More people are getting into the options game as people maintain an appetite short term gains. Exchanges are enjoying double-digit growth in derivatives trading volumes. Online brokers such as TradeKing are offer cool and powerful option analysis tools. Even Zecco.com ($0 commissions) is now advertising support for 'œcomplex options' on their Web site. After all, we all like to be sophisticated beings. There is nothing more dull and boring than sitting on a long diversified portfolio, or even 'œworse' some index fund or ETF. Don't even mention the B word: Bond '“ ew!
It seems to me from Blogs, and content on the Internet, that there is a progression of 'maturity stages' an options trader goes through:
<!--[if !supportLists]--><!--[endif]-->Learn the basics '“ you trade basic calls and puts, and probably more calls than puts because people are optimistic by nature (drug to be FDA approved or pass some level of clinical trials, new product, new contract with DoD, beating quarterly earnings estimates, takeover target, etc.). After all, the potential short term profit is too huge to miss with the nice leverage provided by options!You go through a bumpy ride, with wins and losses, then you realize you are loosing on the long term at worst or failing to beat general market averages at best, because of the time-decay effect (Theta), commissions, unfavorable bid/as spreads, and losses that eclipse the wins on the long run as you do it again and again <!--[endif]-->You realize the unlimited gain with unlimited risk is not a good strategy so you start looking at Spreads and Iron Condors strategies that limit both. You do some reading, searching, crunch some numbers and realize the smart thing to do: Neutral trading on indexes -- easy money! Implicitly diversified, direction-neutral and Theta positive! Everybody is talking about it: Web sites advertising Iron Condor signals, learning materials and software for adjusting Iron Condors. Booyah!Is there money to be made in options trading? I certainly think so, but I'd argue that following a strategy that solely depends on neutral trades with mere technical/probabilistic analysis on index options and broad market ETFs is bound to fail on the long term. Hey, I think whoever has done these in the past has probably made a lot of money, but here is why it's going stop working.
The secret is out. If you are doing it, there are thousands of other people doing it too. That means each individual will be getting a smaller and smaller piece of the pie. You may say, but the pie is getting bigger! Right, it is. But this strategy thrives on a skew in supply and demand (option buyers and sellers) in the market. It's an anomaly. It's a market inefficiency that is bound to get corrected by the rules of the self-adjusting market system. Here is how and why.
For every short spread leg you sell as part of the Iron Condor, there is somebody buying it from you and there are four possibilities here
<!--[if !supportLists]-->An experienced trader or a hedge fund who has resources and proprietary information that makes them buy these options from you in anticipation of the market moving to their benefit with a likelihood higher than the bare technical probabilities of your technical analysis based on recent volatility<!--[endif]-->Somebody doing a short spread too, but one strike above or below your strikesA newbie making some stupid naked option purchase or selling<!--[endif]-->A long term, conservative investor buying protective puts or selling covered calls on his or her shares in order to protect capital or reduce portfolio volatility
Now, let's take (1). Clearly, that one is going to crush you. I'm not going to explain much here. You sell, they buy; one of you is going to win and the other is going to loose. It's not a win-win situation. Who has the higher chances on the long run, over several trades?
(2) can be one of two:
They managed to fill a trade that is better than yours and got their nickel or dime spread with higher probability of success. They will out-win you on the long run over a span of many trades since their probability is better and therefore expected return is higher. Do the math. Calculate what's known in basic probability theory as the 'œexpected value' on different strikes over different time periods and you'll see that whoever manages to grab the furthest strikes with highest probability and smallest return is the winner on the long term, because the further strikes you have, the less likely you need to adjust. The more you need to adjust, the more you loose on commissions and plain losses thus eroding or erasing your profits from successful trades. You'll see that favorable (nickel) spreads between bid and ask are almost always magically pinned around 66-70% probability of success for the condor on the most heavily traded ETFs and index options at anytime. So the moral of the story here is that whoever can fill the best trades has the upper hand. This is an advantage that does not scale and does not last; you may be able to snatch a few dozen contracts at the most, and the Iron Condor is therefore inherently non-scalable if you only rely on this type of market inefficiencyThey filled a trade with a narrower spread. i.e., a bad one on the long term. That's good for you! You hope more and more people will do this, but watch out! According to (a) above, you could be that person too! See, it's a relative thing.(3) is good for you too. You're the shark and they're the fish! However, you hope there are less other sharks and more fish. How long do you think this imbalance in the ecosystem would last as more and more sharks compete for the fish?
(4) is not good for you. They have the upper hand on the long term, because holding the underlying security reduces their risk and enables them to benefit from the underlying security's inevitable growth over the long term. They have more money than you do and therefore are able to achieve a steady, managed growth. Steady slow growth is better than a bumpy one. For example, making 10 +10% gains in a row is better than 5 +20%'s and 5 -10%'s. Do the math of compounding (assuming the losses and gains are scattered randomly over the 10 trades) and you'll see why this is true.
So, as you can see, the Iron Condor works as more people of category 2b and 3 join the market. Keep in mind though, the supply of this kind of traders is not sustainable as they are all losers on the long term and therefore are likely to exit the market or alter their strategy (fish getting eaten by the sharks results in less fish!), or they may advance to higher options trading maturity stages and start doing exactly the same thing you are doing: become a shark, and therefore get a piece of your fish pie! Keep in mind, money you are expecting to make has to come form somewhere, and the more people join the game, the less you'll get. The easy money with Iron Condor has to end by the law of ever increasing market efficiency and the (beautifully) self-balancing market ecosystem.
You may say, well, back-testing proves the strategy works. Well, yeah! There are many strategies that work in back testing then stop working as soon as people start applying them. And trust me, people will. People will always follow the money. Options trading tools offered by online brokers to the masses are introducing these strategies to more and more people and creating a population of small sharks that is certainly growing more quickly than fish (because fish has access to these tools and can become sharks too).
Admittedly, if you had and used these tools only few years ago, you would have made a fortune, and a bunch of people probably did! However, today these online trading tools are starting to become commoditized. The only winner here is whoever finds the next imbalance in the market ecosystem (with tools and methods not available to everybody) and takes advantage of it quickly before it becomes obvious to the masses, and the brokers who'll make their commissions and margin interest either way, no matter what the latest trading fad is.
You may ask, what is stage 4 in options maturity levels? Don't get me wrong, I'm not saying options are bad! If you followed me carefully, you'd know what I think maturity level 4 in options trading is.
