and I welcome discussion and other opinions backed by data. So here is my matrix and what follows is the data and logic behind it.

underlying security vs option risk levels — Some types of option strategies and risk are better suited for certain underlying securities than others. With each combination is a brief explanation. Green choices are best.

Let’s review the boxes one row at a time, by risk level.

Covered Options

Covered or secured option strategies include covered calls, cash secured puts, covered strangles, and the wheel strategy. These strategies use the full value of underlying shares either in cash or shares to protect against loss from selling short options. The options being sold are much less volatile than the value of shares, so covered options are the only option choice that is a clear reduction in risk compared to owning shares outright. All versions of this option trading strategy limit upside growth while allowing the potential of losses to zero, but most of the time these strategies outperform owning stock outright. So how does this type of transaction impact different underlyings?

Individual stocks can be very volatile. Positive or negative news about earnings or products or lawsuits or mergers or management changes can make stocks move way outside their expected moves. These outsized moves happen more often than normal statistical distributions would predict. Even so, individual stocks tend to have options with much higher implied volatility than the overall market. For stock investors that want to dampen day to day moves of their portfolio balances, selling secured or covered options is a great way to participate in individual stocks with less drama. Because of the crazy volatility of individual stocks and the high implied volatility of options on individual stocks, covered options are a great match for individual stocks.

I would argue that for both the covered strategy and the stock underlying type, this is the strongest match in this row and column. There is no better underlying for covered options than individual stock, and there is no better option risk level for individual stock. I know a lot of people will disagree, but as we look at the other combinations, I hope you’ll at least understand my point of view.

Covered options on exchange traded funds are fine trades. It’s probably the safest possible option strategy there is if we want to call any kind of trading “safe.” We combine a bunch of volatile stocks together into a product that dampens volatility down substantially. Then we sell options against that new product that will rarely see moves outside the moves that are expected. The options may not pay a lot, but they won’t lose often either. A very boring way to make steady gains (and I’m thinking of boring as a good word here).

An argument could be made that covered options on ETFs is perfect for both, because it’s a double volatility reduction, and for risk-averse traders that’s a great combination. I get that, but for me, I think it’s a little too much volatility reduction, and sacrifices too much option premium for safety. Be less volatile with stocks by selling covered options, or be less volatile with riskier option strategies by using ETFs, not both. But I’m generally a risk taker, so maybe I under-appreciate the double volatility reduction of covered option strategies with ETFs.

Covered options on indexes is the easiest combination to rate on the matrix, because it is the one combination that can’t be done. We can’t own an index outright, so we can’t sell a covered call. If we sell a put and get assigned we don’t get the index, we just pay up the cash we lost. So, there isn’t a real way to sell covered index options on the underlying index. This is the only red square in the matrix because it can’t be done.

Covered options on futures can be done, but it doesn’t really make sense. Futures and futures options are all governed by span margin, so really there isn’t an official way to sell covered options on futures, because there is margin being used on every leg of the trade. No piece is fully “covered.”

I almost made the covered futures options block red, but you can kind of do it if you set aside the cash that the full notional value of the future is worth when you sell a call against a future, or sell a put on a futures contract. The problem is that your buying power won’t show that you’ve locked up the full notional value, so you have to track it yourself. It just isn’t what futures are about.

Let’s do a quick example to illustrate. Let’s say we have a futures product that trades for $1000 with a multiplier of 50. So the notional value of a contract is $50,000. If we buy a futures contract, the broker will use SPAN margin and only take away at most $10,000 of our buying power, even though we are on the hook for the full $50,000. If we sell a call on the same future, we’ll likely gain buying power, as we just reduced the volatility of the position. Maybe SPAN margin says we now only need $5,000 buying power, while we remain at risk for $50,000. So, our broker and SPAN margin don’t make us “cover” our options. You can keep $50,000 in your account to cover the trade yourself, but nothing forces you to, other than wanting to eliminate any risk of blowing up your account in a downturn. It’s fine to do this, but it technically isn’t a covered option, so it’s a yellow square on my matrix.

Buying options

When most people first learn about options, buying an option is the trade they can easily understand. You pay a premium to have the option to either buy or sell something. Margin is not a factor, because the risk is defined. The risk of the option is the cost, it can end up worthless, a total loss, but no more than what was paid to own the option. If the option ends up in the money, it may be profitable, maybe very profitable. Leverage comes from the possibility of virtually unlimited profit for a relatively low cost.

Buying puts or calls is like going to the security market casino. It’s a low probability bet that might pay off big, but often will lose what you gambled. But let’s not get all “judgy” against the strategy- lots of directional traders buy options to get the most out of a move they think will come. When implied volatility is low and the market is rolling up nice gains, it can be a very lucrative trade that exceeds its predicted probability. But which underlying security types are best fit to take advantage?

Individual stocks can make big moves up or down, and owning an option in the right direction when a big move happens can be great! But the market knows that individual stocks are prone to big moves so options are expensive to buy. A little move won’t cut it. A trader has to be very right on timing and direction.

But, if buying calls or puts is your thing, the biggest rewards are with individual stocks. So, I’ll give it a green square.

Buying options on ETFs is cheaper than stocks, but the likely moves won’t be as big. However, if the goal is to ride a trend that is going up faster than what implied volatility predicts or a slide going down, ETF long options are a good choice.

In a bull market, selling calls is usually a loser, which means that buying calls can be a winner. Buying calls on an ETF in a bull market will hit a lot of winners usually without a lot of capital required, so probably the best use of the strategy in this row.

Buying put and call index options is a very similar situation as options on ETFs. It’s really a matter of preference, depending on several factors. Some brokers restrict access to index options, so it might not even be a choice for some accounts. Most index options are bigger notional value, often 10 times as big as the equivalent ETF, so it might make more sense for a bigger account to use index options, while smaller accounts stick to ETFs. There are a lot more ETFs available than index options, so niche indexes either don’t have an index option or have such poor liquidity that the only choice is an ETF. Commissions per contract are often higher on index options, but per notional amount are lower. So, it depends on a lot of things. I’ve discussed the differences in much more detail in my write-up of different ways to trade the S&P 500. All the same trade-offs are true for the Nasdaq 100 and Russell 2000. So, for some traders buying options, the index option might be best so I’m coloring the combination green, but for most traders smaller, more liquid ETFs are going to be a better choice.

