Trade of the Week - Iron Condor (4/6/2010)

Yes, this another iron condor trade in a very short time. It's the third in about a month and the second in a week or so. 

iron condor trade setup on EWZ

Trade
Sell EWZ 81/79/72/70 iron condor ROI
115%
Exits
1. Exit if I can lock in 60% of my initial credit (i.e. $.43 debit)
2. Exit if I can close each side for 20% of the credit (i.e. $.21 debit)
3. Exit if within 4-7 days of expiration
Credit $1.07

This is a nice little trade that yielded a decent credit and has a fairly wide spread between the short put strike and short call strike.

Why this strategy?

I don't know if you've noticed but the market has had a pretty strong run up since the most recent down-turn in January. Since the bottom of that down turn, it's been almost straight up and no looking back. While I'm not convinced the bullishness is over, I believe it may slow down and take time to consolidate again.

I'm also interested in adding theta to my portfolio while not adding a significant bias to my position, although I am looking at slightly skewing the trade to the bullish side. I'll go over more of how I do that in the next section. Take a look at the option greeks page I recently added for a deeper discussion on the greeks and using them to select an option strategy.

Choosing the right strike prices

My normal ideal goal for a short strike on what I sometimes refer to as the 60% iron condor is to sell the short strike with somewhere between 30 and 35% probability of expiring ITM. That means I will have approximately 65-70% probability the strikes will expire worthless.

Iron condor strike selection - targeting 35% probability of expiring ITM

As the picture above shows, I actually tried to give myself a little more room to the call side by choosing a short strike with slightly less than 30% probability of expiring ITM. By doing so, I give up a little premium but also give myself another $1 of up side movement. This results in an iron condor with $7 range of movement between the short strikes and approximately $9 of movement between the upper and lower break even points.

The other nice thing about the strikes I've selected is that they are above and below support and resistance levels. The short call at $79 is above the prior highs set back in January and the short put at $72 is below the recent breakout area, which should act as support.

This trade setup results in a position with a $1.07 net credit on $2 wide spreads for both call spread and put spread.

Risk/Reward analysis

I don't cover this often but it seems like a good time to discuss the calculation of max profit, max loss and break even points. As in any credit-based trade, the most I can make on the trade is the credit I receive. In this case, that would be $1.07. Since the spread on each side is $2 wide, that would be the maximum risk but since I received $1.07 credit, I can't lose any more than $.93 per contract, which is my real max risk in the trade.

My break even points are calculated by adding the credit to the short call strike price and subtracting $1.07 from the put strike price. That would make the break even points 80.07 on the upper side and $70.93 on the lower side.

Not only does the graph below from the Thinkorswim analyze tab look pretty cool, it gives a pretty good picture of the range of profit for this iron condor trade.  It also confirms my break even points I calculated above. The main thing I look at this graph for is to determine the probability of the underlying expiring between the two break even points, which could also be considered the approximate probability of success of this iron condor trade. If this probability seems low, it's because the expectation is that this trade will go all the way to expiration.

Iron condor risk graph showing an overall probability of success of about 42.6%.

I never hold the trade all the way to expiration. In fact the reason I call this trade the 60% iron condor is because I attempt to capture only 60% of the initial credit, which allows me to close the trade earlier and increases my probability of success.

One other perspective I've recently begun analyzing is the impact to my greeks of a $2 & $5 move up or down of the underlying. By the time I captured this view, the EWZ had made a bit of a move up and so there is a bit of a neutral to bearish skew already with a delta of -6.

iron condor trade analysis of greeks with $2 and $5 move up and down of EWZ

This analysis suggests that a $2 move up would give my position a -18 delta while a $2 move down would only add a delta of 3 or so. It also suggest that my theta will be greatest if the underlying doesn't move much at all. That's no surprise since this is a neutral strategy.

Position sizing

I've already indicated that my risk per contract is $.93 (or $93 since we're talking about an equivalent of 100 shares). I've already determined that each trade that I take will risk no more than 2% of my portfolio.

My portfolio is currently at $19,500 (before entering this trade). That means 2% would be about $390, which means I can sell 4 contracts and remain within my risk limit.

