Trade of the Week - Iron Condor (9/14/2009)

This week I am adding another iron condor to the list of trades I'm currently managing. I'm doing this for several reasons. First of all, I currently already have on a bearish calendar spread and a bullish diagonal spread. This adds extra theta (premium that melts away in my favor) without adding any real directional bias. Second of all, my outlook for this market is to somewhat neutral. In other words, I don't expect to be largely up or down by the end of the next month. We may see some rather radical moves but I expect the net to be between 92 and 98.

iron condor trade of the week

Trade
DIA 100/98 calls 92/90 put
ROI
93%
Exits
1. Exit if I can lock in 60% of the initial credit (about $.39 debit)
2. Exit if I can close either leg for 20% (about $.19 debit)
3. Exit when I get within the 4-7 day window regardless
Credit/debit $.97

This is a $2 wide spread, which is my typical spread size for many of my spread strategies, particularly on these ETF products that offer $1 strike increments.


Choosing the right strike prices

As I've mentioned in most of my trade of the week pages for iron condors and on the iron condor strategy page, I like to chose short strikes that each have about a 70% probability of success (give or take a little).

iron condor strike selection

In this case, the short call shows a slightly higher probability of expiring in the money, which translates to a lower probability of success. That's ok, it's still within my acceptable range.

Also, I've chose the October strike month because there is no time left in September and November is too far out. October is just about right at 32 days remaining.

Trade analysis

So, given that each individual vertical spread has a probability of success of 70% or so, what is the probability of success of the iron condor trade? Thinkorswim makes this analysis very easy. By putting this potential trade in the analysis tab prior to entering, I can get a good idea of my probabilities even before entering.

Iron condor trade analysis

This chart shows that the probability of breaking even or making some money in the trade to be around 46.5 %. This assumes I take the trade all the way to expiration and that I let it expire. I won't be doing either of these things. My goal is to lock in 60% of the initial potential credit, which is about $.97. That means I'll close the entire trade for around $.39 debit leaving a net gain of $.58. 

Position sizing

The trade will be worth about $.96 in credit, which leaves about $1.04 in risk ($104) per contract. Here is the trade set up. 

Iron condor trade set up

With a portfolio of about $20,000 and risking 2% in this trade, I can risk about $400. With $104 in risk, how many contracts can I take? Just 3 if I am to be absolutely strict about it.

By the time I got the trade entered, I was actually able to pick up another penny to make it $.97 with a total credit of $290 and total risk of $310.

Exit plan

As listed in the table at the top of this trade page, I will exit all or part of this iron condor under the following conditions.

  1. I will exit the trade profitable if I can lock in at least 60% of the initial credit. That's $.58, which means if I can close for just a $.39 debit then I'm out.
  2. I will also exit each leg (call spread or put spread) if I can do so for 20% or about a $.20 debit per side. In my last two iron condor trades, this worked out pretty well.
  3. Regardless of what happens, I'll plan to be out of the trade within 4 days of expiration.

Notice that I have no exit related to a maximum loss. Why? Because I am sizing the position for a maximum loss of $1.03 per contract. This allows me to stay with the trade a little longer and possibly realize my target gain even though there may be some radical swings over the course of the trade. 

As an example, what happens if DIA moves strongly up and threatens to run through my upper strikes? I might just be able to close the put spread for $.20 and then I have not down side risk. The same could be true for a strong pullback. That's why my rule #2 is there.

How can I ensure that the trade rule is followed? I could put in a "good until canceled" order to close each side of the spread for $.20 and just sit back and wait. No sweat, minimum maintenance.

Iron COndor exit

Here's an example of my orders that are in place.

Update 9/16/2009

Wow! Just 3 days into is iron condor trade and I"m already out of my puts. This market has put on a strong move. So, I am out as of this afternoon from my put spread - filled at $.20 debit. This will leave me with just a short vertical call spread.

Just for the record, my risk in the trade has actually gone up slightly. Why? Because I initially took in $.97 but gave back $.20 to get out leaving a net credit of $.77. That means my risk is now $1.23 (times 3 contracts).

What are some ways to manage the risk I now have in the trade?

  1. I can close some of my existing calls for a small loss
  2. I can actually sell some puts at a higher strike prices
  3. I can buy a calendar spread 

I always like to go over my choices because it is important to have a plan in place ahead of time so I'm not making a decision rashly. The first option would actually remove risk but requires me to give back some or all of my credit. The second two add more theta to the position but also add risk.

For now, I'm just going to monitor the remaining position and see what happens. If there is a bit of a pullback, there may still be an opportunity to re-sell the put spread.

Update 9/23/2009

There hasn't been much of a change since the close of the put spread last week. Until yesterday, I would have said I was being over run on the call spread, and still run the risk of that happening. Remember, this was originally an iron condor trade that has become a short call vertical since I bought back the put spread for $.20

Is now the time to respond to this risk using the strategies I listed last week? If so, what would be the best strategy to choose? 

