“Undefined risk” is perhaps the most misleading and misinformed term used in trading. The idea that a stock can go up infinitely does not mean it will or that this is even likely. Yet for many, just the mere thought something could happen is enough, causing us to stick with “defined risk” trades. Defined risk might bring peace of mind but they come at a cost.
Selling a strangle means selling a put and a call. The trade has theoretical undefined risk because of its naked call. An iron condor is like a strangle but in this type of trade, a put and call are purchased (the wings) beyond our short strikes, thus limiting (defining) potential losses.
However, when we turn undefined risk trades (like strangles) into defined risk trades (like iron condors), we give up some premium by purchasing those wings. Not only does our total credit received get reduced but so too does our probability of success.
At the time of this writing, the November SPY 205/223 strangle (the 205 put and 223 call) could have been sold for a credit of $1.84. Both short strikes were about one standard deviation away from where SPY was currently trading. In strangles, we have a goal of keeping 50% of the credit received or, in this case, $0.92. The trade had a 67% probability of being profitable and 87% probability of making $0.92.
If we change that strangle into a $2 wide iron condor by purchasing the 203 put and 225 call, our credit received drops down to just $0.46. That is $1.38 less premium and potential profit. However, our max loss is no longer unlimited. Our probability of being profitable on this trade drops to 60% and our probability of making 50%, or $0.23, is 78%.
The iron condor trade still has a good chance of making money. But its chances of success are less than the strangle. Also, if we are looking to keep 50% of the initial premium collected, the strangle will pay us $0.92. The iron condor will pay us just $0.23. That drop in profit potential can significantly impact overall profitability after accounting for trading costs.
In addition to a slightly lower probability of being successful, defined risk trades tend to take longer before reaching their profit goal. A recent study conducted by tastytrade shows the average time for a strangle to reach 50% of max profit is around 25 days, if a trade is opened with 45 days until expiration. A $2 wide iron condor, like in our example above, tends to take closer to 30 days before reaching 50% of max profit.
There is nothing wrong with using defined risk trades. Certain account types such as IRAs have no choice. As traders; however, we owe it to ourselves to understand different types of trades and what our expectations should be in terms of probability, profitability and amount of time a trade will take before reaching our profit goal.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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