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Trade of the Week - Iron Condor (8/10/2009)

I put this iron condor trade on first thing this morning. I've become a bit more bullish but am not convinced the market will power much higher before pulling back.

Iron Condor on the SPY

SPY Sept Iron Condor 107/105/96/94
Target ROI
1. Exit if I can lock in 60% of my initial credit (i.e. close for $.37)
2. Exit 4-7 days prior to expiration
3. Exit individual sides if I can close for $.20 debit

This is a $2 wide spread on each side with $9 between the short call and the short put. That's a fairly wide zone of profit given the current volatility.

Why this strategy?

I have slowly become more bullish in the medium term, although I still think there is a healthy retracement due. With the large bullish move that has taken place over the last month, I suspect that the market will probably want to pause in the area for a while. With a near term neutral perspective, the Iron Condor is a nice trade to put on as it can produce positive time decay with very little market bias while the market goes nowhere.

As usual, I am taking a trade on an index ETF. In this case, I'm using the SPY, which tracks the S&P 500. I like this index because it represents a fairly broad segment of the market.

Choosing the right strike prices

I've mentioned in my iron condor strategy page that there are several ways to select strike prices. I have been putting these trades on using a more aggressive strategy, picking short strikes for both the put and call that have a probability of expiring (one penny or more in the money) in the range of 30-40%.

Iron Condor Strike selection

As this picture shows, I've slightly skewed this trade to the up side (in terms of probabilities). My short put is around 30% probability of expiring while my short call is just over 26%. I could have chosen the 104 call as my short strike to make it a more balanced in terms of probabilities, but notice that I'm actually closer to the short call. The underlying is trading at $100.83 (almost $101). That means it's $4.80 from the short put to the current price and about $4.20 to the short call.

The reality is that many times it is difficult to get an exact balance between the upper and lower sides. I just have to do the best I can.

Prior to entering, I did a quick analysis using the thinkorswim analyze tab.

iron condor trade analysis

Here, the analyze tab shows that with the current strike prices, I have a probability of success  of 45.7% (defined as closing between the two break even points on expiration). That's pretty good for a trade like this and if I exit early, this probability actually goes up.

Position sizing

The nice thing about the iron condor spread strategy is that I know exactly what I can make and exactly what I could lose. In this case, I can get a credit of $.93 on a $2 wide spread on each side. That means my total risk in the trade is only $1.07. Remember that on this kind of trade, there is a chance that the options could expire with SPY all the way through the upper strikes or all the way through the lower strikes but both couldn't happen. In that case, I only need to count one side of the spread as my total risk.

With a portfolio of about $20,000 and risking 2% per trade, I can risk $400 on the trade. With a total risk of $1.07 (or $107 per contract) I can take 3 contracts with a fraction left over. I always round down, not up.

Iron Condor trade entry

Here's my iron condor order set up. I actually bumped the price up to $.93 just before submitting and got filled almost immediately.

Exit plan

Before I go into my exit rules, I want to review some of my assumptions regarding this trade. I sized this position based on the assumption that I could face the maximum loss on the trade (as I often do for my iron condor trades). While the call and put spreads are each $2 wide, I am taking in a credit of $.93 and leaving a final risk of $1.07 or $321 for the 3 contracts. I am willing to sustain this loss if necessary, which means I don't need an exit rule based on worst case scenario.

My exit plan then is to exit when one of several things occur.

  1. I'll exit if I can lock 60% of my initial credit, which would be closing for about $.37 debit. That would leave me with a realized ROI of 52%
  2. Regardless of what happens, I'll close the trade 5-7 days before expiration
  3. If I can close either side for around $.20 debit, then I'll do so. Doing this for both sides would result in an actual closing cost of $.40, which is pretty close to the 60% target I identified in exit #1

Right now, my iron condor trade from last month isn't doing too well on the call side. Let's see how this one fares.