For futures options, the issues are similar as comparing index options to ETF options, except that buying futures options outright negates much of the advantages of futures options, but keeps the negatives. Futures options are a favorite of experienced and sophisticated traders because they can be traded with lower SPAN margin requirements, giving a trader more leverage, and also letting opposing positions reduce buying power. But, if a trader is only buying options, buying future options doesn’t gain much in buying power, but will cost a lot more in commissions and slippage from lesser liquidity than ETFs or index options. In my opinion the only time it makes sense to buy a futures option is to counter a bunch of short futures options or other futures position. I talked about this in my discussion of buying the 1 DTE straddle with futures options.

In the end, unless you have a really good reason to buy options on futures, it generally is a better trade to buy a similar ETF or index option product. So that’s why I colored this combination yellow.

Trading Option Spreads

Let’s define an option spread as buying and selling an equal number of puts or calls. There are a lot of ways to trade spreads, and many of my favorite strategies fall in this broad risk category. Option spreads have defined risk, but as strategies get more complex, understanding exactly how much risk a trade has defined can get a little tricky. It isn’t as obvious as the risk with buying an option, but the risk is known.

We can think of spreads in two main categories, debit and credit spreads. Debit spreads are trades where a trader pays to enter the trade, and credit spreads pay the trader to enter the trade. Credit spreads are often the highest leverage version of selling options, with the highest potential return on capital for many positions. With that potential high return on capital comes the risk of a total loss, often many times the amount that was collected to open the trade. How do these factors impact different underlyings?

With individual stocks having more likelihood of an outsized move, there is a bigger chance of a total loss on a credit spread, although that is somewhat balanced by higher premium from higher implied volatility. Debit spreads tend to limit max gain in exchange for improved probabilities compared to buying options outright. So, debit spreads on a individual stock miss out on big gains without a outsized increase in probability of profit.

Many traders favor spreads for individual stocks over naked options because of the defined risk limiting losses to a defined amount. My view is that both strategies have to contend with outsized moves and it’s a matter of picking which poison does the least damage. But because so many like spreads as a risk reduction for individual stock options and it is a viable strategy, I’ll rate this combination a yellow.

I’m going to lump ETF options and index options together for spreads. Just like with the earlier discussion on buying options, the difference between ETFs and indexes is a matter of preference and an individual’s account situations. Strategically, I like both for buying and selling spreads. Because ETFs and indexes are made up of many stocks, they have much fewer out-sized moves than individual stocks. This makes the leverage of spread trading work well, both in credit and debit type spreads.

In particular, selling put spreads on ETFs and indexes can be a high probability trade. I’ve written about this my page on selling put spreads. I’ve also written about the best delta for put spreads, and the best deltas for rolling put spreads. And in each case, I tend to stick to some version of a put spread on the S&P 500. I’ll add a call spread to turn the trade into an Iron Condor, which I’ve discussed in my post on rolling Iron Condors.

As for buying spreads, I’ll occasionally buy a call spread when the market is particularly bullish and Implied Volatility is low. Buying options in any style is usually a low probability trade, but there are ways to improve odds, and using a spread to have decay on the short leg off-setting the decay being lost on the long leg can be a big help. We can get more exotic with diagonal trades selling a nearer term option while buying a longer term option and actually having positive Theta for our trouble. In all these trades I like ETFs and indexes because the results tend to be more consistent.

Many of the ratio type trades that I do utilize two sets of spreads, like the popular broken wing butterfly trade. Again, I like ETFs and indexes because outsized moves are less likely than individual stocks.

You may be sensing a theme. Less outsized moves make using the highly leveraged option spread on ETFs and indexes my favorite choice for spread trades. It’s green squares for both, and my favorite use of ETFs and indexes, as well as my favorite way to trade spreads.

In theory, futures option trades with spreads should also be as favorable as ETFs and indexes. They work about the same and have the same type of probabilities. But there are two things that I don’t like about trading spreads on futures. One is a personal nit-picky concern, and one is a concern that virtually any trader would have.

Let’s start with the most legitimate concern. Futures options are less liquid than ETF and index options. They have wider bid-ask spreads, and they are harder to fill close to the mid price between the bid and ask. In many trades, the tick size, or the amount you can adjust your limit price by is substantially bigger than for the same trade on an index option on the same thing. For example, on $SPX index, we can adjust our limit orders by 5 cents up or down, but with /ES futures, we have to adjust our order in increments of 25 cents. To make it worse, often the volumes are much lower and even giving up 25 cents won’t get an order filled. So, it can cost a lot to get filled, and we haven’t even talked about commissions, which are generally also higher, both per contract, and even more so as percentage of the notional value of the position. Maybe someday these costs will get lower and it won’t bother me as much, but I just don’t like it for spreads with futures options.

But what about SPAN margin you might ask? Doesn’t that extra margin make it palatable to pay a little more so you can get that super-duper leverage for traders that like more risk and more reward? Well, this is my nit-picky problem with spreads on futures. SPAN margin isn’t that much extra buying power for spreads with futures options compared to indexes, ETFs, and individual stocks. Because spreads have defined risk, the two sides of the trade already have formed a hedge and SPAN margin doesn’t give much more buying power than the reduction from calculating the max loss of the total spread being wiped out. To be fair, futures traders get some additional buying power, but it isn’t enough for me to justify the higher costs of trading spreads with futures options.

I know there are traders out there that like futures with spreads that little extra buying power that comes from SPAN margin, but for me it makes more sense to go with an index option or ETF option where my risk is defined and doesn’t change. So, I’m giving this spot on the matrix a yellow. Proceed with caution.

Selling Naked Options

Selling naked options is supposed to be the riskiest of the whole bunch of risky option trades. In one way it is in that maximum losses are essentially undefined, but even with margin, the leverage of Theta or Delta as a percentage of buying power is often less than what happens with spreads. So, as long as we avoid outsized moves (which we can’t, by the way) there’s a strong argument that selling naked options is not nearly as risky as it would seem at first glance.

