Spread Trading

Hello Mark, and thank you for your kind help.

I would be grateful if you could answer a few follow-up questions.

1a. I am intrigued by the concept of bull put spreads – thank you for bringing them to my attention. Since you seem to prefer them over bull call spreads, could you briefly explain why? Is it just because in the case of the former time decay works in one’s favor and that profits can be retained even if the stock stays steady, or is there something more to them?

I do not prefer selling put spreads to buying call spreads BECAUSE they are equivalent. It makes no difference which you trade. Each spread has the same time decay. The spreads are essentially identical, even though they appear to be different. When you are ready, take this lesson: Equivalent positions.

Understand that some traders are more comfortable collecting cash when entering into the trade and then they can (when it works) watch the spread value decline towards zero. Others are more comfortable buying spread because they know the cash [paid represents the maximum possible loss and they will never have to pay an money to get out of the position. NOTE: The maximum possible loss when selling the put spread is identical, but some are more comfortable when the cash has been paid upfront. It is all psychological and truly makes no difference.

If you are a new option trader (as your questions suggest), then choose the trade that you want to make. If looking at the trade from the buyer's perspective makes you more comfortable, then buy the spread. As you gain experience, you will come to recognize that it really does not matter whether you buy a call spread or sell a put spread as long as one thing is true: The options must have the same strike prices and expiration date. That is iron clad. Change anything and the positions are no longer identical.

1b. Would you say that the optimal way of specifying the strike prices of the relevant puts is to make the strike price of the short one correspond to the level we believe the stock can reach and the strike price of the long one to a point somewhat below the nearest major support level?

No. Let's be honest: Neither you nor I know where the stock price is headed. More importantly, your goal is to make money -- it is not to be exactly correct on your predictions.

If a stock is priced at $100, you may want to buy the $100/105 or $100/110 call spread [or SELL the $100/105 or $100/110 put spread]. These should earn a profit when the stock rallies, but will lose money if the stock price does not budge, or when it rallies by ~$1. That’s not good enough for me. I want to make money even when I am not as correct as i expected to be.

Therefore, I’d prefer to buy the $95 calls and sell the $100 calls (or buy the $95 puts and sell the $100 puts). Noe I make money even when the stock does not rally. That’s good – but there must be a downside to making this trade — and there is. If the stock price tumbles, the $95/100 trade will lose more money than the $100/105 trade [If you do not know why, then I recommend starting your option education at the beginning and not try to jump in at this level.] Sure, you want to avoid the larger loss, but if you have any confidence that the stock price will increase, then you ought to have even more confidence that the stock price will not move lower.

Choosing the specific spread to trade is important — but please: it has nothing to do with your predictions unless you have a wonderful track record of successful predictions. One trade risks losing more, but comes with a higher probability of success. The other comes with the chance to earn more money, but with a lower probability of success. Choose whichever spread appeals to you more. You are the mast of your own risk-tolerance universe.

1c. Would you say that it is worthwhile to close out a bull spread (be it call or put) as soon as the predicted upper price level is reached, regardless of how far away one is from expiration?

I think you know the answer. If the stock rallies and reaches your target price, then you clearly do not expect it to move higher. So, why would you want to own a bull spread when you do not expect the stock to move higher? Yes, exit. Expiration has nothing to do with this decision.

I note that you said “upper price level” and not your target price.

If your question is really this: “I buy call spreads. Should I exit as soon as the stock hits the upper strike price?”

Then my answer is: “NO.” If you make a trade and have a profit target for your spread in mind (rather than a price target for the stock), then exit when you earn the profit. It does not matter what the stock price is. You will not want to choose the strike prices such that you expect “the upper level” to be reached. You should pick spreads than you believe will make money. That is the primary goal for a trader. You must remember that if you expect the stock to rise from 75 to 85, do not buy the $80/85 call spread. If the stock rallies, but only gets to 79 or 80, you must own a spread that earns a profit.

