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Trade Tutorial - Iron Condor (10/10/2011)

I'm getting this iron condor trade tutorial up a little late considering I entered the trade over a week ago.

iron condor trade setup

Sell SPY 125/123/113/111 iron condor
1. Exit if I can lock in 80% of my initial credit (i.e. $.05)
2. Exit if cost to close >= twice initial credit (i.e. $1.15)
3. Exit if within 4-7 days of expiration
Credit $1.25

Why this strategy?

This market has been rather crazy over the last few months. I seems like we may continue to see a lot of up and down action, which is perfect for a more neutral trake like an iron condor. Like the vertical spread, this is a fairly short term trade. I expect the trade to develop in about 2-4 weeks.

The nice thing about this trade is that there is a window of profit that exists between the two short strikes. With the volatility where it is, this window of profit is $10 wide. That equates to about $100 S&P points. Of course with the market volatility where it is, that's only about 3-4 days of market action. 

Choosing the right strike prices

My trading rules for the iron condor call for selecting short strikes for both the call and put having a probability of expiring (ITM) of around 35%. There are of course other strategies that might call for more agressive (closer in) strikes or more conservative (farther out) strikes.

iron condor strike selection

In the case of this trade, that means the $113 put and the $123 call ($10 wide window of profit). I'm trading spreads that are $2 wide on each side so that means I'll by a $111 put and a $125 call to provide a defined risk trade. In this case, the worst case scenario is I could only lose $2 (the spread can only expire fully through the call spread or fully through the put spread). Since I'm receiving a credit on the trade of about $1.25, then my risk is actually the $2 wide spread minus the credit (leaving $.75 risk per contract)

Risk/Reward analysis

With a reward of $1.25 and a risk of $.75, my Reward/Risk ratio is 166%. On the surface, this seems like a really awesome reward/risk ratio. However, reward/risk doesn't equal high probability of success. In fact the below risk graph shows the probability of success of only 36%.

iron condor P&L graph

The basic priciple to keep in mind is that whenever you have a high potential return, the probability of success will be lower. The higher the probability of succes, the lower the return. 

One way to improve the probability of success is to close the trade a little earlier, locking in a profit that is less than the max target profit on this trade. One of my exit strategies in with the iron conor strategy is to close when I can lock in 60% of the initial credit. In this case, that would be $75. Now, I have an absolute risk of $75 and a target profit of $75. That makes a reward/risk ratio of 100%.

Position sizing

As followers of these tutorials know I limit the risk of every trade I make to just 2% of my portfolio. My current portfolio stands at around $17,000. 2% of my portfolio is about 340. With a risk per contract of $75, I could theoretically sell 4 contracts and remain within my risk threshold.

Exit plan

I mentioned earlier that I intend to close this trade early to lock in 60% of my initial credit of $1.25. One way to do this is to close each side of the trade (puts or calls) for 20% of my iniitial credit (for a total of 40%). 

  1. I will exit the entire trade when I can lock in 60% of my initial trade. That means I will close when it cost $.50.
  2. I will close each side of the trade when I can do so for 20% of the initial credit. That means I close when I can do so for $.25 debit.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

Theoretically, an iron condor trade is a neutral trade. However, this trade started out with a slight bearish skew to it. This is indicated by the slight negative delta. We need to monitor this trade as a further bullish move will cause the delta to become even more negative.

Iron condor portfolio impact

Notice also that this trade currently has a positive theta - as do almost all my trades. I like trades that will earn money even when the market goes nowhere.

Trade Update 10/21/2011

With the market showing a strong bullish move, I've decided to make a few adjustments. First of all, rather than closing the put side as I said I would at $.25 debit, I let the put side premium melt off a little more and ended up closing for $.09.

Second of all, I am buying a call calendar spread above the two call options left from the call side of the iron condor. This will help decrease the potential loss to some extent and also potentially add a nice profit bump right around the iron condor's short call strike price. That means my ideal outcome is to have the underlying expire right below $123.

iron condor trade adjustment

The other benefit as illustrated by the analysis graph above is how it pushes out the potential loss point and in fact creates another slight reversal of loss as the underlying passes by $126, which is the calendar's strike price.

Going forward, I may simply close out the call spread while the loss is minimal and leave the calendar spread in place. This will have the effect of actually shifting my ideal outcome for the underlying up to $126, which may be in keeping with a more bullish outlook.

Update 11/07/2011

I have now closed the call side of the original iron condor trade leaving only the calendar spread adjustment in place. The goal of the original adjustment was to limit my loss to the up side. By closing the original trade, the trade as a whole may do slightly better.

I'm now left with the single contract calendar spread, which is not only starting to widen out (gain in value) as we head into the last week of trading but is also becoming more profitable as the underlying heads toward the $126 strike price. As of this writing, the trade as a whole is slightly profitable. If the SPY continues to move up another $1 or so and a day or two passes by, this trade could end up showing a nice little profit.

Update 11/16/2011 (Closing update)

So, I'm now officially out of this trade completely. What had the potential to be an ugly trade with a loss turned out to be a winner.

I've already discussed the fact that I've closed out of the original iron condor. I closed out for a net loss on the original trade but had a net gain on the adjustment. Let's take a look at how this breaks down.

I entered the iron condor for a credit of $1.25. I closed the put side of the spread for $.09 debit and the call side for $1.37. That makes a net loss of $.21 per contract (times 4 contracts), for a total loss of $84. However, I entered the calendar spread for an initial debit of $1.29 and closed the calendar spread today for a credit of $2.49 for a net profit of $1.20. Since I only bought one contract of the calendar spread, my net gain there is $120. The total net gain of the trade then is $36.

That's not bad for a trade that didn't exactly work out as expected. The reason this trade worked out as it did was for two reasons.

  1. I didn't close the put spread as planned (when I could have done so for $.25 debit. I chose to disregard that rule because of the strength I was seeing in the underlying SPY. I offset the risk of having my calls overrun by letting my puts remain and deplete more of the premium there.
  2. I added a calendar spread adjustment. As it turned out, I came pretty close to hitting the short strike dead center with just 3 days until expiration. As a result, the spread widened out perfectly and the gains there offset the minor loss in the iron condor.

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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