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Trade of the Week - Iron Condor (6/10/2010)

I'm going to take a chance by putting on this iron condor trade. The market has been pretty crazy and difficult to evaluate for the last week or two. I've hesitated putting any new trades on until a trend of some sort could be established.

iron condor trade on DIA

Sell DIA 107/104//97/95 put spread
1. Exit if I can lock in 60% of my initial credit (i.e. $.44)
2. Exit if I can close each spread for 20% of the credit (i.e. $.22)
3. Exit if within 4-7 days of expiration
Credit $1.10

This position provides a decent credit and a fairly wide range of profit. The distance between the short strikes is $7, which is equivalent to $700 DOW points.

Why this strategy?

Let me be clear. I am not expecting the market to begin a march upward like we saw last year. I think things will continue to be choppy for a while. What made me decide to enter a trade now? There was a bounce on Tuesday that looked like it might form a double bottom - signaling the potential end of the selling. Wednesday looked like it might confirm this but late day selling left the question open. Yesterday the market opened up strongly and looked like the double bottom would confirm (it hasn't yet but may well in the next day or so).

I believe from here, we'll see more range bound trading like we've seen over the last few weeks. This makes the iron condor the perfect trade, especially given the elevated volatility that accompanies this choppiness. There is still a lot of overhead resistance as the chart above indicates. I've drawn two diagonal resistance lines representing primary and secondary resistance. We did break through the primary level toward the end of the day yesterday but the DIA stopped just under the 200 day MA. For all these reasons, I believe an iron condor trade makes sense right now.

I could have easily chosen any of the broad index ETFs but I already have a partial trade on the SPY and the IWM may show more strength than the DIA or the SPY.

Choosing the right strike prices

As is typical for the iron condor strategy, I look for short strike prices having a probability of expiring (ITM) of around 35%. With the volatility currently in the market, I went a little lower on the probability just to give more room to move.

iron condor strike selection

June options only have a week left so July options are the logical choice. This provides a decent amount of time and a nice wide gap between short strikes. This offers $7 in movement between the short strike prices, which equates to $700 DOW points.

Risk/Reward analysis

Given the elevated volatility, I was able to put this iron condor trade on for $1.10. Since I'm using $2 wide spreads on each side, that leaves $.90 in risk. That means my reward/risk ratio is about 120%.

Of course given my exit rules, it won't be quite that good. Since I'm planning to lock in just 60% of the initial credit, my expected reward will be more like 73%. I arrived at that number as follows.

  1. 60% of the initial $1.10 credit is $.66
  2. My risk in the trade is still $.90 since I've already received the full $1.10 credit
  3. .66/.90 = 73%
iron condor trade analysis

Another way to evaluate this trade is to look at the profit graph. While my short strikes are $7 apart, the range between break even points is more like $9. Another thing to look at is the percentage at the top of the graph. This represents the probability of DIA ending the option period somewhere between the two break even points. This number is 39.6%.

That may not sound like great odds but remember my trading plan intends to improve the odds by exiting the trade early and locking in a smaller percentage of the max credit. This will improve my odds of success quite a lot.

Position sizing

I've already mentioned that the risk in this iron condor is $.90. I always limit my trade risk to just 2% of the current portfolio value. Right now the portfolio stands at $18,159, which means 2% would be just over $360.  Ordinarily, I would calculate my position size by dividing $90 into $360 and arrive at 4 contracts. However, with my trade rules, I could increase my risk slightly, which affects my position size.

If I intend to close each side for 20% of the initial credit, that would be about $.22. What that means is that if I were to close one side for $.22 only to have the trade go completely against me then my real risk is $1.12 (.90 + .22). That means I will only be selling 3 contracts.

Exit plan

I've already mentioned most of my exit rules for this trade. With the iron condor strategy, I size the position for maximum loss so there aren't really any early exit rules other than to lock in profit. In that regard, I basically have two rules.

  1. If I can close the entire trade and lock in 60% of the initial credit, I will so so. For this trade, that equates to paying back a debit of $.44 to close the trade.
  2. If I can close either side at any point for 20% of the initial credit, I'll do so. In this case, that would be $.22.

As always, I have a absolute exit rule where I will exit when approximately 4-5 days of expiration. I've talked about this several times in past issues my monthly newsletter. If you aren't subscribed, do so now and you can review all of the past issues.

Portfolio Impact

One final area to consider is the impact of this trade on my portfolio.

iron condor portfolio impact

As this capture indicates, my overall position is somewhat bullish, which is a result largely of an open long position that is left over from a calendar spread. This also is contributing to the negative theta indicated above. This trade though contributes slightly negative delta - largely due to the move in the market following my entry of the trade and before I could capture the portfolio view.

As in each trade I take, the goal is to add a defined risk position that also adds positive theta and a delta value in keeping with my current bias. Overall, this iron condor trade causes the portfolio to be slightly more neutral, which is my current near term bias.

Update 6/21/2010 

Given the strong move this last few days, it isn't surprising that the put spread has closed already. With the limit orders in place, the order to close the puts for $.22 executed several days ago.

This iron condor is now just a call credit spread that is currently being overrun. That's largely due to the big move over the last week or so. Overall, my delta is still somewhat bullish as I now have a put credit spread on the EWZ and a long call on the SPY.

The ideal case for this trade would be for a pullback to develop that would give me an opportunity to sell another put spread - or just close the call spread.

Update 6/29/2010 (closing update)

Be careful what you wish for! I was looking for a sell-off to close the call spread but we really got one yesterday.

The standing order to close the call spread at $.22 triggered and that leaves me completely out of this position. Let's take a look at how the trade went.

I sold the spread initially for $1.10 and almost 2 weeks later was able to close the put spread for $.22. Then, with the selling over the last week or so, I was able to close the call spread for $.22. That leaves a net credit on this trade of $.66. I sold 3 contracts so that leaves me with a net profit on the trade of $198.

This was almost a textbook trade. In many cases, an iron condor is market neutral trade, although it can work well in an up and down market like we've seen.

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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