We discussed about Iron Condor in Part-1. This is Part-2 in the same series that covers about when to sell and OTM or ITM?
After learning what is an Iron Condor, next thing one need to understand is how much time do we sell? You could sell an option with the highest theta, say expiration week? or least decay say a year’s worth of time (Leaps), but would that be worth while? Normally the answer to that question is No.
The nearest time, has literally no time value and hence will be very cheap. And it may not be worth the risk you are taking. The leaps will not decay fast enough so to give you good rate of return. We know that as options reach to the expiration week, time value erodes very fast. ATM will have the maximum time value and as further OTM you go, the value starts to decrease and will have very little value, and hence the risk/reward ratio starts to look uglier. Interesting!
As a seller, you want to collect as much premium as possible but at the same time you also don’t want it to be to close so as to risk underlying penetrating your territory and eroding your gains.
Based on mathematical formula, it has been noticed the time value erodes very fast when we are roughly 4 wks closer to expiration. If we sell 4 to 8 weeks prior to expiration than there is normally enough time value remaining to be able to sell a strike far enough away from the ATM value to make for a decent risk/reward picture. In the final weeks of expiration, the time value drains out very rapidly. And this is what as an option premium seller you want to see. So in my opinion, the best time to act on selling premium is when there are less than 8 weeks until expiration.
I normally vouch for selling OTM not the ITM. Why?
The price of the underlying may move sideways, it may move away from the strike you sold or it may towards the strike you sold. So as long as the strike sold remain OTM, there is not any value to and it will expire worthless, where you keep all of the premium sold. But when you sell an ITM strike, the price of the underlying MUST move in your favor to make money or you will be facing a loss as the time value will erode as it reaches towards expiration. This means you are facing a much higher risk factor. Another negative of selling an ITM option is that when we talk about selling options it is a given we are talking about selling a spread to control the risk, and also to keep the margin manageable. When you sell an option spread the maximum reward you can get is the premium that is sold, and most of the time your risk (amount of possible loss) is going to be as high or higher than the amount of premium that you collected. So when you sell an ITM spread, first the price must move in your favor, and no matter how big of a move it makes your reward is limited to the premium sold.
It is because of the high risk and low reward that I do not want to sell an ITM option. My goal is to sell TIME value, and the time of a strike that the price is unlikely to reach to change that strike from OTM to ATM or even ITM. That’s where the probability comes into play that I will discuss in the part-3.
Profitable trading, OptionPundit
