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Trade Tutorial - Iron Condor (9/3/2010)

I'm entering an iron condor trade - a fairly neutral trade given the state of the market. This is the first new trade after a few weeks given the choppiness of the market.

Iron condor trade on the DIA

Sell DIA 109/107/99/97 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.36 debit to close)
2. Exit if I can close each spread for 20% of the initial credit (i.e. $.18 per side)
3. Exit if within 4-7 days of expiration
Credit $.90

The trade didn't yield as nice of a credit as I'd hoped for but given the drop in volatility, it's probably the best I can hope for right now.

Why this strategy?

I mentioned in the last newsletter that I'm expecting the market to trade in a range for the next month or so. That doesn't mean I expect the market to be flat. I expect lots of ups and downs to be sure. However, It wouldn't surprise me to see the DIA (and the market in general) end the month only just slightly up or down.

Given the current churn in the market, I think the iron condor is the perfect choice. What I'm expecting to happen is that as the DIA continues to gain strength, I'll close the put spread per my exit rules. Then on a selling phase, I'll look for an opportunity to close the call spread.

Keep in mind there is a fair amount of overhead resistance around the area where I sold the short call. I'd be surprised if September is the month that this breakout happens.

Choosing the right strike prices

Strike selection is important for any options trade, not just for the iron condor. The two key factors are what option month to use and what strike values to use.

In terms of the option cycle, I'm looking at the October options because there are less that 2 weeks until September expiration, which doesn't leave much premium.

For my iron condor strategy, I typically look for a short strike on either side having a probability of expiring of 25-30%. However, I also want to make sure that the resulting short strikes fall at or above resistance for the call and at or below support for the put. The technical component gives me just a little more confidence in the position.

iron condor strike selection

The result is that my short strikes are a $107 call and a $99 put. That's an $8 range (800 DOW points). For the long call and put, I'll select a strike that is $2 away, which means the spreads are $2 wide, which is the maximum risk in this trade.

Risk/Reward analysis

For this trade, I have no early exit rules. In its simplest form, I'll put the trade on for $.90 credit and it will either expire worthless (I keep the $.90) or it expires fully ITM (I lose $1.10). This represents my best and worst case scenario. From this perspective, my reward risk would be $.90/$1.10 or 81%.

iron condor trade analysis

Another way to view the  trade as I described above is that there is a probability of just 51.7% that this will expire somewhere between the two break even points. What if I wanted to improve those odds just a little?

The trading plan I often employ with an iron condor trade is to close the trade early if I can lock in 60% of the initial credit. I often do this by closing each spread for 20% of the initial credit. If I can do this on each side, I'm left with 60% of the initial credit. While my profit in the trade decreases, my probability improves.

With the exit rules I just outlined, I'm selling the position for a $.90 credit but I'd be giving back $.36 to close the position and keeping $.54. However my risk is still the same ($1.10). So with this scenario my reward/risk is 49%. Can I live with that? Of course. Especially if the trades closed with a profit more often.

I've mentioned this before but it's worth repeating. You can't realize unlimited profit and no risk at the same time. It's the nature of this business that you will always be trading off some amount of reward to reduce risk (or increase your odds). The challenge is trying to find a balance you are comfortable with. I can't tell you what yours should be. I only know what I can live with.

Position sizing

Position sizing is one of the more critical aspects of setting up any trade. It's what keeps me from losing my shirt if the trade goes bad. One of the things I like about the iron condor strategy I employ is that I put the trade on knowing I could experience the maximum loss. With that in mind, I should be able to come up with a position size that allows me to remain within a tolerable loss amount.

In my case, I've chosen 2% of my portfolio as the maximum I'm willing to risk on any trade. My portfolio currently is at $16,864, which means I can risk $337 per trade. With a maximum risk of $110 per contract, I can sell 3 contracts and remain within my risk tolerance.

Exit plan

As I've already discussed, my main exit strategy will be to close the position when I can lock in some profit. I will largely do that by closing each spread individually but may also close the entire trade if I can do so according to my rules outlined below.

  1. I will exit when $.36 per contract - This allows me to lock in 60% of my initial credit
  2. I will close each spread when I can do so for $.18 - This allows me to lock in the profit one side at a time
  3. I will exit when approximately 4-5 days of expiration

Due to some of the poor results I've achieved in past trades from adjusting the position after I put it on, I won't be adjusting this trade. I will simply put it on and let the rules take care of themselves.

Portfolio Impact

No trade exists in a vacuum - unless it's the only trade currently on. In this case, that's the way it is. I've closed all the other positions so the iron condor is the only trade on.

iron condor portfolio impact

Notice that the position currently has a slightly negative delta. That's because there was a slight initial skew. Notice the probabilities for the short call & put in the strike selection above. That's ok though. There will probably be plenty of fluctuation on this trade as it progresses.

The important factor to look at is the theta. This is a positive theta position, which means it benefits from the passing of time - even if the underlying goes nowhere. These are the kinds of trades I like to have on.

Update 9/13/2010

With the recent market bullishness, the order to close the put spread portion of this iron condor filled at $.18. I'm now left with a short call spread.

Is it time to start adjusting? Not just yet. In fact I stated earlier that I didn't intend to do more than follow my rules on this trade. For now, that's just what I intend to do. Given that many of my prior trades suffered in either low profitability or loss, I'm going to let this trade run.

 Update 10/14/2010

Since this is option expiration week, I ended up closing the call spread for $1.97 per my exit rule. The upshot is that I made no adjustments other than following my standard exit rules.

First, let's evaluate the results of the trade and then I'll conclude with lessons learned. I entered this position for $.90 credit and paid $.18 to close the put side of the spread. I then paid $1.97 to close the call side of the spread. The result is a net loss of $1.25 per contract on 3 contracts. That means a total loss of $375.

When I entered this trade I determined not to make any particular adjustments other than those associated with my basic trading rules for the iron condor. I chose to do this because a number of my prior trades had varying results for having been adjusted.

Does the fact that this trade lost money mean that I should continue adjusting? Certainly some of my prior trades also lost money even with adjusting. The key point is that one trade isn't enough to evaluate the effectiveness of a management strategy. Before implementing a full scale management strategy many trades are required using the same rules in order to evaluate the long term effectiveness. This can be tested in real time via paper trading or with a back testing tool.

It's worth pointing out that the thinkorswim by TD AMERITRADE platform offers a nifty tool called 'On Demand' that allows one to replay the market tick by tick. Using a tool such as this, you could enter and manage trades using a set of test rules to evaluate the effectiveness over different time periods.

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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