Let’s be clear about what selling a naked option is about. With covered options, we can sell a call or a put and there is either cash or shares covering the short option positions. For naked trades, the broker lets us sell on margin. Often we are only required to have something like 20% of the notional value set aside for covering the option sale. That’s great for our account as long as the price doesn’t move against us more than that 20%. Actually, the broker will increase buying power requirements as price moves against a position, so the requirements are always in flux. But with plenty of extra cash as a buffer and markets not going crazy, it’s manageable.

So, we are selling options on margin. What underlying type does this work best with? Let’s check out our four choices.

Individual stocks are the most likely underlying to have an outsized move, so they are the most likely to get a naked option trade into trouble. It doesn’t take much, a change at CEO, a merger or acquisition, surprising earnings announcements, good or bad product news- any of these can trigger a move way beyond the expected move. With individual stocks, the probability of an outsized move both up or down tends to be greater that what Delta would predict, or it often just isn’t that great compared to the other products with diversified components.

That’s my reason for avoiding naked options on individual stocks. I know lots of people trade naked options on stocks all the time, diversifying their holdings to reduce overall risk. But for me, why not use an underlying that is already diversified? I know individual stocks have higher Implied Volatility to pay a seller to take on that added tail risk, but for me it just isn’t enough. I’ve seen too many situations where a trader has gotten a very nasty surprise and lost way more than they thought they could. It can happen with any naked trade, but it’s more likely with individual stock options. So, for me this is a yellow box- proceed with extreme caution.

Now, let’s not try to make the argument that naked options on the other types of underlyings are super safe. They aren’t, and you can lose big. Ask anyone who had naked puts on the S&P 500 (any version) when Covid hit in 2020. It was bad. But those kinds of moves happen much less often than negative moves in individual stocks. People that trade naked options take a lot of risk, and so the question for the remaining three underlying types isn’t which one is least risky, but which gives you the biggest bang for the buck? If you are selling naked options, you better know what the risk is, but how do you maximize return when you have a trade go your way?

Like the last two levels of risk, ETFs and index options have essentially the same pros and cons for naked options. While there is significant tail risk, it isn’t as high as individual stocks. So, naked options sales on ETFs and indexes tend to perform better than the expected move would predict. This makes these underlyings a better choice for underlyings on naked options. As a result, I’m giving these matrix squares a green rating.

Finally, we have selling naked futures options. On one hand this is a highly leveraged trade with ultimate tail risk due to SPAN margining. On the other hand, this combination gives a trader the potential for significant high returns on high probability trades that otherwise might not make sense.

I look at naked futures options as the ultimate “go big or go home” trade. If a trader wants to trade futures options, selling naked gives the ultimate amount of exposure for the least buying power. SPAN margin allows a trader to use a fairly small amount of capital to open a naked trade. And if a trader balances the Delta of both sides of a trade, buying power requirements become even less, as the total risk is considered in required capital.

SPAN margin also lets a trader have different sides of the trade be at different expirations and have the net exposure of each side be considered in the SPAN margin calculation. The point is that for the most agressive, risk-tolerant option trader, there is no higher leverage way to sell options than selling naked options on futures. For that reason, I really like futures for naked options.

Selling futures options naked still have the issue of poor liquidity and higher commissions, but the flexibility of SPAN margin finally makes it worth the cost for risk-tolerant traders. It is worth noting that the liquidity and commissions are significantly more of an issue for traders that trade “micro” versions of futures options, like /MES, compared to /ES. Whether it is a futures product on an stock index, a commodity, or a currency, the micro versions just have a lot less open interest and liquidity. So, if account size limits trades to micro futures, a trader has to watch which expirations and strikes can be entered and exited without huge price slippage, particularly when exiting early.

Despite the cost issues with futures options, selling naked futures is my favorite use of futures options, and my favorite way to sell options naked. I give it a green box on the matrix. I don’t rate it this way to suggest it is a safe trade, but that it is the ultimate use of options leverage.

Bonus sections

There are a few option strategies that don’t fit neatly into the four categories of risk that I think deserve a special mention because I talk about them in other parts of the site.

Bonus #1 Ratio Style Trades

Ratio style trades are a more complicated type of strategy where there is an unbalanced number of contracts sold vs bought- a lot of times a 2:1 ratio in some variation. If there are more contracts sold than bought, the trade becomes a level 3 naked trade, like the 1:1:1 or 1:1:2 put ratio trade that I discussed in other pages. But often, I use a level 2 defined risk version of the trade by adding long options to equal out the short options, usually creating a wide credit spread along with a narrow debit spread, like a broken wing butterfly (1:2:1), broken wing put condor (1:1:1:1), or 1:1:2:2 put ratio.

These trades are technically either a group of spreads (level 2), or a spread with a naked short option (level 3), but is there a difference in what underlyings are best for these kinds of trades because of the ratios and odd ways of managing these types of trades? The short answer is not really.

For level 2 defined risk ratio trades like butterflies, condors, and 1:1:2:2 trades, I like ETF and index options for their liquidity and reduced volatility. This is the same logic as with spread trades in general.

For level 3 naked versions of ratio trades where there are more short options than long, my preferred underlying is futures options due to the reduced buying power of SPAN margin. These trades tend to be fairly highly probability of profit, but with significant tail risk from black swan type events. SPAN margin considers this risk and allows a trader to use a fairly small amount of capital to enter this kind of trade. Anyone trading this way must consider the significant tail risk into their management strategy.

A trader can use ETF or index options for these naked ratio trades, but they consume a lot of capital with standard option margining. Traders with portfolio margin accounts might find this more acceptable. For understanding of different types of margin in options, see my post on the topic.

Bonus #2: 0 DTE trades

0 DTE trades have special considerations because of their short time frame. Let’s throw in 1 DTE and any options trade that has just a few days until expiration. All these trades focus on either last minute moves or the extreme decay that comes in the final days or hours of an option contract.

Individual stock options don’t have daily expirations, so expiration day trades are usually limited to Fridays or end of month at most. That essentially eliminates them as a candidate, but it gets worse.