1d. Am I right in thinking that the margin requirements for any given bull spread (be it call or put) essentially correspond to the amount of cash one has to put up when assigned, so, for instance, if one sold 2 contracts with the strike price of 40, then the required margin is $8000?

NO. When you buy a spread, there is zero margin. You just pay for the spread. When you sell a credit spread, the margin represents the maximum possible value for the spread, but you can use the cash collected to meet some of that margin requirement. If you sell a naked put option, that is where the Reg T margin requirement is essentially the cash required of assigned an exercise notice. But it is reduced by other considerations, including how far OTM the strike price is.

2. You said “If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options.” Am I right in thinking that what you mean is that you are happy with committing more of your portfolio to option positions provided that they are tied up with non-directional strategies?

Yes. When my positions are much less risky than owning calls, and when they are hedged, I am willing to place more money into option positions. But please note: That is my personal comfort zone and it is NOT a recommendation for anyone else.

3. And, finally, one very different question – are you aware of any free software/website that displays not only unusual options activity, but also shows the list of biggest daily transactions and indicates whether the options involved were bought at the ask or sold at the bid? I know that thinkorswim offers this function, but apparently you need a TDAmeritrade account to use their software, and since I’m not US-based, I don’t think that I can access it.

No, I do not. Nor do I like the idea of using that information. It is 100% useless to you. Yes, 100% useless. So what if you know that someone buys 10,000 calls for a given stock? What does that tell you? It does not tell you whether this is a new position of if the buyer is covering a short position. It does not even tell you whether the trader is making a bullish play because there may be another part of the transaction that you cannot see. For example, if he buys 10,000 ATM calls and sells short 500,000 shares, then he owns a market-neutral position equivalent to owning 500,000 straddles. And if he sells short 1,000,000 shares, then he essentially bought 10,000 puts but to the casual observer it loos as if he bought 10,0000 calls.

One more point, even if you do know whether this big buyer is bullish or bearish, or neutral, what do you know about his track record as a call buyer? Nothing. Acting on this type of information is foolish.

Once again, thank you for your time – I really learn a lot from you and greatly appreciate your expert help.
Best wishes,
Jakub

My pleasure.

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Option Owner’s Perspective

As long time readers know, I prefer selling option premium to owning it. But that is not for everyone. Today I respond to questions from a trader who typically owns options.

Hello Mark,

I would be grateful if you could share your experience and answer a few general questions for me:

1) Do you see any benefits of using long calls rather than bull call spreads if one uses sell limit orders, thus capping one’s upside from the outset anyway?

2) When swing trading with the use of monthly options, would you normally recommend closing one’s positions no later than on Friday preceding the expiration week, or do you sometimes see some merit in holding them into the expiration week?

3) When one does not intend to hold one’s position into earnings but wants to capitalize on the pre-earnings volatility rise, do you – other things being equal – recommend closing one’s positions immediately prior to earnings or a few days earlier? Does your experience suggest that there is some general rule as to when volatility rises the most?

4) What, in your opinion, is the maximum percent of one’s portfolio that can be safely committed to options positions? Is it around 15-20% or more/less?

Thank you in advance for your help.
BK

Hello BK,

1) When comparing the strategies of owning calls (with the potential for unlimited gains) vs. owning call spreads (with a higher win/loss ratio and reduced cost — but with limited gains) in my opinion the most important factor is your expectations for the trade. Obviously if you expect to see a huge price increase in the underlying asset, you will buy calls and not spreads. [Caution: Sometimes the stock moves far less than expected, so please do not buy out-of-the-money calls.] If you anticipate the stock price to increase, but you do not have any idea how far, then you want the lower-cost position as well as the position that is more likely to provide a profit. That means buying the call spread. Remember that the call spread can return a profit even when the stock price is unchanged (assuming you buy an ITM option and sell an ATM or OTM).

To answer your specific question: Yes, there are small advantages to owning calls in the scenario you describe. If you want to exit the trade and take your profit (at your limit price), you may be dissatisfied with how much you can collect when selling the call spread. In other words, you may not be able to exit without accepting less than you think the spread is worth. That is always a risk when trading spreads. It is always easier to sell your single call option when it reaches your target price.

