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What is Options Trading? Equivalent Risk

Equivalent Risk
Equivalent Risk

In our quest to understand trading options for income, the topic of this article covers the difference in outcomes for the same equivalent risk: same standard deviation level and the same capital at risk. That is, at the same levels of POP (probability of profit), what are the results for trading one Iron Condor with $25 wide spreads vs. five Iron Condors with $5 wide spreads (both are risking $2,500 of capital)?

This question arises frequently in discussions with other traders. Given that the POML (probability of max loss) increases the smaller the width of the credit spread (which also means the Risk of Ruin is higher as well), I would expect the results would favor the $25 wide spread.

We use the following metrics to compare the two approaches: P&L (profit and loss); total losers; and ROC (return on capital).

The test was conducted on the SPX (the S&P 500 index) for 2011 only (a year with a combination of bear and bull periods, ending exactly where it started). We tested an IC (iron condor) at 1, 1.5, and 2 SDs (standard deviations) representing POPs of 68%, 90%, and 95% respectively.

What were the results (see Table above)? The 5-IC @ $5 underperformed the 1-IC @ $25 at every level of risk (1, 1.5, and 2 SDs). In fact, the former had a positive P&L at 2 SDs only with total losers of 2; the latter was positive at 1.5 and 2 SDs, with total losses of 3 and 0 respectively.

It is also interesting to note that the 1-IC @ $25 at 1.5 SDs had the highest ROC of 126.4% (at 2 SDs, the ROC was 101.5%); this is a respectable return by any measure.

In conclusion, to increase premium using credit spreads (and ICs), you will increase the ROC by widening the spread, not by increasing the number of spreads; this is primarily due to minimizing the POML and Risk of Ruin. For the SPX, 1.5 SDs seems to be the ideal POP level. As an added bonus, you will also be minimizing transaction costs.

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

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