With options near expiration, assignment at expiration or near expiration is a big concern. Individual stock options and ETFs in the money can be unexpectedly assigned into shares in the days before the options expire. And if options are held to the end of the expiration day, assignment can happen even if the market closes with options out of the money. A late after the market news event could trigger option holders to exercise their options on individual and ETF options, so you never know.

So, that leaves index and futures options. Index options are settled to cash at the market close. Futures options expire into futures contracts at the market close. A trader doesn’t have to worry about after market events impacting an expired position. The only exception to this is monthly index options that settle on the open of the market, but stop trading at the market close of the previous day. These contracts have AM expiration, where almost all other options expire in the PM, at the market close. The ticker symbols for index options expiring and settling at the market close generally end with a “W” for weekly, which originally was for the weekly expirations that happened every week, but now happen every day. The monthly options, which are the very original index options, don’t have a “W” at the end of their ticker indication.

Settling to cash vs settling to futures contracts or shares is a big difference. Most expiration day traders don’t want to deal with the underlying securities ending up in their account and the significant notional value that comes with them. Because of that, index options are far better choices for trades approaching expiration.

Traders with small accounts can choose between micro index options, like $XSP, micro futures options like /MES, or ETFs like SPY. They have different pros and cons. Micro index options have fairly poor liquidity with wide bid/ask spreads and big tick sizes for poor fills, but settle to cash at expiration. Micro futures options have worse liquidity and bid/ask spreads, plus high commissions, and settle to futures contracts, all negatives, but are usually half the notional size of the other two low capital choices. ETF options tend to have good liquidity, but settle to shares at expiration, or after expiration. None of these are ideal, but if a trader wants a small option stake on expiration day, these are the choices to consider.

Conclusion

So, there you have it. A fairly exhaustive analysis of the various combinations of trade types vs underlying security types. Some of the factors I consider most important in this analysis, may be less important to other traders, and some accounts at certain brokers may not even give a trader a choice to have some of these types of underlyings available. Others may not have some risk permissions available.

In any case, my hope is that whatever level of risk or underlyings a trader has available, it is clear what combinations make might more sense from a viewpoint of risk, potential reward, capital usage, and trading costs.

The 1-1-2-2 Put Ratio Trade

Like all the front ratio type trades I have shared, this trade is a defined risk version of a very similar front ratio trade featuring naked short puts. My versions hedge the trade with long puts to limit the risk. However, in this trade, I will also discuss the unlimited risk version of the trade, the 1-1-2, because the additional risk isn’t that much from a practical standpoint.

I’m a big fan of front ratio type trades. I’ve written about my success with Broken Wing Butterflies and Broken Wing Put Condors. Another trade that fits in the group is the 1-1-2-2 Put Ratio. I don’t know of a named reference to a bird or insect for this trade, so I’m going with 1-1-2-2. Like all the front ratio type trades I have shared, this trade is a defined risk version of a very similar front ratio trade featuring naked short puts. My versions hedge the trade with long puts to limit the risk. However, in this trade, I will also discuss the unlimited risk version of the trade, the 1-1-2, because the additional risk isn’t that much from a practical standpoint.

I picked up the concept of this trade from one of my favorite traders, “Sweet Bobby” Gaines, who I have mentioned previously in at least one other page on this site. Bobby is a big proponent of the 1-1-2 trade, and has posted numerous videos on it on his YouTube channel, including his recent rising star appearance on Tasty Trade. But really, the trade is the next level of evolution moving from broken wing butterfly to broken wing condor to “one louder” as they say in the mythical group Spinal Tap.

What all these trades have in common is selling an out of the money debit put spread, and financing by selling further out of the money puts or wider credit put spreads. The combination delivers a net credit, but also sets up an interesting dynamic of extra rapid decay of the premium involved. The farther out puts or put spreads decay faster than the closer debit spread, and often lead to the debit spread having more value than the credit spread. These trades take in a credit to open, and often can take in a credit to close. At least that’s how I set them up and manage them.

All these trades are a variation of a front ratio spread, where more options are sold than bought with hedges added to define risk. I’ve also written about back ratio spreads where more options are bought than sold. Front ratios are designed for maximizing decay, while back ratios set up multiple long positions paid for by a costly short position.

The previously discussed broken wing condor could also be called a 1-1-1-1 trade. In that trade we buy a put spread and then sell another put spread further out for more money, collecting a net credit. Four different strikes, 1 contract each. So what is a 1-1-2-2?

1-1-2-2 Basic trade setup

The 1-1-2-2 takes this a step farther, because we use two credit spreads very far out of the money to pay for the debit spread. The 1-1 part is buying a put around 25 delta and selling a put around 20 delta. The 2-2 part is selling two puts at around 5 delta and buying two puts around 1 delta. The goal is for the 2-2 to sell for about twice what the 1-1 cost. I like to set these up with 45-55 days remaining to expiration, quite a bit longer than the other ratio trades I’ve discussed.

What is the advantage of this? Well, because each of the two short strikes are further out, we greatly improve the odds of being profitable, and increase the initial rate of decay of the total position. We end up with a big gap between the debit spread strikes and the two short put strikes. Lots of good things happen with this setup. The biggest upside is that there is no upside risk- if price goes up, the trade makes money. The downside of this trade is that it can consume a lot of capital and has significant tail risk, which we will get into before we are done. Let’s look at a typical example.

Pricing and Greeks for the 1-1-2-2 position — In this example, each of the two low delta puts collect about what the debit spread costs (~$10).

The first thing I want to point out in this example is that the 3100 short put is 900 points below the current price of $4000. For that strike to get in the money, it would take a 22.5% decline in the market in 55 days. That won’t happen very often. To be fair, this example uses values with VIX at 25, a historically higher than average value, but for the timeframe of 2020-2022, a fairly middle of the road level. The higher that implied volatility is, the farther away the short strikes can be and still collect meaningful premium.

The next thing to point out in the setup numbers is the Greeks. Delta is fairly flat at +3. For a credit trade, that isn’t much and means that the position can handle some movement in price. Theta is $69/day, and we collected $805. So, the position is expected to lose 1/12 of its value each day. But we have 55 days, so how does that work? Quite well, I’d say.

