Trade Tutorial - Iron Condor (7/7/2011)

I think it's time for an iron condor trade. I've let most of June go by without adding any new trades - mostly because I've been rather busy with other activities. However, I think  this would be a good trade given the current market conditions. I'll talk more about this in a moment.



Trade
Sell DIA 131/129/124/123 iron condor
ROI
73%
Exits
1. Exit if I can lock in 60% of my initial credit (i.e. $.44 to close the entire position)
2. Exit each leg  if I can do so for 20% of the initial credit (i.e. $.22)
3. Exit if within 4-7 days of expiration
Credit $1.10

This is an iron condor with $5 between the two short strikes and $2 wide spreads on each side. That means I have the equivalent of $500 in movement on the DJ30 index.

Why this strategy?

I'm looking at the market over the last few weeks and we see a fairly large sell-off over a period of almost 2 months and a recovery of almost that entire amount in the space of a week and a half. From this, I suspect that there is still some market volatility to come. The iron condor is a neutral strategy. This doesn't mean I expect the market to remain flat, but I expect the fluctuations over the next month to allow me to close each leg of the position.

In selecting an underlying ETF to trade, I could really have chosen any of the standard index-based ETFs such as the SPY, IWM, DIA and so forth. In this case, I went with the DIA because it is one of the higher priced ETFs, which means the option prices will be a little higher. I could have gone with the SPY since it is priced a little higher but just closed a trade on the SPY so I wanted to mix things up a little.

Choosing the right strike prices

This particular trading strategy I use with the iron condor trade calls for selecting short strikes with a probability of expiring (ITM) of between 30% and 35%. If possible, I like to get as close to 35% as possible. In this case, I selected a short put strike with a probability of 35% and a short call strike with a probability of 31%. This gives me just a little more room to the up side, which I think is the bias of the market anyway.

Since I prefer $2 wide spreads, I end up with a $131/129 call spread and a $124/123 put spread. This spread trades for $1.10 credit. Because in the worst case scenario the trade could end with the DIA either completely through the call spread or completely through the put spread, my absolute risk in the trade is only $2. That means my net risk is only $.90 ($2 - $1.10).

Risk/Reward analysis

Since I know my reward and I know my risk, I can calculate the reward/risk. On the surface, the reward/risk is .90/1.10 or 122%. Now, that seems like a really good reward/risk. However, this assumes I hold the trade until expiration AND the trade works out exactly as planned (i.e. the options all expire worthless).

On the other hand, my exit strategy calls for closing the trade when I can lock in 60% of the initial credit. That means, I'd keep $.66 of the original $1.10. With this net reward, my reward/risk is now 73%. That's still pretty good. If I thought I could generate trades that have this return all day long, why not trade exclusively iron condors?

If you've read some of my recent newsletters or watched the introduction to spreads video, you are aware of the tradeoff between reward/risk and probability of success. Above, we see the probability of success in this trade is 42.7%. It appears then that my probability of success is lower while my potential reward/risk ratio is higher. What this means is that my likelihood of success may be lower than other strategies, but when it pays of, it pays better.

Take a look at some of the trades that have been posted on the option trading tutorials page and notice that the gains (or at least expected gains) for the iron condor is higher than the other strategies.

Position sizing

We've already gone over the risk in this trade. With a credit of $1.10, the risk in the trade is $.90 (or $90 per contract). As I often state in these tutorials, I intend to risk only 2% of the portfolio on each trade. Prior to entering this trade, the portfolio value is $17,322. That means I can risk just $346 on this trade. With these values determined, I now know I can sell only 3 contracts and remain within my acceptable limit.

Exit plan

With the iron condor strategy, I have just a few exit rules. This particular strategy attempts to be a little more aggressive in location of the short strikes but compensates by closing the trade when I can lock in 60% of the initial credit. There are two ways I attempt to do this. The first is to simply close the entire trade for a debit value of 40% of the initial credit. The other way is to attempt to close each side of the trade (the call spread and the put spread) for a debit value of 20% of the initial credit.

To summarize then I will exit under the following conditions.

  1. I will exit when it costs $.44 to close - This will close the entire spread, locking in 60% of the credit.
  2. I will exit when I can close each side of the iron condor for $.22 - This will attempt to exit each side for 20% of the initial credit (a total of 40%).
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Given that the iron condor is a fairly neutral trade, the expectation is that this trade would have little affect on the delta. Since there are no other trades on, the delta effect is simply the delta value of this trade.

Notice though that the delta is slightly negative. That's because I captured this information after the DIA had some time to move toward the short call strike. This is to be expected as the market fluctuates up and down. Meanwhile, the trade offers a nice theta, which will increase as time passes and we get closer to expiration.

Update 7/21/2011

With the market selling that took place the second week of this month, I was able to close the call side of this iron condor trade.

As planned, I closed the call spread for $.22 debit, which leaves me with a put spread. If the market continues the rally I expect to be out of the put spread shortly. So, what risk remains in this trade? With my short put spread in place, the risk is that the market will sell off. At this point, the short strike is below the last pivot where the DIA reversed direction and began to rally. It's also below the 30 and 50 day moving averages, which will help add support above the short strike.

It's possible we'll see some more volatility and perhaps some selling before breaking above the $127 level that is current resistance. However, as long as the DIA stays above support we're fine on this trade.

 

Update 8/19/2011 (Closing Update)

I finally closed the put side of this trade but I did so for a loss due to the huge market sell-off. Let's first complete the analysis of this trade and then I'll talk about some potential strategies for protecting against such large selling events.

I entered this trade for $1.10 credit. I closed the call side of the spread for $.22 debit, which leaves a net credit of $.88. I was forced to close the put side of this trade for a debit of $1.90. That leaves a net loss in the trade of $1.02. I only sold 3 contracts so that means my net loss in this trade is $306.

This trade has gone through a number of interesting phases.  Following the closing of the call side of the spread in the middle of July, the market rallied for almost a week. While not reaching the target closing price, I could have closed the trade for a profit. Of course at the time, it wasn't clear the big sell-off was coming. However, the indications were there.

When selling continued heading into the end of July, I considered an adjustment strategy of buying back one of the short put strikes. This creates what is called a backspread and has the benefit of offsetting the losses encountered by the other part of the trade. However, it requires a fairly deep move to be of benefit.  I hesitated in making such a move on my virtual account but did in fact employ this strategy on one of my own trades. 

Bottom line, you want to be prepared to either take an adjustment strategy or close the trade completely to minimize the loss. Given the nature of this trade and my existing trading rules, I simply let the trade play out. As a result, it suffered the maximum loss in the trade. It's a good thing I sized my position accordingly!

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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