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Trade Tutorial - Iron Condor (12/03/2012)

Why another iron condor? Let's take a look the market environment and see why this kind of trade might make sense.

Iron condor trade setup

Sell SPY 147/145/138/137 iron condor
1. Exit if I can lock in 60% of my initial credit (i.e. $.42)
2. Exit if can close either side for 20% of the initial credit (i.e. $.21)
3. Exit if within 4-7 days of expiration
Credit $1.05


Why this strategy?

If you look at the above chart, you can see there has been a good size sell-off all the way to 68.1% fibonacci retracement from a past highs. This was followed by a strong bounce. As I mentioned in the last newsletter, I am expecting that this run up will take a pause and perhaps push a little higher. But I also believe there will be a lot of give and take between now and mid January when these options expire.

What kind of a trade takes advantage of a neutral outlook with a slightly longer timeframe? An Iron Condor makes a lot of sense. With the fluctuations up & down over the next few weeks, there is a high likelihood that both sides can be eventually closed at the target closing prices.

Choosing the right strike prices

For my iron condor strategy, I am usually looking for short strike prices on the call and put side that fall between 65-70 probability of expiring worthless.

Iron condor strike selection

As you can see, this corresponds to the $145 call and the $138 put. Notice though that there is a slight skew toward a higher probability on the call side. This is often the case as we don't usually get an ideal balance with equal probability of both put and call.

By the way, I'm selling $2 wide spreads on the call and put side, which means my absolute risk in the trade is $2 and I can do so for a net credit of $1.05 per contract.

Risk/Reward analysis

This trade is a little different than my typical vertical spread setup. First of all, with an iron condor, there is twice the credit. In fact with the credit being more than $1, the reward is actually greater than the risk. In fact, on the surface this appears that the reward/risk ratio is 110% (105/95). However, let's consider a few things.

First, I don't let the trade go all the way to expiration so the absolute reward & risk amounts don't reflect the nature of the trade. As a result, to more accurately calculate the reward/risk we need to look at the the expected reward. Since I'm planning to close the trade when I can lock in 60% of the credit, all this trade will make is $63. The absolute risk doesn't change so the calculated reward/risk ratio will be more like 66%.

That's a pretty decent return. The only requirement to success is that at the end of the day, the SPY must be between the two short strikes of $145 and $138. That's a $7 wide spread or $70 S&P points.

Position sizing

My unchanging rule in trading is to never risk more than 2% of my portfolio. The portfolio currently is worth $17,317. That means I can risk $346 in this trade and remain within my risk threshold. With a $346 risk tolerance and a risk per trade of $95, I can sell 3 contracts and remain within the risk threshold. What that means is that if I am planning to lock in $63 per contract, my target gain is $189.

Exit plan

With my iron condor trades, there are typically two target exits I look for. The first is to exit if I can close the entire trade and lock in 60% of the initial credit. However, it is rarely the case that you can close the entire trade at once. Instead, I attempt to close each side for 20% of the initial credit (total of 40%). Of course, I will also have a rule to close the trade when I get within 4-5 days of expiration.

To summarize, I will exit under the following conditions.

  1. I will exit the entire trade when I can do so for $.42 debit. That allows me to lock in the entire 60% of the initial credit.
  2. I will exit each side when I can do so for $.21.
  3. I will exit when approximately 4-5 days of expiration

Portfolio Impact

One would think that a neutral strategy like an iron condor would be a delta neutral trade. However, as I mentioned earlier, it is rare to be able pick a perfect entry where the position is absolutely neutral. In this case, there is a bias toward the call side. The negative delta means that the SPY would need to sell a bit to reach a more neutral point.

Iron condor portfolio impact

Notice the positive theta, which means that every passing day, the trade earns money as the underlying option value melts away. Also, notice the negative vega. This indicates the trade will benefit from a decrease in volatility. This also means that the trade can be harmed by an increase in volatility. It's important to realize this as it's the biggest risk in this trade and the overall portfolio.

Trade Update (12/19/2012)

With the buyers finally showing up in the market, it's no surprise that the put spread was able to close.

I'm getting this update out a little late but here it is. The trade closed as planned for the $.21 debit. That leaves the call spread still in play. However, I believe we're seeing the a bit of a pullback as the initial run starts to lose steam. That combined with time passing will help the other side of the trade.

What risk remains in this trade? There is still a chance that the pullback is only a pause before making a push to higher highs. That means we need to keep an eye what happens over the next week or so. I think the wisest course of action is to simply watch and close if we see a reversal.

Trade Update (12/31/2012) - Closing Update

I closed out the call side of this iron condor trade a little early. The reason is that it was becoming clear that the market was developing a bullish bias. Rather than risking too much of the profit I had already, I decided to close early.

Let's go over the details of the the trade and then I'll conclude with some thoughts. I sold the iron condor for a credit of $1.05. A few weeks later, I closed the put spread for a debit of $.21 as planned. Finally, I closed the call side of the spread for a debit of $.46. That leaves a net credit of $.38 per contract. I sold 3 contracts for a total net profit of $114. At the end of the day, I risked $.95 per contract for my final gain of $.38, which yields a return on risk of 40%.

That's not too bad of a profit or a return but it's quite a bit less than the target gain. So, why close the trade early rather than letting it run longer for a possibly better gain? Have you heard the phrase, "Close your losers and let your winners run"? That sounds good in principle and often makes sense. However, there are times when it makes sense to manage your winners to keep them winners. In this case, the weight of evidence was indicating a more bullish bias, which would have further ate away the profit that had been built up.

Truthfully, I should have closed even sooner but I wasn't convinced that the bullish move was for the longer term. At any rate, this last trade of 2112 is a winning trade at $114.

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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