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Trading options for income: Debit spreads when IV is low

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In our quest to understand trading options for income, we use credit spreads (selling Iron Condors) when IV (implied volatility) is high to generate consistent income. Does it make sense to use debit spreads (buying Iron Condors) when IV is low?

The Iron Condor is a defined risk non-directional strategy that is often employed for underlyings that have high IV (implied volatility) or high IV rank (greater than 50%). It is comprised of two vertical spreads: a Put spread and a Call spread.

A vertical spread is comprised of two options within the same option chain (Weekly or Monthly) which are bought and sold concurrently. To form a credit spread (which brings premium into your account), you sell one option with a strike that is closer to ATM (at the money), or closer the current price of the underlying, while buying an option with a strike that is further OTM (out of the money), or further away from the underlying's current price. A short IC (Iron Condor) is comprised of two credit spreads.

Conversely, to form a debit spread (which takes money from your account), you buy one option with a strike that is closer to ATM while selling an option with a strike that is further OTM. A long IC is comprised of two debit spreads.

To determine if long ICs will work as a strategy when IV Rank is low (periods when IV is low for the underlying), Tasty Trade recently conducted a test from 2009 through May 2014 of five ETFs: SPY, GLD, EWW, TLT, and IWM.

The test criteria is as follows: open a long IC position on the first trading day of each month with approximately 45 DTE (days till expiration) if IV Rank is below 50 percent; each debit spread should be $2 wide; the long strike should be at 80 percent OTM; and hold the position through expiration.

The results: out of 241 trades, the win ratio is 32 percent with a P&L of -$1,742; a slightly better than the expected win ratio of 29 percent (0.58 / 2.00). Only two (GLD, EWW) of the five ETFs had a positive P&L (percent winners of 35 and 34 percent respectively); IWM had the worse P&L at -$1,020 (25 percent winners).

In conclusion, the strategy of long ICs during periods of low IV Rank does not work. In a previous article on short Strangles during low IV Rank the results were positive, indicating that short strategies (Strangles and ICs) offer better outcomes than its inverse: long strategies.

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.