Trading Iron Condors, Part III

Learn how and when to adjust an iron condor when the trade moves against you

   

This article is brought to you by LearningMarkets.com.

Iron condors are relatively straightforward in the pre-trade analysis and order entry process. It is a high-cost strategy to trade, so most options-centered brokers have made it easy for traders to execute. (Learn 7 Reasons You Need a Broker Who Specializes in Options.)

The difficulty of an iron condor is in the trade management and adjustment process. Effectively managing an iron condor trade when the market is moving is ambiguous and subject to your own personal risk tolerance.

Iron condors are typically entered with a very high risk/reward ratio and a very high win/loss ratio. That means that if you set each trade and left them alone through expiration, you would probably be right much more often than you are wrong; however, when you are wrong, the losers are much bigger than the winners.

See Part I of the Trading Iron Condors series.In the example that I used in the prior two articles, I had a risk/reward ratio of nearly 1:1. However the short strikes were very close together, and based on prior experience, I would expect to be wrong frequently.

See Part II of the Trading Iron Condors series.

You may choose to move the short strikes much further away from the current index price to increase the win/loss ratio, but remember that this will also increase your risk/reward ratio. When the short strikes are moved very far away from each other, the risk/reward ratio increases against the trader.

If you were to look at the iron condor orders currently working on the SPDR S&P 500 (SPY) for June expiration, there are more traders trading with risk/reward ratios in the 2:1 or 3:1 range than in the 1:1 region.

This tendency to take on more risk and less reward in order to increase the win/loss ratio is common; however, this kind of exposure makes adjustments to the trade very difficult.

5 Rules for Adjusting Iron Condor Trades

There are many rules of thumb for how and when to adjust an iron condor, but there isn’t a “rule set” that can be reliably applied to all markets. However, there are a few concepts that you should keep in mind as you evaluate an adjustment when the trade moves against you.

1. The probability of expiring is not the same as probability of touching.

When you execute an iron condor, you may evaluate the short strikes’ deltas or other estimates to place a probability on whether the trade will expire inside the short strike range (win) or beyond them (loss). (Learn more about how delta affects your trades.)

This probability of expiring within that range is not the same as the probability of the stock’s price touching or passing those short strikes, and then pulling back before expiration.

It is far more likely that, at some point during the trade, prices will touch or pass one of the short strikes temporarily before expiration, than that prices will actually expire beyond those strikes. These fake-outs or whipsaws will make an iron condor trader very nervous and can motivate over-trading behavior. It is best to make sure you are using a small enough trade size that these “touches” do not affect you emotionally.

2. Be careful when adjusting a trade by entering a new spread.

There is nothing wrong with exiting a losing iron condor and reentering with more time before expiration; or with a tighter spread between the short strikes; or with a larger trade size in order to offset losses. But those actions should be carefully evaluated.

In fact, most experienced iron condor traders will recommend that a new trade should only be entered if it looks like a good opportunity on its own. Only enter a new spread if you would have wanted to trade that new spread anyway.

3. If the loss is unacceptable, plan to exit.

Many option sellers already have a predetermined maximum loss that they are willing to endure. If losses are mounting, know when you want to get out and be ready to take action.

Iron condor traders with a very large risk/reward ratio may be surprised to find several months of profits eliminated by one trade that they let reach their maximum loss level. This account volatility can be difficult to come back from.

4. Option pricing changes over time.

There is a lot of variability in option pricing, so it can be very difficult, if not impossible, to transpose rules that work today into the future. (Learn more about options pricing.)

For example, in 2008 and 2009, option premiums were and are high, so the spread widths can be very wide. That was not the case in 2005, when premiums were lower. This means that your analysis has to be flexible in order to make sure you are accounting for current prices.

5. Don’t believe the hype.

Lastly, keep in mind that there are a lot of “advisers” seeking to help you enter, adjust and exit these trades on a monthly basis. The promise of 10% monthly returns is common. These are scams. (Learn how to avoid trading scams.)

There are legitimate sources for help with these kinds of strategies, and they are typically registered as actual investment advisers and will not make these too-good-to-be-true promises. If you need help to get started, check them out and follow their picks for a while as you get the hang of this option selling strategy.


Article printed from InvestorPlace Media, http://investorplace.com/2009/06/trading-iron-condors-part-3/.

©2014 InvestorPlace Media, LLC

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