Traders need to think about wing placement in defined risk trades. There are typically two setups from which to choose. We can set our wings using a fixed width, such as $5. Our other option is structuring the wings based on probabilities.
At this point, we should all know in a defined risk trade our short option needs to be placed around the one standard deviation expected move. Often time, the 16 delta put or option is used as an approximation for that move. The long option, or wing as it is called, is used to define our risk. Where we place that wing is a personal choice and it can be either be placed using a fixed dollar difference or using deltas.
Using a fixed width is common when we want to increase the credit we receive. These trades are often referred to as being “static.” However, when using fixed widths, trades may take on directional risk. Fixed width does not translate into fixed delta.
An alternative approach in placing our wings is to use probabilities. We call these spreads “dynamic”. In dynamic trades, the long wing is placed at a specific delta. In a dynamic iron condor, for example, if we sell a 16 delta put and a 16 delta call, our fixed wing is placed at a specific delta as opposed to setting its width based on a fixed dollar amount. Therefore, unlike a fixed width, dynamic trades tend to be more directionally neutral.
Fixed width trades tend to bring in larger credits. That makes sense when considering these trades often take on directional risk. The credit received for a dynamic trade might be less. However, in this style setup, we might be willing to accept slightly less risk for a directional neutral.
There is no right or wrong choice between fixed width and dynamic trades. It is a preferential choice. All traders should be aware of the differences in either approach and comfortable with the risk/reward that comes with static versus dynamic defined risk trades.
Josh Fabian has been trading futures and derivatives for more than 25 years.
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