If, I believed there was a risk of running up through my upper strike, then selling a put spread (strategy 2 above) can help limit some of my up side risk. I can use the analyze tab on the thinkorswim platform to add a simulated trade and see what that would do to my trade risk profile.

iron condor adjustment trade

Note that I only added one contract to the put side while I have 3 contracts to the call side. That creates an unbalanced or skewed iron condor. Here is what the risk profile looks like with this trade incorporated.

iron condor analysis

The thing I like about this adjustment is that I'm basically adding back in a component I had previously closed. By adding in fewer contracts on the put side, I have no real downside risk of loss, although I do risk giving back some of my profit in the trade. 

I'm not convinced that the selling is over so I'm going to monitor for a while. There may be an opportunity to put this trade on at a lower price, which would give me a wider range of profit.

I'll post an update if I do put the trade on.

Update 9/25/2009

I did go ahead and put the trade on this morning making a sort of skewed iron condor. I put on a one contract 96/94 put  spread for $.55 credit. That will lower the overall risk in the trade by that amount. This will kind of make the math a little complex in the end in terms of determining the return but that's ok. I think this is a decent adjustment given the state of the market.

I was expecting today to be a buying day but in the end it was another selling day. That's OK - there is no down side risk other than taking less of a profit.

By the way, the above graph isn't completely accurate. It only considered the credit of the call side. By my calculation, the current maximum gain remaining in the trade is $296 while the downside risk is $145 leaving a potential profit of $151 if the DIA falls through the floor.

Update 10/2/2009

Wow! Be careful what you wish for... We had a nice sell off today and it's really helped my positions overall - although with this heavy of a sell off, I'm starting to shift to positive delta in my overall positions.

So, with the large pullback today, where does that leave this iron condor position (or what's left of it)? With DIA pulling back to $95 and change, I'm just over $1 away from hitting the point where this trade won't lose any more. I explained that in last week's update that I can still make $151 in profit on this trade even if DIA goes to $90.

However... one possible scenario is that DIA could sell off some more and that would allow me to close the call spread. Then, I have no more up side risk in the trade at all. My order is still in place to close that call spread for $.20. With the weekend coming up and and a little more selling, it shouldn't be too long before I can close that spread.

FYI - for technical analysts, we are at an interesting juncture. Today's selling cause the 30 day moving average to be broken on pretty much all the major averages and we are now close to the 50 day MA. This is coupled with an established lower high and lower low. I'm at a point of sifting my trading bias to be more bearish - at least for the near term.

Update 10/9/2009

Well, its certainly been an interesting week! Last week, we were down almost 5% from the highs, in fact DIA had completely penetrated the put side of this iron condor. Remember, two weeks ago, I put on a 1 contract put spread to hedge some risk that DIA would close above my call spread. 

iron condor trade

I closed the put spread of the initial iron condor just three or four days after opening the trade. Since then DIA (and the market in general) has been up, down and back up again. In all this time, the trade continues to gain in value, although I am again at risk of having my call spread over run. Next week makes the final week of trading so I will be closing the position Monday or Tuesday no matter what because that is one of my rules.

Update 10/13/2009 (closing trade)

I closed this trade first thing Tuesday morning and I'm really glad I did. Had I waited any longer, I would have been seriously overrun.

Yesterday began with weakness and so I took the opportunity to close my call spread on this trade. In addition, I closed the accompanying IWM put spread. Here is where this trade stands.

I closed the call spread for $.79.  A few weeks back, I closed the put spread for $.20 making the total cost to close the trade $.99. I received $.97 in credit to open the trade so I lost a few pennies on this iron condor trade. I initially sold 3 contracts so the total loss is $6. Since I risked a total of $309 (3 contracts * $1.03 margin * 100). That would make the loss as a percentage of my risk only 2%.

I want to conclude this trade analysis with a review of some of my thinking as I took this and other positions.

The market overall has shown itself to be stronger than I expected. I put this trade on the expectation that the market would remain in a range. That turned out to not be the case. I might have been tempted to exit the trade early at some point and of course in hindsight, that might have seemed an obvious decision.

However, we always are trading at the hard right edge where we actually have now assurance of what the market will do tomorrow. The only way to keep from being tossed around by the waves of market movement is to stand firm on the rules I've established. 

I do this because I size my position for a loss I am willing to tolerate if I'm completely wrong. For me, the worst case scenario is that I would lose around $306. I can tolerate that.

Consider that in an iron condor, we run the risk of being anxious if the market moves up too much or down too much - or we can simply respond to what we see at the moment. We can focus on what's going wrong (our calls being overrun) or we can focus on the good (our puts can now be closed for a target price). 

It's important not to allow ourselves to be whipped around by the market as it does what it does. When my calls were being overrun, my overall portfolio was showing negative delta (an indication that I would benefit more from a move down). So, I decided to put on a vertical spread trade that gave me more positive delta. That trade ended up making some money. If you combine the $6 loss of this trade with the gain of that trade, I made money overall.

That's the important thing to focus on. It's not about whether I win on every trade... it's about whether my portfolio equity shows steady growth.

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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