Update 8/18/2009

I had intended to get this update out earlier this morning before the market opened but was dealing with internet issues. Had I done so, the update may have looked a little different. At one point yesterday, I was within pennies of closing the call side of this iron condor spread. However, today, the SPY has headed more toward the middle of the spread again.

Will we go up? Will we go down? I don't know but already, the trade has gained from time erosion. I put the is iron condor spread on for a $.93 credit and I could close it today for $.79. Being just a week into the trade, there isn't really much to do. I did put an order in to close the call side if I can do so for a $.20 debit (my exit rule #3).

Thinking defensively, I could ask myself what I might do if the selloff to the downside continues. What strategies might help me hedge some risk without imposing too much risk in the opposite direction?

  1. I could buy a put calendar spread near the location of the put side of my iron condor. This would actually make a move (and close) down in that region profitable
  2. I could buy back one of my spreads (1 contract) on the put side. That would lower my risk and skew the trade to the bearish side a little.
  3. I could buy back one or more of my short puts to create a ratio spread. That would cause the trade to skew a little more bearish. 
  4. I could buy back the entire put spread expecting a big move down - but I've suddenly made my semi-neutral trade very bearish as all I have left is a short call vertical.

At this point, I don't know that I'll do anything, but in situations like this, it's always good to have some ideas ahead of time instead of waiting until the point of panic when one side or the other of my spread is getting run over.

Remember too, I've already sized the position for a max loss of $1.07. Anything I do to mitigate the existing risk in a directional way will potentially add risk in the opposite direction.

Update 8/25/2009

Wow! A week ago, I was planning strategies to hedge the downside. Yesterday, I hit my trigger to close the put spread for $.20. So now, I'm left with just a 107/105 call spread (and lots of negative delta).

There's still a lot of time left in this iron condor spread (or what's left of it) so there's not much else to do but wait for more time to pass. In the mean time, since I talked last time about downside hedging or adjustment strategies, I thought I'd cover some possible upside hedging strategies. What are some ways I could make adjustments to this position, especially now since I closed the put side?

  1. I could buy a call calendar near my calls. Although I'm not much of a fan of buying call calendars, it can be a decent adjustment.
  2. I could close one of my call spreads (currently trading for around $.60). This has the advantage of taking some risk off the table and locking in a small profit to boot.
  3. I could buy back one of my short calls to create a bullish skew. However, this creates downside risk.
  4. I could sell a put spread closer to the current price of SPY. If I sold a few contracts of a 100/98 put spread, I'd pick up another $.50 per contract in credit, thus decreasing my potential loss if we have another blowout month like last month. I'd want to make sure in doing so that I didn't add too much downside risk.

I'm going to wait to see if this move up continues, but I kind of like option #4. The key thing to remember is that any time I make an adjustment, I'm really just shifting my risk around.

Update 9/2/2009

Well, it's a good thing I closed my put spread last week. Now we finally have a pullback forming that has allowed me to exit the call spread and be completely out of this trade. I closed the call spread this morning for $.20 leaving my net profit in the trade $.53.

With the trade closed, let's take a look at the statistics. My original target ROI would have been 86% if I had let both sides expire worthless. However, my exit plan for this iron condor strategy is to exit when I can capture 60% of the credit. With an initial credit of $.93, that would be $.55. In this trade, I had a fixed exit rule of closing each of the spreads at $.20 so my actual net credit is just slightly less than that.

My actual ROI is 49.5%. I arrive at that number by dividing my actual credit by the initial risk amount of $1.07. Remember, even though I close early, my actual amount risked (or amount held in margin) is still $1.07.

Could I have done anything different in this trade? Since I only took a few contracts in this trade, the few pennies I gave up from my target 60% exit probably aren't that significant. However, it is worth considering that instead of using a fixed amount of $.20 per side to close the individual spreads, maybe I should go with 20% per side. That would get me the 60% net profit regardless of my initial credit.

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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