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Trade Tutorial - Iron Condor (6/7/2012)

As I mentioned the last newsletter, I'm entering an iron condor given the recent market bounce.

iron condor trade setup

Sell DIA 130/128/120/118 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.40 debit)
2. Exit if either side can be closed for 20% of credit (i.e. $.20)
3. Exit if within 4-7 days of expiration
Credit $1.02

Given the recent market sell-off, is this a wise trade? Read on for my rationale.

Why this strategy?

It is possible that after the recent strong selling that we'll see a bounce and resumption of a bullish trend. However, it's also likely given the unresolved issues in Europe that the unrest isn't over. As a result, I'm counting on the market rallying and then selling back and basically bouncing around for some time.

Overall, I'd say I'm neutral for the next 4-6 weeks heading into the early summer. What's a good neutral trade for a time frame such as I've outlined? The best trade (or maybe just my preferred trade) is the iron condor. There are some other strategies that could work. For example, I could use a double calendar spread (a time-based trade) or a double diagonal (a time based trade that rolls into an iron condor eventually).

In this case, I'm going to keep it simple. I want an iron condor with plenty of time left and $2 wide spreads on each side. I'd like to select an underlying that is a) an ETF and b) represents the broader industry. While the SPY is a good choice for this, I'm going to use the DIA, which represents the Dow Jones index. It has a large enough value that the underlying options are well priced.

Choosing the right strike prices

My rule for an iron condor is to sell $2 wide spreads on each side where the short strike has a probability of expiring OTM of around 70% and at least 20 days to expiration. In this trade, I'd prefer a little more than 20 days so I have more premium value to melt off over the next 4 weeks or so.

Note: I've mentioned this in the newsletter, but the thinkorswim platform recently added the ability to specify the probability of expiring as both ITM and OTM. As a result, I now specify my trades that way.

As the above option chain shows, I've selected the $128 short call and the $120 short put. That means my range of profit is between $121 on the low side and $128 on the up side. That's equivalent to $800 Dow points of movement. For that position, the premium value is $1.02.

Risk/Reward analysis

There are actually several ways of analyzing this trade. One is with reward/risk. The other is probability of success.

With reward/risk, I simply divide my potential reward by the potential risk. We know the maximum reward in this trade is $1.02 per contract. Since each side of my iron condor is a $2 wide vertical spread, the maximum risk in the trade is $2 less the credit of $1.02 or $.98. That means my reward/risk is 104%.

That's great, but I never let this kind of trade to expire worthless, therefore, I will never achieve the maximum reward. I can increase my chances of success by closing the trade to lock in a percentage of the initial credit. The two ways I can do this is by having an absolute exit (i.e. exit if I can do so for 40% of the credit - thus locking in 60% of the credit). The other is by closing each side of the spread individually using 1/2 the target closing percentage. That means I would close each side if I could do so for 20% of the initial credit.

In that case, my target profit is about $.62 while my maximum risk remains at $.98. Using this approach, my reward/risk is more like 63%.

iron condor trade analysis

The other aspect of this analysis is probability of success. One way to analyze this probability is using the analysis tools provided by the platform. On the thinkorswim platform, you can actually set up this analysis quite easily to get a graph roughly as shown above. As the chart shows, the probability of success (that is, having a probability of break-even or better) is about 50%. That again assumes I let the trade go until expiration.

If I exit early as planned, my probability of success improves. It's harder to analyze this probability though as there is no graph that can take an early exit into consideration. However, this principal is in play. Probability of success and reward/risk are always a trade-off. Increased reward always comes at the expense of a lower probability of success.

Position sizing

At the risk of repeating myself many times over, I want to state that my rule for EVERY TRADE is to limit my risk in the trade to 2% of the portfolio value. My current portfolio value is about $17,000. That means my risk in this trade must be limited to $340.

My risk in this iron condor trade is just $98 per contract ($.98 x 100 shares). As a result, I can sell 3 contracts and remain within my risk tolernance. The result is that my maximum risk in the trade is $294 while my target profit (based on the early exit rules) is $186.

Exit plan

In my iron condor strategy, I have one main exit rule, which is to exit to lock in 60% of my initial credit. That's like taking a nice big profitable bite out of my trade and by doing so, improve my probability of success. That main rule can be implemented two ways. I can exit all at once, which doesn't happen very often or I can exit on each side as opportunity offers. This often turns out to work better because the up and down market fluctuations will create that opportunity in many cases.

To summarize:

  1. I will exit if I can lock in 60% of the credit all at once. I'll do so by closing when I can do so for $.40 debit. That leaves $.62, which is just barely over 60%.
  2. I will exit each spread (put and call) for 20% of the initial credit. The end result is that the total debit will be 40% of the initial debit just like rule #1.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

An iron condor is generally a neutral trade. As a result, you'd expect the resulting delta of the position to be close to 0 (zero). However, it's rare to get an evenly balanced position like this.

Iron Condor portfolio impact

As the portfolio greeks show above, the delta is actually a little negative. That's because the underlying price ratio is slightly skewed toward a larger credit for the calls than the puts. Still, for 3 contracts this would be considered a reasonably balanced trade.

The other nice thing about this position is the positive theta. It currently isn't very high but will increase as we get within 30 days of expiration. Remember, that the rate of premium decay isn't linear over time. Premium value actually melts away faster the closer you get to expiration (all other factors remaining the same).

Update 6/18/2012

The limit order triggered on the put side of my trade, allowing me to exit at $.20 debit.

I was late in getting this update in but as of now, we have only the call side to be concerned with. The ideal case would be to have the DIA drift down from here. If we start seeing strength then it will be necessary to consider an adjustment.

Update 7/1/2012

With the DIA starting to show strength, it may be time to consider an adjustment. As of Friday, we are back near the highs of the month and may see some additional strength.

What would make a good adjustment that has some tolerance for being wrong? How about a calendar spread? I'm looking at a 2 contract calendar spread at $131 (July/August) for $.80. If the DIA continues to push up.

Update 7/11/2012 (Closing Update)

 I decided to wait things out and took an opportunity to close for a slightly higher exit price than I originally planned.

Here's how the trade played out. I entered the trade by selling 3 contracts for $1.02 credit for a total credit of $306. I closed the trade for a cumulative debit of $.50 (total of $150), which made my net profit $156. My original risk was $.98/contract or $294 so my actual return on risk is 51%.

This trade turned out successfully due to two key principles I try to follow.

  1. When then trade is going successfully, follow your standard exit rules
  2. When the trade isn't going as well and existing profit is being threatened, consider an exit to lock in existing profit.

When the calls were being threatened, the first thing I looked at was whether I could exit the calls for a total net profit. Initially that wasn't the case, which caused me to consider the calendar management strategy. After a few days, the brief selloff gave me the opportunity I was looking for to exit for a little more than my target debit but the trade was a win as a result.

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

Stay tuned for further updates as the trade progresses...

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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