Trade Tutorial - Iron Condor (7/8/2010)

The market may be tipping its hand here so I'm entering an iron condor. The question is... will this be a relief rally in a longer term down trend or a bottom in place?

Iron condor setup on the SPY

Sell SPY 112/110/102/100 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.44)
2. Exit each side for 20% of the initial credit (i.e. $.22)
3. Exit if within 4-7 days of expiration
Credit $1.14

Given the past market action, it may seem a little crazy to put on a neutral trade right now, but this trade can work out just fine unless a bottom has formed and it's straight up from here.

Why this strategy?

We often say that the iron condor is a neutral strategy, which often implies that we expect the market to remain flat. What about the case of a more volatile market where we expect a lot of up movement and down movement but ending near when it started? About a month ago, I put on an iron condor on the DIA that did just that. We don't know for sure what the SPY will do, but it's likely that the market will experience ups and downs that could allow this trade to work out.

The worst case scenario would be a pure resumption of the up trend with no pauses like we experienced last year. As I've said in the past two newsletters, I believe we're entering into a time where the market will churn more but no necessarily make any longer term up or down progress. That's an ideal climate for an iron condor trade.

Choosing the right strike prices

As with almost all my trades, my plan calls for selling options with at least 20 days left in them. Right now, that means August options. For the iron condor strategy, I typically look to sell short strike options for the put and call that have a probability of expiring ITM of 30-35%. In this market, I'm leaning a little more toward the 30% side.

iron condor strike selection

The above chain shows my selections for short strikes. Notice also the open interest. I don't usually worry about this with high volume instruments like the SPY, but it's important to make sure that the open interest is quite a bit larger than my intended order size.

This is important for two reasons. First, I want to make sure that my order doesn't 'move' the market for the given strikes. Second (and related to the first), higher open interest means I usually can get better fill prices.

Risk/Reward analysis

The general goal for this particular strategy is that my reward/risk is 1:1. In reality it is usually a little more or less. In this case, I have a potential reward of $1.14, which is my initial credit. My risk is the width of the strikes on one side ($2) minus that credit, which makes the risk $.86. My reward/risk in this case is  132%.

One thing to keep in mind though is that my target profit is going to be less than the maximum credit. This strategy relies on closing the spread to lock in approximately 60% of the initial credit. As a result, my actual target profit per contract is $.70. However, my risk is still $.86 since I intend to let this trade experience the max loss if necessary. That makes my real reward/risk 81%. That's still a really good ratio.

Position sizing

I've already established my maximum risk in the trade of $.86. On all my trades, I limit my risk per trade to just 2% of my portfolio. With the recent string of losses, my portfolio has shrunk somewhat and stands at $17,443 which means the trade risk is $348.

With my risk per contract at $86, I can sell 4 contracts (barely) and remain within my risk limit.

Exit plan

The nice thing about the iron condor strategy I employ is that it's position sized for a maximum loss. That means I don't need to have a lot of exit rules except when to lock in profit. In this strategy, I generally have a 60% rule, which means I'm going to attempt to lock in 60% of of the initial credit. I'll do that by closing the trade for a debit that's 40% of the initial credit. I often can't do this simply by closing the entire spread all at once so I'll usually establish orders to close each side for a debit that's 20% of the initial credit.

For this trade, here are my exit rules.

  1. I will exit when I can lock in 60% of the initial credit, which means I'll pay a total of $.44 to buy back the spread.
  2. I will exit each side of the spread when I can do so for 20% of the initial credit, which means when I can close the spread for a $.22 debit.
  3. I will exit when approximately 4-5 days of expiration, which is a rule I always have for all my trades.

Portfolio Impact

Since trades don't exist in a vacuum, I want to conclude by looking at the impact of this trade on my portfolio. Since this is the only trade I currently have in place, I'd expect the delta to be pretty close to 0.

iron condor portfolio impact

This will not be the case for long as the SPY moves either up or down. Given my current market outlook, I'll be looking to keep a fairly neutral delta until my bias changes.

Update 7/21/2010

Since entering this trade the SPY has been up, down and now may be up again.

We're currently only slightly higher than when the trade was entered. However, consider the following recent chart movement.

iron condor trade management

With a higher low in place, the recent highs represent a higher risk area that if broken may mean continued bullishness. If that is the case, then my call spread will be overrun. If you've followed my past iron condor trades, you know there are a few ways we can manage this position.

If you have any thoughts on this, feel free to contact me and I'll post some of these possible management strategies later this week.

Update 7/31/2010

The order to close the put spread portion of this iron condor triggered the day after my last update. That left me with a bearishly biased short call spread that is still in danger of being overrun.

Following the higher low that was established back on 7/20, the market went up for almost 5 straight days and formed a higher high. I mentioned on the last update that we'd be getting into the danger area at around $110. This happened in only a matter of days. The last four days have been selling days, which has given a little relief.

I mentioned last time about possible adjustments. I went ahead and put on a 2 contract calendar call spread at the $113 strike. This is just a short one month calendar spread that adds some up side protection.

iron condor adjustment analysis

Notice the impact of adding this spread. It doesn't prevent a loss on the upper side, it just minimizes it. There is no way to create a no loss trade without adding huge risk. The best that can be achieved is to minimize the loss. In this case, I've slightly pushed out my break even point but more importantly, I have reduced the potential loss if the SPY closes in the 112-114 area.

This adjustment comes with additional risk as well. Notice that now I am potentially giving up some of my profit if the SPY falls back down below about $109. Am I ok with this? Yes, because I'm more bullish overall now than I was when I put the trade on.

I will also look for an opportunity to add a put spread if the selling continues another day or so. However, I'm now inside the 20 day window so the chances of doing so will become less likely if something doesn't appear Monday or Tuesday.

Update 8/22/2010

Option expiration was this last Friday. With that, I'm simply left with a long $113 call. This trade has been a pretty wild ride so let me summarize where we are so far.

I sold the initial iron condor for $1.14. I closed the put spread for $.22 several weeks back. Not too long ago, I closed the call spread just recently for $22. I did buy the call 2 contract call calendar for $1.12, for which I closed the short call for $.05.

Where we stand right now then is that I have a net profit of $.70 on 4 contracts for a total of $280. On the calendar spread, I have a net debit now of $1.17 (times 2 contracts) or $234. One way to think of the position is that I have two contracts of a $113 SPY call for free (but I only have a net profit of $46 on the original iron condor trade).

The worst that can happen is I only make $46 on this trade. From here, the up side is virtually unlimited (theoretically). With the SPY at 107, it might be a long shot but who knows...

Unless I close the trade early for a profit, I won't be making another update until the long call expires the third week of September.


Update 9/3/2010 (Closing update)

I went ahead and closed the long call position on the SPY. This was a $113 call that I was able to sell back for $.39. I might have waited to see if there was more buying and hold out for a better price but time is against me as we head into a 3 day weekend and the last 2 weeks of this option cycle.

Remember on the last update, my profit was $46, not counting any profit I might make on the long call. So now the total gain in this trade is $124. That's not too bad for a trade I had messed around with so much. Could I have stayed in hoping for a larger credit? Of course but I could also risk my existing profit. I decided not to get too greedy on this one.

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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