Finally, we can’t ignore the capital risk of $115,000. How can this be? If the price drops below $2500 at expiration, a 47.5% drop, the loss would be $115,000. While extremely unlikely (we didn’t lose that much in the Covid crash of 2020), it is possible in some disastrous scenarios. We’ll discuss this later as it impacts capital requirements and how one perceives risk. At the end of this post, I’ll explain how we can get into this trade for a fraction of this buying power.

Numbers are one thing. A picture or three might help make this all more clear.

The dotted lines represent expected moves. This trade is profitable at expiration if the market doesn’t go down more than two expected moves.

This chart shows how changes in the underlying price will impact the profit and loss of the trade. We evaluate at four points in time. The green diamond shows our initial position at 55 DTE, underlying price is $4000, and the P/L is zero. The curvy lavender line shows how price would likely impact the position with 35 DTE. The green curve shows the likely profit at 14 DTE, and the sharp purple lines are the expiration values. We know exactly what expiration values will be at any price, but the curves are estimates based on likely impact to implied volatility as time passes and prices change.

I’ve put in dotted lines to show the expected move and multiple expected moves down. If you need a refresher, check my earlier post on expected moves. It is likely that price will end up inside of one expected move, the dotted lines on either side of the current price of $4000. There is approximately a 2% chance that price will move two expected moves to the second dotted line below the current price, which would still be max profit for this trade at expiration. And there is approximately a 0.3% chance of moving three expected moves to the far left dotted line. We can go further, but the odds keep dropping as we go to lower levels. However, as history has shown, moves down tend to have somewhat higher probability than theoretic probabilities once we get beyond two expected moves. The bottom long puts are a final defense to limit losses for going even more extreme in a rapid crash. The point is that this trade is very likely to end up profitable, but there is risk that an extremely big move down could lead to an extremely big loss. We’ll talk about ways to reduce exposure later.

Now that we’ve talked a bit about the very unlikely outcomes, let’s zoom in and discuss the most likely scenarios. Here’s the profit chart showing prices down to 25% below the current price with profit and loss zones highlighted.

This chart shows the profit and loss compared to most likely underlying price levels.

Zooming in allows us to see the profit levels in the timeframes referenced above. Notice that down moves initially can drive the position to a loss, but if the move doesn’t go below the two short puts at 3100, the position will be highly profitable at expiration. In fact, this trade does best in the very wide range of a price drop between 6 and 22 percent, bringing in up to $5000 additional credit.

If price goes up or drops less than 200 points, we can keep our initial premium at expiration. We may be able to collect more. The profit curve at 14 DTE is actually above the expiration profit if the price remains the same. How is this possible? Because the 1-1 debit put spread decays slower than the 2-2 credit spread, eventually the 1-1 part is worth more than the 2-2 part, even though the 2-2 part started out worth twice as much as the 1-1.

Let’s look at this another way. Prices don’t generally move immediately to a new level, but have probabilities of moves that get bigger over time. Again, going back to expected moves, let’s compare how we might expect price to move during the duration of the trade.

Price expected moves — This chart shows expected moves day by day from initiating the trade until expiration, and compares to the put strike prices.

In this chart I’ve shown several outcomes. The zero move is if price doesn’t change at all, a baseline. I’ve shown a +1% move which is in line with the positive drift of the market. There’s also a line for the positive expected move and the negative expected move, where price is likely to be within at any point in time. And finally I’ve shown a curve for a price move of two times the expected move down. Notice where the strikes are relative to the price curves are. The negative curves take time to get below the upper 1-1 put strikes, and never reach even the short put of the 2-2 credit spread.

Now let’s look at what happens to the value of our premium if price were to follow each of these curves. This is a view that you don’t see much because it is based on lots of assumptions for the pricing models. Since implied volatility is not predictable in the future, the chart makes assumptions for how price and time will most likely impact volatility and premium value.

option premium vs time — This chart shows how different underlying price trends would likely impact option premium over time.

Initially, this position collected $8.05 in premium, so we start with a negative or short value of -8.05. From there the price moves shown in the previous chart drive the premium up or down along with time decay. If price is flat or going up, premium decays and moves quickly toward zero premium. If the price goes down, the positive Delta pushes premium to more negative values. The price move of negative two expected moves really does a number on our premium initially, driving it down to below -30.

But, remember our profit chart at expiration? The flat and positive moves end up with a profit of our initial premium (all the puts have zero value at expiration, and the negative expected move and negative double expected move end up at maximum profit. Since our debit spread is 50 points wide, the negative moves would leave it fully in the money for a premium value of +50 points. And that’s in addition to the initial premium collected to open the trade. The challenge is that to get that max profit, we likely will have points in time where our position loses money.

The probability of getting to max profit is low because it would require a price drop between 6 and 22%. Based on our put strike Deltas we can estimate that we have about a 20% chance of that. Most of the other 80% is expiring with all strikes out of the money. So, it might be wise to zoom in and understand what happens with the vast majority of trades.

1-1-2-2 value vs. time chart — In most situations, the premium of the 1-1-2-2 front ration decays quickly, maxes out, and then levels off before losing value.

I used this chart as the featured image of this post because I thought it best illustrates how this trade plays out most of the time. If you remember when we discussed the Greeks, I pointed out that Theta is very high compared to the premium. From this chart we see that if price stays the same or is slightly up, premium will decay to zero by 35 DTE, or just 20 days into the trade. This is an example that Theta isn’t 100% accurate by itself as it looked like 12 days of Theta should move us to zero value. It could be that IV modeling is slightly off or the Theta was off, but still we have very rapid decay that I don’t think anyone can complain about.

Like all ratio style trades we have discussed, this trade has the possibility of switching from negative to positive premium. The difference with this trade is that it is actually quite likely, and as such we need to plan for it and manage our profit accordingly.

I’ve colored in the area under our three flat-to-positive curves with three zones each. There is a green zone where positive premium is growing, a yellow zone where premium is topping out, and a red zone where positive premium is being lost. Notice that the curve of the 1% up move and no price move are fairly close together, and that’s because the price movement is relatively close to the same compared to the other moves we are analyzing.