Exit plan

The nice thing about my iron condor strategy is that I don't have many exits if the worst case happens. The position is already sized for that. Instead, most of my exit rules are oriented toward how I will close the trade (or parts of it) to lock in profit.

As a result, I will exit under the following conditions.

  1. I will exit when I can close the entire trade for a debit of $.43. That would lock in 60% of the initial credit as net profit.
  2. I will exit when I can close each individual spread for about $.21, which is 20% of the initial credit. This is really just dividing my first exit rule approximately in half.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

While the iron condor strategy is generally a neutral one, it has the potential to become biased one way or the other fairly quickly with any move of the underlying as we saw above. The position already has a slightly bearish bias to it as indicated by the negative delta. That adds to my existing negative delta making me even more bearishly biased in my portfolio.

Iron condor impact on my portfolio adds very little delta and some additional theta.

The good news is that this trade adds more theta to my position so time becomes even more my friend. For new, we'll just sit back and let time pass and I'll be reviewing this trade a week or so from now.

Update 4/22/2010

I'm out of my call spreads. I actually wasn't paying close attention and didn't have my exit rule implemented as a limit order like I usually do. As a result, I got out for $.15 instead of $.21 as my rule had stated. This time, I got lucky (it wasn't skill).

It wasn't too long ago that I had a trade where I had the opportunity to get out of my call spread and I missed it by a penny. The result was that the market rebounded and my spread got completely overrun. That's why there are rules - to protect me from the worst case scenario.

So now, all that's left of this iron condor is a put spread that is at risk of being over run. The question now is whether I'm bullish enough to leave the spread on as-is or make an adjustment. The market is in the midst of a correction (maybe). I'm monitoring this now to determine if my outlook overall has changed.

If I'm switching to being bearish near term, I may look at implementing an adjustment of some sort. Again... I'd like to hear suggestions from folks. This is your chance to participate. Feel free to contact me with comments about the trade or suggestions for potential adjustments - or questions about the trade.

Update 4/29/2010

I went ahead and sold a small call vertical spread for $.45. This is a May 77/75 call spread and results in a skewed iron condor. EWZ has been showing some weakness and the risk is to the downside in my mind.

This trade adds approximately $.22 per contract to my position. It essentially covers the cost of closing the prior call spread but leaves me with virtually no risk to the up side. I received $400 in credit for the spread, bought back 4 call spreads and sold 2 more closer in that left me with a net $.08 credit. Since the max risk to the up side for these 2 call spreads is $400, I would basically break even if EWZ breaks fully above this spread.

I still have $400 of risk to the down side unless an opportunity presents itself to close or adjust this position.

Update 5/11/2010

After the last week of heavy selling, what's left of this iron condor (the put spread) is under water. That's interesting because my other iron condor trade on the SPY worked out the opposite way. The good news is that I was able to cover my short call spread that I sold just over a week ago for $.09.

Going into the trade, EWZ was a little weaker relatively speaking. As a result, it got hit harder and has recovered slower than the other indices. The upshot is that this trade may expire ITM on the put side, which means I may lose entire planned max loss on the trade of $400.  We'll have to just let the trade play out now this week and into early next week to see what happens. The next update I make will probably be the closing update.

Update 5/21/2010

The problem with this trade is that the EWZ was showing relative weakness while the rest of the market was trending sideways to mildly up. It seemed like a nice counter trade to the SPY iron condor I had on. After some time passing and a but of a sell-off early on, I closed my call spread for $.15. The ideal scenario then would have been to have the EWZ rally up to close the put spread.

However, the market pretty much fell apart in early May. I don't usually exit iron condor trades early but this would have been a good time to have done so. I did make a small adjustment several weeks back by selling a 2 contract 77/75 call spread for $.45. I covered that spread for $.09 about a week later.

I ended up simply closing the put side for a complete loss. I ended up paying $2.00 to close the spread since it was so far in the money. So let's do the math...

I entered the iron condor for $1.07 at 4 contracts for a total credit of $428. I closed the initial call spread for $.15, which is a total debit of $60. I then sold a 2 contract call spread for $.45 and closed for $.09, which is a net credit of $72. I then closed the put spread (4 contracts worth) for a debit of $800. The net loss then is $428 - 60 + 72 - 800 = $360.

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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