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Trading options for income: Increasing spread width vs. number of spreads

Increasing spread width vs. increasing number of spreads
Increasing spread width vs. increasing number of spreads
OptionsAnnex.com

In our quest to understand trading options for income, we often consider whether increasing the width of a credit spread would be better than simply increasing the number of credit spreads. In this article, we look at which approach provides a better outcome.

A credit spread is a defined risk vertical spread (either Call or Put) in which an OTM (out of the money) option is sold while a further OTM option is bought resulting in premium received. The difference between the strikes, less the premium received, defines the maximum possible loss. For example, a Put credit spread that brings in a premium of $1 with strikes $5 wide, is risking $4 ($5 - $1) to make $1; the POP (probability of profit) should be around 75% (or a loss of 1 out of 4).

When combining two credit spreads, one Call and one Put, the option strategy is called an Iron Condor (IC). The advantage of an Iron Condor, over a single credit spread, is that it does not impact the margin requirement (or Buying Power Reduction). This is because you can only lose on the Call spread or the Put spread, but not both.

To determine which is a better approach (increasing the width of the credit spread or increasing the number of credit spreads), Tasty Trade recently conducted a test using the following ETFs: DIA, EWZ, and QQQ. Data was collected over a 5 year period.

The test criteria is as follows: initiate a trade when IV Rank exceeds 50% using a Monthly option with 45 DTE (days till expiration). Two trades are initiated that would bring in a premium of one-third the width of the spread: $1 wide spread Iron Condor that provides a premium of $0.33 and held to expiration; and a $5 wide spread Iron Condor that provides a premium of $1.67 and held till 25% of the premium is realized (or approximately $0.42 equivalent premium).

The results: The P&L of the $5 wide spread ($1,447) exceeded the $1 wide spread, even with 5 options ($940). The winners for the former was 94% vs. 74% for the latter. This would appear to confirm that widening the width of the spread would result in a better outcome.

In conclusion, while the test points us in the right direction, there are some issues with the approach. First, the requirement that the IV Rank has to exceed 50% limits the number of total trades to 35; this population is far too small to be statistically meaningful. Removing the restriction would increase the population (or number of occurrences) to 180 (12 x 5 x 3) and provide a statistically meaningful value.

Second, using one-third the width of the strike would lead to the expectation that the POP is close to 68%, or 1 SD (standard deviation). Looking at the DIA MAY 14 with 45 DTE and an Option Chain IV (implied volatility) of 13.22% (a 1 SD expected move of 6.138), the premium at the close was $0.27 (171/172 & 159/158); just to get the requisite $0.33 would require reducing the POP (taking on more risk). This problem is compounded when we look at the $5 spread (171/176 & 159/154) where the premium is just $0.84 (vs. $1.67). It is clear that the POPs between the two ICs are not the same. A better approach would be to use the 1 SD expected move to locate the short strike, thereby keeping the POPs the same for both widths.

Third, reducing the holding period of the $5 wide IC to 25% of the premium (vs. till expiration on the $1 wide IC) introduces another factor that distorts the comparison. When we increase the $1 wide IC by five (to equal the Capital at risk for both), then the hold period for the $1 wide should also have been set to 25% of the premium received. This would provide a more accurate result.

And fourth, when dealing with one $5 wide IC vs. five $1 wide ICs, transaction costs should be included. For example, if the cost per contract is $1.50, then a single IC will have a round trip cost of $12 (opening and then closing the position). For five ICs, the total round trip commission would be $60; a substantial expense when considering the average premium received is $41.25 ($0.33 x 5 x 25%). Compare this to the $5 wide IC with a premium of $41.75 ($1.67 x 25%) and a commission of $12.

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