However, I still prefer spreads. I must ask this: How good is your track record? If you are skilled at picking stock direction and if you are skilled at timing the trade, then you have a huge edge over almost everyone else. With that skill-set, you can afford to buy single options. However,it is most likely you don’t have an outstanding record and that translates into trading positions that give you the best chance of earning a profit. That is the call spread. [Side note: You may prefer to sell put spreads instead. If you are not familiar with this concept, you can read about it and decide later. When the strike prices and expiration date are identical, selling put spreads is an equivalent strategy and produces the same profit/loss as buying the call spread.

2) Swing trading is for traders with a specific price target in mind for the underlying stock. Let’s assume that you own calls and want to continue to own calls as expiration nears.Then the true way to look at this problem is: How much does it cost to roll the position out to the next month. In other words, what does it cost to buy the same strike (as you own now) calendar spread? You know that your long option is going to decay rapidly over the final week, unless your stock QUICKLY performs as expected. So most of the time it is better to buy the calendar spread now than it will be to buy it next week. Unless you get the price change needed. I prefer to roll in this situation, knowing that the timing of my expected rally is unknown. The swing trader has a price target but not a time target. Thus, you do not know when the stock will move to your target. That means it provides a better average result — over the longer term — to roll as necessary to minimize the cost of owning options. If you accept that opinion, then Friday, one week prior to expiration is about as long as you should hold the current position.

3) Immediately prior. Although not all stocks act the same, the vast majority of options show a rising volatility on the last day of trading – prior to the news announcement. That is not 100% true, but as a general rule, I would sell options on that last day. HOWEVER: Do not get blinded. If the price increases and you can lock in target profit earlier than that date, take your gains because it does not pay to get greedy.

4) That must vary from trader to trader. If you are only going to buy options (or option spreads), then 10% of your portfolio is far too much in my opinion. But that is because I do not like the idea of predicting the market by buying options. If you are skilled — if you make money via this strategy — and here is a tough one: if you are really a good predictor rather than being a trader who is making money just because it is a bull market — then by all mans, you can afford to invest more than 10%. But understand that bull markets end and if you have little or no experience with buying puts and put spreads, then by definition you will enter hard times if and when this bull market ever comes to an end. Please consider that. I have seen too many traders ride for years with a single strategy, only to lose a ton of money when the market behaved differently.

Good questions.

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How Should a Beginner Approach Option Trading?

The following question seems rather tame, but it addresses a very important issue:

Is there a correct syllabus for new option traders?

Hello Mark,

I’ve just starting to read your Rookie’s Guide book, bought from Amazon. I also read several other options books, while doing my paper trading with OptionXpress with thinkorswim platform.

I also have joined an options course and what they teach are very basic, which is just Buy To Open (Call / Put) and Sell To Close (Call / Put) and pay attention to the candlestick chart for entry point. So making profit from that simple strategy. What do you think of that strategy? They didn’t teach any strategies mentioned on many options books.

Candlestick Charting

Candlestick Charting

But after reading couple of books on options, they all teach the Covered Calls as basic strategy, which from my understanding that one investor has to have real stocks in order to make the options trading. Do I need to buy real stocks? Is that true?

How about if we only open an options account, and didn’t have a real stocks to trade in that Covered Calls strategy? And why I can’t trade the Covered Calls in optionsXpress? Please help me.

Thanks in advance,
Aldo Omar

Paper trading is an excellent idea. It teaches you how to handle your broker’s platform and it gives you experience learning to make critical decisions — entering and exiting positions.

However, this course is a disgrace, in opinion. I do not care how respectable the course giver is, but these lessons are almost guaranteed to see their students go broke when using options. Unless they explain that the course is designed only to teach you something about options and that “buying to open and then selling to close” is NOT a strategy that you ever want to adopt, they are doing you a great disservice. I hope this course is free because it is not worth even that much.