Let’s review how this happens. This trade essentially has two spreads, a slow decaying debit spread (1-1), and a fast decaying credit spread (2-2). The credit spread decays faster because it is farther out from the money, is much wider, and has twice the value to start with. All these factors help decay happen more quickly. As long as the price stays fairly stable, this relationship will hold. Theta will be the primary driver of the premium value, and the wide credit spread will get to be worth less than the narrow debit spread.

The most likely scenario is that we stay inside the expected move and travel somewhere close to the no price move or 1% up move. Let’s realize that the market doesn’t move in equal amounts every day like this chart, so think of it as a smoothed out version of what premium would do. In the real world, premium would bounce up and down with price. However, if our price is close to where we started with 20 days until expiration, we would expect that the premium switch to positive has about maxed out, and it is probably a good time to close out the trade. Hopefully,your trading platform has a analysis feature that lets you look at your position and see how profits are changing day by day to help determine when the position is as high as it can go.

Without a chart, another way to determine how close the trade is to switching direction is to watch the position Theta. At the beginning of this trade, Theta was 0.688, or $68.80 for the full contract per day. As the trade progresses, Theta will decrease and at some point when the premium goes positive, Theta will turn from positive to negative. As it gets close to zero, that is the peak premium value. I generally try to exit the trade a few days before Theta is projected to turn negative. A big up day for the market could quickly change my very positive premium to not as positive premium, so it isn’t a time to get greedy.

So that brings us to the curve for the positive expected move. This is the curve that assumes that the price follows the one standard deviation move up. The good news when this happens is that premium decays very quickly because Delta and Theta team up. The not so good news is because the price move gets so far away from the strikes, the total position won’t get to a very high positive value. This is because all the options will drop in value quickly, approaching zero, and the upper debit spread won’t have much value. A big move up means that the probability of any of the strikes going into the money will be very low, so there is very little premium. As a result, it is likely we won’t be able to get out for much positive premium if any at all, but we will be able to keep most, if not all the premium from the opening trade. This is the least stressful outcome of the trade. If the price moves up faster than the expected move, premium will likely drop to very close to zero and may not ever go positive. So, if price is up a lot and the trade can be closed for a credit, I take the money and run. I’m happy to have a quick, winning trade.

The risky outcomes

Looking at the position vs time value chart, there are two lines that represent what happens if price goes down. One is the move down one expected move and the other is down two expected moves. Interestingly, in this example, both end up at max profit by the end of the trade. So, it would appear that the trade can’t lose, which is far from true. Notice that these premium values may go very negative if prices drop quickly after opening the trade. This is because the narrow debit spread doesn’t pick up as much value from increasing delta as the wide credit spread does in a down move. We know that if price stays above our credit spread short strike at expiration, we will make money, but when price moves quickly down, it isn’t clear that price will level off.

So, as a trader, we are left with a choice when the market drops, We can take a loss and get out of the trade, or wait to see if the market quits dropping before it tests or violates the credit spread strikes. If we are a week or two into the trade, a decent down move will not make a huge impact, but initially the trade can take a big hit from a down move. The longer we are into the trade without a big down move in price, the less the risk is of a loss. On the flip side, a big move down opens the possibility of additional big down moves that can lead to a very big loss. We reviewed the odds earlier- about 4% of the time the trade will lose based on the far short puts having an initial Delta of 4. If this trade is done enough times, there will be some losses. Let’s look at some management actions that could be taken.

1. Set a stop based on premium price. In this example, we collected just over $8 premium to open the trade. So, we could set a stop to avoid losing twice ($16) or maybe even three times ($24) our initial premium. This would mean a stop loss if premium climbs to $24 or $32, given that $8 premium is our starting break-even point. This is the simplest risk mitigation strategy. Using this will lower the overall win rate as many negative scenarios would end up fine if not closed, but this management technique will prevent huge losses that might impact the account dramatically.

2. Close the trade if the underlying price goes below a trigger point. We know this trade has a lot of cushion. We can handle much more than one expected move and be profitable. But if the move is much more than expected, we have to consider that the move is very unusual and dangerous for us. Perhaps our point to get out is when the debit spread is in the money, or when we are half-way between the debit spread and credit spread. Or maybe it is the short strike of the credit spread that is the final trigger to get out. The further down we allow price to go down, the more we stand to lose. Pick the underlying price where it gets too uncomfortable and use that as the trigger point to get out of the trade.

3. Roll out in time if premium or price triggers are hit. If the position is rolled before the credit spread is in the money, it can be rolled out for a credit. This gives more time for the market to turn around. However, it gives more time for a losing trader to lose more, because we likely can’t roll down that far and still get a credit, and we will likely have to pay to roll the debit spread or narrow the distance between spreads, making the trade less attractive. If the price move continues down, there will be much less room to maneuver going forward.

4. Simply hold on and hope the probabilities play out. With 55 days in the trade, we just need to move down less that two expected moves by expiration. If the capital is available, and the conviction is there, holding can bring max profit with a big down move. Note that as time passes and the credit spread stays out of the money, the premium has to go away, so the value can evaporate very quickly with very high Theta as expiration approaches. This can be observed in the value vs time graph for the -2 EM curve. It can also result in max loss. As expiration approaches, the difference between max profit and max loss is just a few percentage points of price movement and max loss is much more than max profit.

In this example we can see that a move down of one expected move really doesn’t challenge our position, while two times the expected move is playing with fire. So, one approach might be to hold as long as the move stays within the expected move to the downside and switch to closing or rolling once the move exceeds that or some other multiple of expected moves. In any case, a trader has to know their risk tolerance and have a management plan for both winning and losing trades.

What about calls?

A logical question might be- if this works so great for puts, why not double up and do it for calls as well? Well, there’s one problem- skew. On indexes implied volatility is higher as strikes go to lower values and declines for higher strike prices. As a result, out of the money puts have higher implied volatility than out of the money calls. More importantly, far out of the money puts have higher implied volatility than puts closer to the money.

