Biffermas's "Grandma" stock picking contest and his reaction/ connotation that options were a bit racy kinda got me thinking…

Generally I prefer to forgo
the “ownership experience” and pretty much stick with an associated
option. Often misaligned and frequently misused, options were (this
is a recording) actually invented to control risk. But here’s how
Grandma might do it:

 
Let’s say PFE opens Monday
at today’s closing tick and the old lady buys 1000 shares @ $19.47
total cost $19,470. 

After many years in the market
Grandma has a few cast-in-stone rules; one is to never let a stock run
more than 10% against her. Since she doesn’t like stop loss orders
she’ll purchase 10 PFE Jan 2011 $17.50 puts @ $1.40 total cost $1400. 
Grandma has defined her risk at 10% (give or take, roll with me on this please). 

The puts for insurance were
$1400. PFE pays 3.70% dividend which comes to about $720. So if PFE
goes nowhere this year (certainly possible) this trade’s still a $680
loser. To counter, our geriatric derivative wizard sells 10 out of the money
(OTM) February 20 calls, about 2.7% OTM, @ .30 for a credit of $300.

Here’s how this year might pan out: 

Grandma collects $300.00 x
12 months for $3600 selling OTM calls. Minus the remaining $680 bill
for those puts= $2950 or about 15% return on her original investment.
Not bad…

-or-

Grandma’s PFE gets called
away every month. She’s made the $300 call premium plus the $530 difference
from her original purchase and the strike price that she “loses”
her stock. And she reloads to do it all again. Here’s the math $300
call premium + $530 stock appreciation= $830 x 12 months= $9960 or 51%
on her original investment. Tasty.

-or-

Some combo of the above.

Trade is complete and utter
failure. PFE falls into the abyss (we’re talking the largest heathcare/
drug manufacturer in the US here) Grandma loses the spread between purchase
price and put insurance floor, plus the price of that insurance for
a total of $3390 less the est call premium collected for 12 months $3600= 
no loss? Yep.

Yes they’ll be commissions.

All quants please stop reading
now. This is a base primer on iron condors with myriads of detail to be joyfully
omitted. Options are funny that way, they can preoccupy the mathematically
inept (moi`) and PhDs alike. And though in the hands of wrong intentions they quickly become weapons of mass account destruction, options were actually invented
to control risk and protect assets.

Popular mantra goes something
like; “iron condors have a high probability of making a little profit”. To that
I would say please quantify a “little”. 
I find 30% profit on amount risked to be frequently obtainable. That’s
typically a 60 day or so trade which annualizes at a piddling 180% give or take… Well
maybe I’ve set my sights too low but that works for me. Likely you’ll also hear
about the bothersome maintenance of adjustments, but the only “adjustment” I
ever make is to simply close the position.

Market neutral trading means
avoiding sharp or prolonged surprises and trading indices helps me accomplish
that.  I sell RUT iron condors 90 to
120 days out and buy them back before they become front month. To explain why necessitates an intro to a couple “Greeks” so here’s the shortest
most over-simplified one you’ll ever get:

Theta (time value you sell then
collect) is your friend.

Gamma (the condor’s sensitivity to RUT price fluctuations)
is the enemy.

The closer to expiration the condor spread gets the more daily theta is
collected but the higher gamma risk becomes. Eventually the reward isn’t worth
the risk so I close and move on to the next trade. I want at least $3.00 premium to write a
$10.00 RUT spread and I'm looking for approximately that ratio on any iron condor I sell. As mentioned I never adjust my spreads but merely close
the entire trade if things get unruly. I use both broker software and good old
fashion TA to place then manage my positions and once opened I manage only for risk never for profit.

Here's what an iron condor looks like on a chart

…and on a risk graph

Spread trading is as much art
as science. It can fill in a lot of gaps– from softening the sting of a
directional guess gone wrong to quietly generating income in the background without eating up excessive buying power. Nobody should write an iron condor based on what little information
I’ve provided but hopefully some will be nudged into further exploration.

Tired of the old up or down? Venture beyond directional guessing and you’ll find an excitingly profitable
world that isn’t nearly as complicated as you might fear. Quants may now
return.