Trade Tutorial - Iron Condor (10/5/2012)

I'm entering another iron condor trade. Why now? Why in market that appears bullish? The reason will be explained below. This may be a bit more of a riskier trade to the up side given the  bullish bias but I think we have more volatility ahead.

iron condor trade setup

Trade
Sell DIA 140/138/132/130 iron condor
ROI
86%
Exits
1. Exit if I can lock in 60% of my initial credit (i.e. $.38)
2. Exit if close either side of the spread for 20% of the credit (i.e. $.19)
3. Exit if within 4-7 days of expiration
Credit $.93

As usual, this is a $2 wide spread on each side but the width between short strikes is $6, which is equivalent to  600 DOW points.

Why this strategy?

It may seem odd to be taking a neutral trade like an iron condor in a bullish market but I'm thinking that we will be seeing more turbulence ahead. The elections here in the US will be in about a month's time and the market is likely to be highly news driven. As a result, I wouldn't be surprised to see the market push up and poke it's head above the highs before falling back to the 30 day moving average again.

All of that is meant to be my rationale for why I'm taking a neutral trade in a bullish trend. That said, I'm not entering into this trade without a backup plan. I will likely enter an adjustment if we see more strength than I'm expecting.

Choosing the right strike prices

I'm looking for strikes that have an approximate probability of expiring OTM by about 65-70%. Ideally I would prefer something with a little lower probability of expiring. This would give me a lower probability of success but a higher reward potentially. However, given the unknowns going forward it seems better to be more conservative.

iron condor strike selection

This leaves me with a short $138 call and a short $132 put as my short strikes. That's a wide enough spread to give the DIA some room to move either way. Since I'm trading a $2 wide spread on each side, that means my long options are the $140 call and the $130 put. This trade is entered for a $.93 credit. Not the typical $1 I like to see but given the more conservative nature of the trade, it's not surprising.

Risk/Reward analysis

I like to perform the analysis the iron condor trade a couple of different ways. First, let's look at the overall reward/risk ratio or return on risk. Since I entered the trade for a credit of $.93, my absolute risk in the trade is $1.07. That means my reward/risk ratio is about 87%.

That assumes I hold the trade all the way until expiration let all options expire worthless. However, as followers of my trade tutorials know, I close the iron condor trades when I can lock in 60% of the initial credit. This allows me to get out of the trade sooner and improve my overall success rate. In doing so though my return on risk drops some. Since I'll only be keeping about $.55 of the original credit, my return on risk is actually more like 51%.

iron condor analysis

The graph above shows the analysis of my trade but again assumes that I'll be holding the trade until expiration. In this scenario, the probability that the DIA will reach expiration weekend being between the two break even prices is about 51.8%. That's better than a 50% chance but not by much. Exiting early improves the chance of success because I'm not holding out for the full credit.

Position sizing

We've already discovered that the risk in this trade is about $1.07 or $107 total per contract. As in every trade I enter, I want to make sure my risk is limited to 2% of my trading portfolio. At this moment the balance sits at $17,643, which means I can risk $352 in this trade. With a risk per contract of $107, I can sell 3 contracts and remain within my risk threshold.

That means my total credit will be $279 but since I'm targeting to lock in $55 per contract, my actual projected gain will be $165.

Exit plan

I don't have many rules for my iron condor trades. The main rule focuses on closing the trade to lock in 60% of the credit. This can be done one of two ways. One is to simply close the entire trade for a debit of $38 per contract. This isn't very likely though. The more likely scenario will be that the DIA moves in one direction allowing the opposite side to be closed for 20% of the initial credit. If I can do that for both sides as the market is moving up & down, then I'll pay a total of 40% of the initial credit leaving my target 60% as gains.

That said, there is a higher than usual risk that the DIA will act more bullishly then expected so it is also worth having a contingency plan in place. I'll be looking at a couple of different strategies to adjust this trade if we see the DIA pushing to newer highs.

To summarize my current exit plan, I will exit under the following conditions.