Look at our setup for this example. Implied volatility of the single long put is around 25, while the two short puts have implied volatility of 39. This helps two ways. The short puts have more of their premium tied to volatility, bumping up their price compared to the long put. Also, the higher implied volatility pushes the strike price further down to get a matching premium to the debit spread, making the trade a higher probability of success. We are selling more of the higher implied volatility and buying lower implied volatility, a key reason to use front ratio spreads.

A similar setup for a 1-1-2-2 call trade would reverse the dynamics. The long call closest to the money would have the highest implied volatility and the two short calls would have the lowest. To collect similar amounts to the put trade, the call strikes would be much closer between the debit spread and credit spread, and the difference in the deltas of the strikes would also be closer together, meaning a narrower window of max profit, and a higher probability of max loss. While still a trade with positive probability, it generally isn’t as attractive as the put side.

1-1-2 vs 1-1-2-2

I haven’t talked much about the two long puts bought at less than one Delta to open the trade. They are very unlikely to ever be in the money, and most traders would opt to close or adjust the trade well before they came into play. So, why have them? The simple answer is that they define or limit the risk of the trade, potentially reducing the capital required for the trade, and protecting from absolute disaster in the event of a market crash of over 37.5% in under 55 days. It could happen, like it did in February and March of 2020 during the Covid pandemic. We are giving up 20% of our premium to protect for a once or twice in a lifetime super crash.

So, what if we eliminate the long puts and do a naked 1-1-2 ratio spread? Is it different in outcome or probabilities? The answer is that it is very similar in most ways, and we will also see that a lot depends on the type of account you are trading in as to what choices there are. First, let’s start with the setup of the 1-1-2 trade.

The 1-1-2 setup is similar to the 1-1-2-2 — The 1-1-2 trade has two naked puts sold short, but way out of the money.

While this table shows the risk as unlimited, it is actually $618,855, the value of two 3100 puts if SPX went to zero by expiration ($620,000) less the $1,145 collected to start the trade.

Some accounts and some brokers require all trades to be defined in their risk. For example, retirement accounts generally aren’t allowed to use option margin and so any naked put would have to be cash secured. For this trade, eliminating the two long puts would mean the max loss would go up to $618,855, assuming that SPX went to zero, while we are holding two short 3100 puts. SPX will only go to zero if we see modern society end, and in that case, we’ll probably have bigger problems than our option positions. But rules are rules, and so if you want to trade without the long puts in a retirement account, you would need $620,000 capital to make a likely $800-$1200 or less than 0.2% return in 55 days or less. We’ll discuss other alternatives after we review the details of the 1-1-2 trade.

The profit profile for the 1-1-2 is very similar to the 1-1-2-2 other than the virtually unlimited loss.

Remember that our starting underlying price is $4000 and the trade is profitable at expiration as long as price is above 3100. The chart above doesn’t show losses all the way down to zero price, but just imagine zero price and -$618,855. Our probability of profit is 96% if held to expiration based on the Delta of 4 for the naked puts.

value vs time for 1-1-2 — Most scenarios show a profit with 1-1-2

Looking at 1-1-2 values over time at the same price moves that we looked at for the 1-1-2-2 trade, we can see that the premium changes are fairly similar. Staying within one expected move keeps the trade moving in the direction of decay.

zoom in on 1-1-2 value over time — Zooming in on most likely outcome’s value over time

If we zoom in on the likely outcome, we see that premium behaves very similarly to what we saw with the 1-1-2-2 trade setup. We just have more premium collected to start with, taking a bit longer to fully evaporate and have the premium turn to a credit for closing. The concept is the same.

Summarizing the differences between the 1-1-2-2 trade and 1-1-2 trade, the 1-1-2 trade collects about 20% more premium in exchange for more loss if the market drops more than 37.5% in the 55 days of the trade. How likely is it for the market to drop more than 37.5%? Is buying the long puts for protection worth it? That’s up to each trader to decide.

Buying power requirements

I usually don’t spend much time talking about buying power because most trades I do are defined risk credit trades where the amount collected is a significant portion of the capital at risk. This trade is not so much, whether defined risk (1-1-2-2) or a naked ratio spread (1-1-2). In non-margin accounts, we collect 0.7% or 0.2% respectively, which isn’t much.

Below is an analysis of different possible ways to trade. I looked at trading each of these strategies three different ways. First, I looked at a cash secured account, like a retirement account. Next, I looked at an account with margin for naked options. Finally, I looked at a much different approach, trading futures options with span margin. The margin and span margin amounts came from entering this trade into the tastyworks trading platform.

Buying power differences for Margin and Futures — Comparing buying power impact of different account types for the two strategies

I highlighted some key takeaway points. First, is how leveraged span margin with futures options can be for this trade. Our most capital efficient trade would be doing the 1-1-2-2 on futures span margin where we would collect 100 times the premium as a percentage of buying power (20%) than the non-margin account of the 1-1-2 trade (0.2%). Of course, with leverage comes much more risk. I chose to consider a loss of 10 times the initial credit as a practical worst-case scenario. The span margin would end up costing huge amounts more in a disaster and could potentially wipe out an account if the trade used a high percentage of the account’s capital.

A couple of weird margin anomalies to point out. In my margin account, the defined risk 1-1-2-2 trade required almost twice the buying power as the undefined 1-1-2, which is weird because clearly there is more risk in the naked 1-1-2. I think it may be that the calculation for defined risk is normally much less than undefined and the software may just assume that margin is not useful in defined risk. On the other hand, defining the risk on the futures version cut the buying power by 1/3. Different brokers may calculate their margin requirements differently, so don’t take this as universal truth. Similarly, remember that while defining risk usually increases the return on capital, it makes outsize losses more likely, especially when scaling up. Notice that the highly leveraged futures 1-1-2-2 would lose twice as much as a percentage of capital that the futures 1-1-2 setup in a 10x loss. I discussed this phenomenon in detail in my post on comparing risk.

Remember that margin and span margin change as the trade progresses depending on the market behavior. Span margin is subject to big swings when prices go against a position. A broker may force a position to close much earlier than a trader would want to get out due to expanding capital requirements. So, while initially the position is cheap to enter, a trader needs to limit each position to a fraction of the overall account size.

