December 29, 2009

Three Days of the Iron Condor

We’re back after a refreshing one-week break! Here in Denver we packed the house with visitors, the kitchen with delicacies, the slopes with our skis, and our bellies with generally excessive consumption. Good thing reality returns with a bite soon!

Remember that Redford flick from the 1970s, Three Days of the Condor? It’s a thriller about high-level conspiracy. In volatility trading, an Iron Condor is not conspiratorial, just an income trade. You sell two puts and buy two calls, with the spread between both always giving you an initial credit in your account (your highest possible return). If the underlying issue, say an individual stock or the S&P 500 Index, the SPX, trades between your puts and calls, your options expire and you keep one or both credit spreads. It’s a popular thing to do in sideways markets.

Since the SPX converted Dec 24 from the June 2009 version to the next iteration of the S&P 500 Index (it’s called the SPX converting to the SPL), the three days before that might’ve been a deliberate effort to put a squeeze on some Iron Condor traders. Why? Quiet markets. No news is good news if you’re trading for a credit profit. Money’s on the sidelines.

Instead, the “Vega,” or unexpected volatility, increased. Was it chance, or did counterparties take advantage of the situation and push some Iron Condors into the money, forcing them to cover and pay rather than keep their credits? It’s possible. Also, Iron Condor is a pretty good name for a rock band.

Now, why would you care about Iron Condors, IROs and execs? Because once again something besides fundamentals affected market prices. The cool, contemporary and confident IRO has got to know market structure. If you thought it mattered in 2009, wait till you see the variables lined up to hit the 2010 markets.

Here’s one. If you wanted a swear word this past year that reflected something infinitely venal, you would mutter sharply, “auction rate securities.” Yesterday, the Federal Reserve announced that it would offer term deposits to banks through periodic auctions to try to bleed some of the $1-2 trillion of excess, created cash out of the system.

In the private sector, manufacturing an artificial means to deal with excess cash is called “money laundering.” But the Federal Reserve is counting on banks to park cash with them at your expense next year, since interest will be paid on these manufactured deposits.

The point is, what happens if banks use the new government auction-rate market instead of trading with that excess cash as they did in 2009? We don’t know. It’s a Vega Risk. Vega risks abound.

We actually think 2010 could be a ripper of a year in equities, at least for awhile. Why? It’s less risky to trade with money than to loan it into economies dictated by regulations and monetary policy. Loaning requires a term and performance by another party. Trading you can do any given day and end flat, and you can take advantage of what other people do, instead of depending on them. Maybe with some laddered Iron Condors.

Wry humor to end 2009! Have a fantastic New Year, and we’ll have more to say in 2010.

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