How To Manage Put Skew On An Iron Condor - YouTube

Okay, we are back!

In this section, we are going to talk about another trade example.

We've gone over placing a trade in several, different vehicles.

We've looked at stocks, indexes, ETFs, and now we're going to look at the SPX.

The SPX is the S&P 500 Index.

It's a very large, high-priced underline.

And, there's just something a little different about trading a stock index that I want to

make sure that you understand, so that if you run into this when you're placing trades,

you'll know what to do.

Let's go ahead and jump right in.

There's a couple things I want to talk about.

One is dealing with put skew.

And, what put skew is, is the fact that in a lot of stocks, individual stocks and stock

indices, or a stock index, a lot of times there is what's called put skew.

All that means is that the puts are priced higher than the calls.

The reason that is, is because the risk is usually to the downside when trading options

on a stock or index.

The velocity in which the market moves down, a lot of times, is much quicker and more velocity

than an up move.

The analogy that you'll hear is, the stock market takes the stairs up, but the elevator

down.

To account for that, the puts are priced higher to account for that downside potential velocity.

Let's take a look at an example, and I'll show you what I mean.

If we pull up the platform, and I've already got this set up.

So, I've gone through the steps of how to set the trades.

So, what I've done, I've gone through and I've set my short strikes at the 28% probability

of being in the money.

Here's the graphical, the visual graph of our trade in the SPX, S&P 500 Index.

Let's go ahead, and we'll set our slices like we always do, break even.

17 is expiration, so we've got a little over 60% probability of profit.

The one thing that' you'll notice about that's a little different from some other trays that

we've set up is, look at where this, look at, this is where price is trading right now.

And, look where this is, in relation to the rest of the graph.

It's further over to the right hand side that it is to the left hand side.

And, because the puts are more expensive, when we look at the 20% probability of in

the money puts, they're much further away from where the price is currently trading,

than are the calls.

The calls are closer, because they're cheaper.

Again, that's to account for the downside velocity.

So, you have a lot more protection going to the downside.

So, a couple things.

One, I place the trades, and I take into account this put skew.

Meaning, I place it based on 20% probability of in the money, because that's how the probabilities

actually do play out over time.

And, I like to have a little of what I call short delta, or downside protection in my

trade.

So, if we do see a major downturn in the market, a certain day, we put this [straight 00:03:47]

on, it's not gonna hurt you as bad.

In fact, if it starts to go down, you'll actually start to make money right away, as you see

the pink line right there, the profit line.

I just want to make sure, when you set this graph up and you see it skewed to one direction,

that's why.

The puts are more expensive.

If we go to the trade tab, and I'll show you what I mean.

Let's look at the 20% probability numbers, because those are the options that we're selling.

So, if you look at this one, and we always default to the higher of the ... When you're

looking for 20%, you default to the higher percentage.

In this case, it's a little over 21%.

What you'll see, is that these calls are trading at 8-10 bid, 9-10 ask.

So, right between eight and nine, let's say, just for rounding.

Remember that, they're trading between eight and nine.

Well, if we look at the 20% probability on the PUT side, these are trading for, between

12 and 12.80.

So, about 12 and a half is probably where you would get filled.

So, 12 and a half versus eight, that's quite a bit of difference.

That's what's reflected on the graph here.

There's a couple ways to do this.

You can place the trade just like this, and that's what I do.

And, there's no problem with doing that.

You're just giving yourself a little downside room to do so.

The other things that traders will do in this situation, because they want to, because if

it does start to really move up, you're seeing that your profit line really slopes down pretty

quickly over here.

To account for that, what they will do is, they will simply buy a single call to cut

down that direction, what we call, delta.

Let's just take one of these price slices and move it over here to where price currently

is.

And then, what you can see down here is, if you look at your price slices, this one is

at 205.8.

So, you can see the delta of where price is right now on this trade, is a negative seven.

Okay, that means we have it that, for every point the market moves down, we'll make $7.00

on this trade.

Okay, so some people don't like to have that negative delta.

They want to set up a trade, and they want it to be what's called delta neutral.

Well, one way to do that is, well, you still can account for the skew and put on the graphs,

so it's at the 20% probability of being in the money on each side.

What we can do, is you can buy a single call.

And, excuse me.

What we'll do is to look at that, is what we really want to do is cut that delta in

half.

Right now, it's a little over negative seven.

So, we want to get that down to about negative three, or even a little less is fine.

What we can do, delta is a term that's, also, synonymous with probability of in the money.

If we're looking at a negative seven delta, we want to look at a ... If we want to cut

it in half, we can look at a delta, about 3.7, that would be about half.

And, by buying this call, that is gonna help neutralize our delta.

Or, help make our trade more delta neutral, as opposed to skew to the downside.

So, if you just right click on that call, and do 'buy single'.

It's gonna populate here.

And then, just take that.

Right click, and do 'analyze trade'.

Get rid of this one here.

And, if you see what happened to our graph is, now, this pink line, our profit line,

doesn't continue to slope down this way, like it was.

It actually flattens out and starts to curve up, outside of our graph.

What this does is, it flattens out that delta, it takes away some of that directional bias

that is included with the trade, by just setting it up in our normal fashion.

And, gives you a little more protection if SPX were to continue to the upside.

Again, I'm giving you different ways to do this, because some people prefer to have a

little downside bias.

And, some would prefer to actually put it on extremely delta neutral.

So, let's take a look at what this actually does to our trade.

You can see that when we have this call protection, it's called a protection call.

When we have the protection call on there, our max profit is 800, and our max loss would

be 2200.

If we were to take that call off, now our max profit goes to 925, and our risk is 2075.

Okay, so it takes away some of our profit potential, but it gives us protection if it

continues to move up.

So again, watch the graph as I click the call.

You can see our max profit goes from 925 to 800.

But again, the slope of the pink line, the profit line, is not as skewed to the downside,

so it gives us that protection.

Hope this is helpful.

There's no right or wrong way to do it.

I typically tend to, unless I have a real bias that I think the market is gonna keep

going up.

I'll typically put the trade on, just like we've walked through every other trade.

And, I won't worry about that skew, and I'll deal with the trade if it gets to our break

even.

But, some people like to have that extra protection.

So, it's just a matter of preference in how you want to do that.

I just wanted to give you that, another idiosyncrasy, and a nuance of different things that you

can help build your trade and help guide you in the best direction that you want to go,

depending on what your assumption is.

If you think there's more room to the upside, you probably want to add the call.

If you're okay with the skew, and you think it may be going to the downside, then you

can leave it as is.

Nobody knows what the market is gonna do.

There's no magic about one way or another, it's just a matter of preference.

Hope this helps, and we'll see you at the next video.