But the good side of this is that this trade can be entered for a very small cost. The trade is very high probability. We can also make more than the premium collected. I didn’t include it in the chart, but maximum profit for the most leveraged choice above would be $5,805 profit on $4,000 buying power, a return on capital of 145%. And there is over a 20% probability of that happening.

One final note on the buying power analysis table. To keep the quantities an apples-to-apples comparison, I used double the number of /ES futures options because futures options only control half as much value as SPX index options. So, technically, those futures options trades listed are 2-2-4-4 and 2-2-4 because they use twice the number of contracts to get the same notional exposure. I reviewed differences between index options and futures options in detail in my post about different ways to trade options on the S&P 500 index.

What about small accounts?

Readers looking at this may be thinking, “Gee, this is great for multi-millionaires, but what if the account is too small to consider any of these buying powers?” Great question- there are other alternatives. First off, a trader could use half the buying power listed by just trading options on one contract of the Mini S&P 500 futures (/ES). The 1-1-2-2 example would only take $2,000 buying power for $402 premium received. But, if that is still too much, we can make it a lot less.

Many traders are more familiar with options on the SPY exchange traded fund, which trades at approximately 1/10 the value of the S&P 500 index. For futures options, there is also options on the Micro S&P 500 futures contract (/MES), equal to 1/10 of the /ES contract size, or 1/20 of the size of an SPX option. By using SPY or /MES, we cut the size of the trade down by 1/10 compared to the above table. If the account is taxable, another choice would be the $XSP index, a 1/10 value index of the S&P 500 with favorable tax treatment, but lower liquidity. Again, all these alternative versions of S&P 500 options are discussed in my post on different S&P 500 choices.

So, for an account with futures trading capability, this trade could use /MES futures options and get into the 1-1-2-2 trade for just $200 buying power. An account with options margin could use SPY or $XSP and get into the 1-1-2 trade for $6,800 buying power. A trader doesn’t need a million dollar amount to trade this.

Concluding thoughts

I know a number of people who have traded versions of this trade during the bear market of 2022 without any issues. In fact, it could be argued that this trade, like most trades that collect credits from selling puts, works best if entering when the market is already down and implied volatility is high. Bad scenarios are already priced into option premium and there is a lot of cushion between strikes. This trade is most dangerous when volatility is low and prices are high- the probabilities are not as good, because a move of more than two times the expected move down is not nearly as far.

While not for everyone, the 1-1-2-2 and 1-1-2 trades provide a very high probability of success with a nice payout when used with leverage. The trade requires monitoring to maximize profit and to prevent catastrophic loss, so it really is not a set it and forget it trade. The key is to have a plan to manage the position if the market goes against the trade and stick to the plan.

500% Return from Broken Wing Butterfly Options

I hit a milestone trading the broken wing butterfly strategy, passing 500% return in one year.

In June I hit a milestone trading the broken wing butterfly strategy, passing 500% return in one year. I learned the basic concept from Nick Batista and Mike Butler of TastyTrade.com. I was so pleased that I wrote the following note to Nick and Mike:

BWBF Success 500% in a year

Nick Batista/Mike Butler-

I’m writing to thank you for introducing me to trading broken wing butterflies.

A few years ago, you guys turned me on to the concept of Broken Wing Butterflies. I played around with the concept and settled into a trade that I was able to repeat over and over. Last June I set up an account with $9,000 trading only butterflies. Earlier this year I added Broken Heart Butterflies to the mix, because my strategy was a little susceptible to big drops. Not really sure why I have kept a single strategy in this account, but I’ve just kept going with it. After a year, I’m now at $54,000, which is 500% above where I started. I’m “only” up 119% this calendar year as I’m carrying around 50% cash most of the time to have for fighting downturns.

I played with this trade for over six months until I settled on this strategy in early 2020. I realized that butterflies hold value until expiration is close, so I adjusted this to a 21-day trade. I also wanted to make the trade worth my time, so I collect a lot up front. And I realized that hitting the high profit butterfly butterfly was close to impossible, so I just hold to get my premium collapse, which is much faster than a simple spread with the same risk.

broken wing butterfly setup — typical setup of a broken wing butterfly trade (negative premium = credit to open)

My butterfly strategy is to sell two of the 25 delta puts and buy one a strike or two above, and buy the one twice as far below. I sell these 17 to 21 days before expiration and collect 12-18% of the width of the narrow spread or max risk. I close when this gets to 2%, by converting to a free butterfly. This works around 90% of the time. I was doing this in several accounts last year and had over 100 wins in a row at one point, making 10% in two weeks, over and over again. Eventually, I had some tests where I sell the debit side and roll the credit side, often for a debit. As long as I have cash to fight, I can hold out. I then wait them out for recovery.

Adding the Broken Wing Condor

I noticed that my tests were more likely when the market was going crazy up, hitting new highs every day and then a correction occurs. So, I was attracted to the broken heart butterfly in those situations for a little more probability, but less benefit. I think it is actually a broken wing condor, but whatever. For that trade I buy a 40 delta put and sell the one a strike or two below, then sell a spread three times as wide centered around 20 delta. I try to collect 6-8% of 2/3 the width of the wide spread (max risk). I open this up 14 days to expiration. Because of how this setup decays faster on the credit side, I target to collect 1-2% on the close. So I collect about 7% to open and collect another 1% to close. I can make a little more if I’m on the verge of being tested with 2-3 days left to expiration. Worst case, I sell the debit spread and roll the credit. I think I’ve only had one or two of these need to be rolled. I’m all about return on capital, so I look to make at least 10% a month on any short option strategy I do, while keeping probabilities very high.

All in all, I’m happy with how this is going and continue to watch Tasty for new tidbits every day. I especially like your show, because you are all about trade mechanics- what works and why. You also seem to venture out from standard Tasty style trades and look for creative ways to think about opportunities. Your discussions on leveraging skew and other unique situations are very insightful. Anyway, I just wanted to let you know that what you do is really helpful and that your approach to trading has given me tools to keep experimenting and try new things that have ended up being very successful for me financially.

Thanks so much-

(I received a nice note back from Nick)

If you want to see how I set up broken wing butterflies and how they work, go to the page I wrote on it here.