Trading Iron Condors, Part II

by John Jagerson | May 15, 2009 1:52 am

This article is brought to you by LearningMarkets.com[1].

See Part I of the Trading Iron Condors[2] series.

An iron condor[3] can be designed to accommodate your risk tolerance and account objectives, but those adjustments will always have a trade-off.

As with most option selling[4] strategies, this means there is an exchange of a higher probability of a successful outcome and lower premiums, or higher risk and larger premiums.

Most iron condor traders opt for a fairly wide spread between the two short strikes to increase the probability that the underlying exchange-traded fund (ETF)[5] won’t close at expiration beyond those prices. This obviously reduces the premium paid and should not be taken to extremes.

How far apart those short strikes “should” be is a difficult question to answer.

As with trading any stock or option strategy[6], the answer probably depends on your personal risk tolerance. Getting to know what kind of risk you can tolerate within a trade like this requires some experimentation and paper trading[7].

We have spent a fair amount of time talking about the trade-off between probability and premiums so that you will understand the importance of appropriate expectations. Managing risk is a function of position size, as well as the choice of strike prices[8]. Getting into a position that is too large for your peace of mind can be a disaster.

Position sizing for an iron condor is relatively simple because the maximum loss is known in advance.

You can consistently size your iron condor trades by allocating a consistent percentage of the portfolio available for these strategies per trade.

In the example we used in the first article[9], we knew that the max loss was $1.04 per share, or $104 per iron condor. If we assume that we are willing to risk 5% of a $5,000 portfolio, then we can use that maximum risk amount to calculate the appropriate position size as two spreads.

1. $5,000 (capital) x 5% (maximum acceptable loss) = $250 (available capital per trade)
2. $250 / $104 = 2 spreads

Being consistent in your position sizing is important and varies based on what strategy you are using and you personal preference. A bad trade can be emotionally trying, but you can minimize those issues by understanding the risk in the trade and staying with small position sizes. (Learn more about position sizes[10].)

In the next part of this series[11], I will cover the rules of thumb for how and when to adjust an iron condor when the trade moves against you.

Endnotes:
  1. LearningMarkets.com: http://www.learningmarkets.com/
  2. Trading Iron Condors: http://www.optionszone.com/learn-more/john-jagerson/trading-iron-condors-part-1.html
  3. iron condor: http://www.optionszone.com/learn-more/josip-causic/2009/01/flying-high-with-iron-condors.html
  4. option selling: http://www.optionszone.com/learn-more/jim-woods/put-writing-and-call-writing-explained.html
  5. exchange-traded fund (ETF): http://www.optionszone.com/learn-more/bryan-perry/gallery/5_etf_advantages.html
  6. option strategy: http://www.optionszone.com/profit-with-options/options-strategies/
  7. paper trading: http://www.optionszone.com/broker-center/education/paper-trading-practice-makes-perfect.html
  8. strike prices: http://www.optionszone.com/learn-more/john-jagerson/2008/12/strike-the-right-position.html
  9. first article: http://www.optionszone.com/learn-more/john-jagerson/trading-iron-condors-part-1.html
  10. position sizes: http://www.learningmarkets.com/index.php/200904081890/Forex/Forex-Portfolio-Management/position-sizing-for-forex-traders.html
  11. next part of this series: http://www.optionszone.com/learn-more/john-jagerson/trading-iron-condors-part-3.html

Source URL: http://investorplace.com/2009/05/trading-iron-condors-part-2/
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