  1. I will exit when it costs $.38 to close - This will allow me to lock in 60% of the initial credit and get out of the trade sooner.
  2. I will exit when I can do so for $.19 - This represents 20% of the initial credit and doing this for both sides still leaves me with 60% of the initial credit.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

The iron condor strategy is theoretically a neutral strategy. However, it's rarely the case that it is 100% balanced. As a result, the delta will often reflect a bias one way or the other by just a little.

iron condor portfolio impact

As the portfolio greeks above show, this trade would like to see a bit of a downward move. That said, since we're currently between the short strikes, all we need to do is sit back and let the market move sideways while the trade gains in value. Time will pass and we will get closer to expiration. At this point, theta will increase indicating that more premium value is melting away.

Update 10/11/2012

The selling has turned out to be fortunate for the call side of the iron condor. As per my trading rules above, I closed the calls at the target debit.

With the call spread closed, that leaves us with a put spread. Now, the market has done a fair share of selling so there is now a risk that the put spread will be overrun if the selling continues. What can be done about that?

One option is to simply close the put spread altogether. However, there might be a chance to put a little protection in place to minimize the risk. Any thoughts as to an adjustment strategy for this spread? For a hint, take a look back at the newsletter from a few months back on adjustment strategies. Or... stay tuned for a potential adjustment this week.

Update 10/19/2012

It looked for a while like the market was going to rally and cause the put spread (the remaining part of this iron condor) to reach the target closing price. However, yesterday and today's selling has changed that perspective.

I asked last update what possible adjustment strategies might be employed.  One option would of course be to close the trade for a small total profit. I decided instead to use a put calendar spread just to illustrate how to do the analysis and manage the trade.

What I did was go to the Analyze tab on the thinkorswim platform and look at my existing DIA position. By itself, it has the typical P&L (or risk profile) of a put vertical spread. The break even point would be around $131.64 and maximum loss would be realized at $130 (assuming we let the trade to to expiration).

Iron condor trade adjustment

By adding a calendar spread right between the two strikes (at $131), the risk graph changes quite a lot. Check out the above graph. The calendar spread introduces two side effects to this trade. One is that it moves the break even down to about $130.76 (almost $1) and the other is that a sweet spot is created where profit is maximized IF the DIA ended up near $132 by expiration week.

This is a 2 contract calendar spread put on for $1.11. That means I'm adding a $2.22 risk to my portfolio as part of this adjustment. Let's see what happens over the next week or so to see if this will provide some protection for the position.

Update 11/12/2012

I finally closed out the put side of this trade as well as the calendar spread adjustment; Unfortunately, I had to do so at a loss overall.

Let's look at how the trade worked out. First of all, I entered the initial iron condor for a credit of $.93. I closed the the call side of the spread for $.19 debit and had to close the put side of the trade for a debit of $1.92. That's a net loss of $1.18 per contract and a total loss of $354.

I also entered a calendar spread as an adjustment. This calendar spread was placed right between the short and long strikes of the put side of the spread. I entered the spread for a debit of $1.11 and closed the spread for a credit of $1.25 for a net profit of $.14 per contract or a total gain of $28. That makes my net loss in the total trade just slightly less at $326.

You might say 'ouch' on this trade. However, I did initially size this position to sustain a 2% overall portfolio loss. While the the loss was a little painful, it didn't significantly hurt the portfolio balance.

You might also observe that the adjustment didn't seem to help as much as expected. Notice that at the point of closing the trade that the underlying (DIA) fell below the $131 strike price that I sold the calendar at. That means the short strike was several dollars in the money at the point I closed it. The problem with a calendar spread is that it stands to make the most profit if the short strike expires with the underlying exactly at the short strike price. Any deviation either side of this price and the trade becomes much less profitable to even losing money as it nears expiration.

While a calendar spread can make a nice adjustment strategy, it does potentially add additional risk in the trade. In this case, the trade was profitable but it just wasn't profitable enough to overcome the loss on the put side of the iron condor trade.

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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