I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Tuesday Book Club, I share an idea from a book.
The Black-Scholes model, also known as Black-Scholes-Merton, is a mathematical formula used to calculate the fair theoretical price of a stock option.
In Options and Options Trading, Robert W. Ward offers “Market insights and edges from studying Black-Scholes”:
- There are no automatic winning option strategies that will blindly generate profits.
- Option models are not crystal balls, nor are they ever bullish or bearish the market.
- Delta neutral option positions are rarely profitable.
- Option mispricings are phantoms.
- Without an accurate opinion of the future you can’t make money in options. If there is a single key to beating options, it is understanding volatility.
- Market prices are not stationary statistics; they do not repeat themselves.
- People make the prices and people are often emotional.
Black-Scholes involves an equation that dictates how the price of an option changes over time relative to the underlying stock, and the greeks, risk sensitivities derived from the model. The greeks include:
- Delta – the option’s price sensitivity to the stock
- Gamma – the rate of change of Delta
- Theta – time decay
- Vega – volatility sensitivity
- Rho – interest rate sensitivity
I’m interested in two of the above principles: item three — delta neutral option positions are rarely profitable — and item five — without an accurate opinion of the future you can’t make money in options.
This is particularly interesting to me because I’ve been exploring iron condors, and even have one trade open. Iron condors are usually delta neutral or close to it. The delta on the call spread offsets the delta on the put spread.
One reason one iron condor trader I’m familiar with prefers iron condors is because they don’t require him to have an opinion on the market.
But, in fact, they do. An iron condor expresses the belief that the underlying stock or index won’t leave the range established by the two short legs of the condor. Because if they do, that’s when the condor begins to lose value.
Ward is likely thinking of delta-neutral hedging rather than trades designed to profit from future stock moves (or rather from future stock stability) like iron condors. If you hedge by maintaining a delta neutral stance over time you will be spending premium to do so.
For iron condors, delta neutrality is a starting point, not necessarily a permanent state. The wings — long put and call — cap losses. Meanwhile theta (time decay) and vega (volatility changes) make the iron condor cheaper to buy back, creating a profit for the trader.
Ward’s book was published in 2004. Multi-leg risk-defined spread trading for retail traders didn’t explode until the mid-to-late 2000s and 2010s. Trading platforms at the time were basic. Retail options trading looks very different now, with single-ticket multi-leg orders and automated margin calculators.
Today I’m working on adding iron condor support to my trading support system. I appreciate having another tool in my kit that expresses a particular view of the future, that is, that a particular ticker or index won’t do much of anything over the next few weeks. If Russell Napier is correct that equity valuations fall slowly during inflation — or just stay flat nominally — then this could be a good way to trade in the upcoming months and years.