Important Announcement

Trade Tutorial - Iron Condor (3/14/2011)

With the recent market churn, I'm thinking it's time for another iron condor trade. I haven't done one f these for a while simply because the market has been so bullish.

Iron condor on SPY

Sell SPY 135/133/126/124 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.44)
2. Exit either side if I can do so for 20% of the creidt (i.e. $.22)
3. Exit if within 4-7 days of expiration
Credit $1.09

With the increased volatility and a little more time, this trade has slightly more juice in it.

Why this strategy?

As you can see from the chart of the SPY, there has been a strong trend of several months of bullishness followed by a month of pullback and then a resumption of the trend. I mentioned in the last newsletter that we could possibly see some range bound trading for a little while and it's beginning to appear that is the case.

At the moment the medium term bullish trend appears to still be intact. That being the case, I think this is a good opportunity for an iron condor. What I expect to happen is that we may see additional selling, possibly down to the $1275 level. That should provide an opportunity to close the call spread. Then the ideal case would be to see a rebound up to the recent highs, which would provide an opportunity to close the put side.  Of course small movement in a sideways channel would work as well.

Choosing the right strike prices

As I usually do for an iron condor trade, I'm looking to sell a short strike for both the put and call having a probability of expiring (ITM) of between 30 and 35%. I also want to sell a month that still has at least 20 days until expiration. At this point we're looking at the April $126 put and $133 call.

iron condor strike selection

As most of my trades are, this is a $2 wide spread on either side. The current credit for this iron condor trade is $1.09, which leaves a risk of $.91.

Risk/Reward analysis

The thing about this approach to trading an iron condor is that the target reward/risk is roughly 1:1, although sometimes the odds slip to one side or the other. In this case, the reward is slightly higher than the risk yielding a reward/risk ratio of 1.19:1. As it turns out, this also means that since I'm risking $.91 to make $1.09, I'd realize a 119% return on my risk.

iron condor trade analysis

Another way of looking at this trade is to consider the probability of success. In this case, I'll define 'success' as breaking even or better. As this image from the analysis page shows, there is a $9 range that the SPY can move and still be a successful trade, as long as it ends between $124.91 and $134.09 by expiration. This translates to a 41% probability of success. That's a fairly decent probability to receive a 119% return on my risk.

Keep in mind with this iron condor trading plan I close the trade early when I can lock in 60% of the initial credit. By doing so, I'll actually improve my probability of success.

Position sizing

As I always point out, I want to make sure I limit my risk in each trade to just 2% of my portfolio value. At this point, my portfolio is valued at $17,323, which means I can risk $346 on this trade. Since my risk per contract is $.91 * 100 (or $91), that means I can sell 3 contracts and remain within my risk tolerance.

Exit plan

My plan is to sell 3 contracts of this iron condor trade, which will yield a total credit of $327. However, I also plan to close the trade early if I can do so by locking in 60% of the credit. That means I'll give back 40% (or $.44 per contract). This will leave me with a target profit of $196 if all goes as planned.

It is rarely the case that I close the entire trade all at once. In fact, the typical way I manage this trade is to attempt to close each side of the trade for 20% of the initial credit for a total of 40%. That means I'd attempt to close each leg of the iron condor for $.22 debit.

Just to summarize, I will exit under the following conditions.

  1. I will exit if I can lock in the entire 60%, which means I'd pay back $132 and keep $196.
  2. I will exit each leg if I can do so for 20% of the initial credit, which means I'd pay back $.22 per contract or $66 total per side.
  3. I will exit when approximately 4-5 days of expiration

In addition, I will monitor this trade to see if any adjustments are necessary. I want to be careful not to mess with the trade too much but sometimes adjustments can help improve the odds and profitability.

Portfolio Impact

In this final section I want to take a moment to analyze the impact of this fairly neutral trade to the overall portfolio. The prior trade I had on was a bullish trade that resulted in positive delta to my portfolio.

iron condor portfolio impact

This trade is relatively neutral but adds additional theta. This is handy right now since the other trade now has negative delta as it's being overrun.

Update 3/25/2011

The market is beginning to establish a short term direction. As a result, the move up today resulted in the put side of the spread closing for the target debit price of $.22.

This iron condor trade has now become a short call vertical (or call credit spread). It's interesting as you look at the last few weeks how this position has been stressed on both sides.

Iron condor trade

Let's take a moment and look at the current market. The low point was on Wednesday, March 16 and was largely news driven with the earthquake in Japan the Friday before and ensuing fears regarding potential nuclear reactor issues as well as turmoil in Libya and Bahrain. By mid week, traders seem to have gotten over most of their fears.

Why didn't the sell off during that time cause the call spread to close? There are three main reasons.

  1. I'd just entered the trade on Monday and not very much time had elapsed (theta impact)
  2. On the day of the low point, the VIX jumped 5 points alone and volatility affects calls and puts both (vega impact)
  3. Calls tend to be priced slightly higher than puts that are equally distant from the current price of the underlying. I believe this is due to the dividend risk that comes with being short a call that could eventually be in the money near dividend time.

The upshot is that if the rally continues, the call spread will be threatened. However, consider that the SPY has moved a fair amount already without much of a pause. It wouldn't surprise me to see the SPY test the $132/133 level and pull back initially. With just 3 weeks until expiration, the theta should start melting away much more quickly. And with a continued move up volatility should drop, which will cause the price of the options to drop as well.

For now I don't plan to adjust the position in any way but I'm going to keep an eye out for opportunities.


Update 4/11/2011 (Closing update)

I caught a kind of break today that allowed me to close my call spread and the overall iron condor trade for a profit.

After an extended period of time hanging out near the highs of the range, the SPY sold off enough today that I was able to buy back the call spread for $.60. When combined with the $.22 I paid to close the put spread, my total debit is $.82. Since I received $1.09 credit to enter the trade, I'm left with a profit of $.27. Since I sold 3 contracts on this trade, my trade profit is $81. While not nearly as profitable as anticipated, I still am pretty happy with the outcome given the bullishness in the market of late.

Could I have held out for a smaller debit? Maybe but I would also be risking the existing profit I could lock in if the market suddenly reversed again. Unfortunately as traders, we don't have a crystal ball to tell us what will happen at the right side of the chart. We can only surmise given the market action and technical analysis. We're always caught in a tension between exiting early and locking in a profit or loss versus waiting to get a better price but risking getting a worse price. For me the decision is clear when I have a trade that is in profit and time is running out. Take the money and run. There will always be another trade.

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.

[?] Subscribe To This Site

follow us in feedly
Add to My Yahoo!