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Trade Tutorial - Iron Condor (2/21/2012)

A week ago I entered an iron condor but am only just getting to the write-up new. Some of you who have been following the tutorials lately know this is nothing new.

Iron condor trade setup

Sell SPY 141/139/134/132 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.58)
2. Exit either side if I can do so for 20% of the credit (i.e $.19 each side)
3. Exit if within 4-7 days of expiration
Credit $.96

I'm trying to stay on top of these trades but seem to always be lagging. Hopefully you may still be able to track with the trade even if you can't trade along (in paper money of course).

Why this strategy?

It may seem strange to be entering a fairly neutral trade when the market appears to be a raging bull. However, there are several reasons for considering an iron condor at this time. First of all, notice how long the SPY has remained above the 30 day moving average.

In addition, or maybe because of it, it seems like the SPY may want to remain range bound. Compare the SPY with the IWM. While the SPY has moved up slowly, the IWM has simply moved sideways for that last few weeks. it may be that the SPY will need to do the same thing - or it may move up strongly before pulling back sharply.

Choosing the right strike prices

My typical trading rules for the iron condor is to sell short strikes for the put and the call that have a probability (ITM) of expiring of around 30%. I usually tray to make sure this is the case but there is some latitude in this decision. If for example, I expect a little stronger move to the up side, I can push the short call out a strike. That may leave the position slightly unbalanced.

Iron condor strike selection

Notice here that I've selected a short call with a probability of expiring of 29%. That gives me just a little more upside room in case there is more bullishness in the SPY. I also went with the March options simply because there are still more than 20 days until expiration, which will provide sufficient premium.

As usual, I select a long option on either side of the short option that is $2 away to limit the risk. This results in a trade that yields a $.96 credit. With the $2 wide spread on each side, that means the risk in my trade is $1.04 per contract.

Risk/Reward analysis

The simplest way to analyze this trade is to simply divide the credit by the risk (.96/1.04). In the case of this trade, that means reward risk ratio of 92%.

iron condor risk analysis

Notice in the above P&L analysis the two break even points. That amounts to a range of potential success of $133 to about $140 or a $7 movement. That's a $70 move of the S&P. In the above graph, the percentage represents the probability that the SPY will expire somewhere between these two points. That really represents the probability of success.

A probability of 45% is really pretty decent. And the probability gets even better when I mention the other part of my iron condor trading plan. That is the rules to exit if I can lock in 60% of the initial credit. That means I give back 40% of the credit or 20% per side. This gives me the advantage of exiting early and not having to wait for expiration.

This changes my potential reward risk. While my risk remains unchanged at $1.04, my target profit is $.58.  That makes my reward/risk 55%. The thing to keep in mind is that when the reward/risk (or return on risk) decreases the probability of success increases.

In addition, with an underlying that is moving up and down the possibility exists of closing each side individually on the opposite side of the move. That's why an iron condor can be successful even in a trending market.

Position sizing

Given the fact that this is a defined risk trade, I know exactly what the risk per contract is. I stated above that the risk per contract is $1.04. As I state in every trade, I limit the risk to 2% of my current portfolio. The current portfolio value is $17,119, which means I can risk $342. That means I can sell just 3 contracts and remain within my risk

Exit plan

I talked above about my exit rules for the iron condor strategy. These include an absolute exit if I can lock in total 60% of the initial credit (paying approximately 40% of the credit to close). However, it's rarely the case that this happens. More often, I find I exit each leg individually. As a result, I will close each leg if I can do so for 20% of the initial credit.

Just to summarize...

  1. I will exit when I can lock in 60% of the initial credit. That means I will attempt to close for a debit of $.38 and leaving a net profit of $.58 per contract.
  2. I will exit when I can close each leg for debit of 20% of the initial credit. That means I'll exit each leg if I can do so for a debit of $.19.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

In general, you would expect a neutral trade to result in an initially neutral delta. However, a trade like this is rarely exactly centered over the underlying. As a result, the delta will usually be slightly positive or slightly negative. In this case, we see that the delta has a slight negative skew, meaning the trade will benefit from a slight sell-off.

iron condor portfolio impact

In addition, notice the positive theta. This is the common denominator of all the trades I enter. This is because every trade I enter is a premium selling strategy. What this indicates is that as time passes, the trade gains in value by having the premium value of the options melt away. That's why I can buy the trade back at some point in future and potentially profit in this trade.

Update 3/6/2012

With this sell-off today, the calls were closed. In fact, because the market gapped down on the open, the trade closed for a better price than the initial limit order.

I had the limit order set to $.19 per my exit rules. Because of the gap down, the trade closed for $.12. There are times when a gap down or gap up can hurt the trader but it's nice to have a case when it works in your favor.

I'm left with a put spread that should close before too long if the selling stops at one of the support levels I mentioned. Time is growing short on this trade as I'd like to close the entire trade early next week. We'll let the market play out and see what happens...

Update 3/8/2012 (closing update)

This iron condor trade couldn't have played out any better. With less than two weeks until expiration, it's good to be completely out of this trade. Let's take a look at how it played out.

I got a little boost in profit on this trade because of the gap down the other day that caused my call spread to close for less than the target price ($.12 debit). This morning, the put spread closed for the target $.18 debit. That's a total of a $.30 debit. I entered the iron condor for a credit of $.96, which means my net profit in the trade is $.66 on 3 contracts for a total of $198.

As I mentioned earlier, this trade couldn't have played out any better. The iron condor can do well in a trending market as long as it isn't strongly trending. With the ups and downs of the market there are chances to close both sides. What helped this trade work out so well is that the sell-off and then bounce happened in the last few weeks of the option cycle, where most of the option premium is found close to the money. As a result, value drops off quickly as the underlying moves very far from the short strike.

Rule # 1 - Don't lose money.
Rule # 2 - Never forget Rule #1  (Warren Buffet)

Note: This trade discussion is for educational purposes only. I am NOT making any recommendations on the trade or the underlying stock or ETF. If you decide to follow this trade, please do so in a paper trading account. Trading options involves risk and some options strategies can result in losing more than the original amount invested.

thinkorswim, Division of TD Ameritrade, Inc. and Success With Options are separate, unaffiliated companies and are not responsible for each other's services and products.

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