  • First; A trader, and especially a new trader, cannot be expected to know how to use Candlestick charts. It is extremely difficult to “pay attention to” charts and come away with useful information. Think of this way: Candlestick charting is well-known and used my millions of traders around the world. Despite that, the data is clear: The average individual investor does worse than the S&P 500 index. The average mutual fund manager — someone who ears big bucks to pick winning stocks and beat the market averages — cannot beat the averages. Do not get trapped into believing that you can read one or two books on charting and know how to sue the charts. My conclusion is that it is far more difficult to pick entry points than your course teachers suggest.
  • Second; You are learning the simplest of all strategies, and that is a good thing because one should begin with the most basic concepts of options. However, it should have been mentioned as often as possible that buying to open and then selling to close is a death wish. Unless you (A. O.) have a proven track record of predicting which stocks will rise and fall, then you must not — for your financial well being — believe that you can suddenly start trading options and become a successful stock picker. Life does not work that way and using Candlesticks will not turn you into a successful stock picker. The professionals cannot predict stock direction on any consistent basis, and neither can you
  • Third; Even if you work diligently and learn to read the charts successfully, there is more to “buy to open” than simply picking a stock and correctly forecasting the direction of the stock price. Did they teach you that buying out-of-the-money options is not a viable strategy? Did they teach you to pay attention to the implied volatility of the options? In fact, did you learn anything at all about volatility and how crucial it is to an option trader? I assure you of this: If you but out-of-the money options and if you buy them when their prices are relatively high, you will ruin your trading account, even when you get the stock direction right. My advice: If you are going to play the “buy to open” game, at least stick with options that are already several points in the money when you buy them.
  • Fourth; I know that advanced strategies cannot be dumped into the lap of a beginner. Building a sound foundation in option basics comes first. But that is no reason to teach a strategy where the vast majority are guaranteed to fail.
  • Fifth; Yes, covered call writing is a sound basic strategy and yes, it does involve the purchase of stock (in multiples of 100 shares). However, it is still a bullish strategy and the covered call writer can still lose a lot of money if the market takes a dive. Obviously you lack the cash to buy stock. That is okay because there are other ways to use options to generate exactly the same profit/loss profile as writing covered calls. You will get to that in Chapters 13 and 14 in the book that you are reading (The Rookie’s Guide to Options; 2nd edition).
  • Last; The whole idea about using options is to hedge (reduce) risk and still give yourself a good probability of earning a profit on any given trade. Buying options based on Candlestick chart reading is not one of the paths to success. Sure some people can do it, but you don’t want to count on being one of them. Covered call writing is “better” for the new trader – but only when he can afford the downside risk. However, there are other strategies that I would recommend for you. At the top of the list is “credit spreads.” But please have patience. Don’t jump to the chapters on this and related strategies. Go through the lessons at your own pace and if possible, resist the temptation to trade until you feel comfortable.

Aldo,
I hate that course and the sad fact is that this is popular stuff taught by many people.

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Q & A. Weekly’s Put Spreads and Straddles

Two ideas from a reader.

Mark,
I think vertical spreads (bullish put spreads )would be the way to go. Especially on the Weeklys. Find a stock or etf that barley moves, and make sure u sell the profitable side before expiration, and let the loosing side expire… It’s a no brainer for streaming income…

OR buy straddles or strangles during earning season, and only buy highly volatile stocks…same as above.. Close out the winning side and let the other expire worthless.. Better chance using these strategies to make $ than many other strategies .

Bill

Hi Bill,

I agree that vertical credit spreads represent an excellent opportunity to make money with limited risk — as long as position size is appropriate.

However, reality is not quite as simple as you describe it. For one thing, it is difficult for the inexperienced trader to earn income as a straddle buyer.

Vertical spreads

  • Weeklys options tend to be low priced, and that makes the available premium small.
  • If you use stocks or ETFs that “barely move” then the option premium will reflect the non-volatility of these stocks. Translation: very small premium with very little profit potential. We each have out own idea of how much credit to accept for a 5- or 10-point spread, but I do not like the idea of accepting only $0.05 or $0.10, even though the odds of having a winning trade are high.
  • “Close out the winning side” and allow the other to expire worthless is not viable, in my opinion.
    1. When selling credit spreads, the usual practice is to sell OTM options — with the hope that all options will expire worthless. Thus, there is seldom a “winning side.” And when there is, the other side will not be too far out of the money and carrying it naked short is far too risky.
    2. Selling one side leaves the trader with a naked short position. Although a reasonable strategy for the experienced trader, I strongly discourage newer traders from owning naked short positions. When the option is a call, most brokers will not allow their customers to own such positions because (in theory) the potential loss is unlimited.
    3. I like the idea of no-brainer strategies as much as anyone, but in the trading world, these strategies rarely occur and most fall under the umbrella of “arbitrage.” For me, this plan has a small possibility of causing a giant loss (after selling your long option), and that takes it out of the no-brainer category.
  • When trading Weeklys, instead of adopting your suggested approach, I’d prefer selling the options naked in the first place, rather than buy the spread and then sell the long option 2-3 days later. I’m not recommending this plan, but if position size is small, it should work better – especially when the premium for a spread is so little.

Straddles

Buying straddles in earnings season is a high-risk play. It can work, and one advisor whom I know has done very nicely with this strategy. But it is mandatory to do your homework. The timing of the purchase (never at the close of trading when earnings will be announced prior to the next day’s opening) matters. Some stocks lend themselves to the straddle play better than others. Again do your homework.

It is very acceptable to sell the winning side, but in my opinion, that sale should be made sometime near the opening of trading. NEVER enter a market order; and especially not at the opening. Always use limit orders. You bought an option at high volatility and you cannot afford to hold and allow residual time value to decay. Do not turn this into an investment.

Yes, you can allow the non-winning portion of the strangle to expire worthless, but I believe that it is far better to sell it at the same time that you sell the winning portion of the trade. Of course, I would not sell for as little as $0.05 or $0.10 (because miracles do happen), but $0.50 is real money when trading straddles and you cannot simply allow that cash to get away.

One more point: When the earnings news is right on target, your straddle will lose a lot of value. Accept that and dump the position before IV collapses even more than it did at the opening of trading.

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Expiration Date Changes from Saturday to Friday

Most traders believe that “expiration Friday” is the true day that option contracts expire. That has never been true. Expiration occurs on the Saturday that follows the 3rd Friday.

However, next year expiration officially moves to Fridays.

You may ask: How is this important to you, the options trader?
Answer: It is of no importance. But you may want to learn the rationale behind the move.

Here is the official definition of “expiration date” according to the CBOE.

Expiration Date:
Expiration day for equity and index options is the Saturday immediately following the third Friday of the expiration month until February 15, 2015. On and after February 15, 2015, the expiration date will be the third Friday of the expiration month.

To understand why expiration was originally set to Saturdays, read my explanation here.

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Adjustment Woes

Hi Mark have been trading iron condors for awhile but always get burnt when time comes to adjust

Hello Kaye,

Adjustments prevent getting burned. So let me make a few observations:

    –If you wait too long and have already lost too much money by the time that you decide to adjust the position, then all the adjustment can do is help you not lose too much additional money. It is unlikely to produce a happy overall outcome. I understand that we don’t like the idea of adjusting too early because the market may reverse direction. However, there is a good compromise that depends on your comfort zone. I hope that you can discover that compromise. Consider adjusting in stages.

    –If it is the adjustment trade itself that produces the poor results, then there are alternate adjustment strategies. Rolling is not the only choice. And if you do roll, I urge you not to increase position size by more than a modest amount. It is okay to roll from 10 spreads to 12, but increasing size to 20-lots is just asking for trouble because some trades get rolled multiple times and positions can become var too large.

    –It is easy to get burned when you sell extra put spreads (on a market rally) or sell extra call spreads (on a decline). It the scheme of things, it is very important to prevent risk from escalating. Translation: If you must sell new put spreads on a rally, please cover the already existing put spreads — just in case we see a market just like the past week. The rising market reversed direction suddenly and made a bit move lower. There is not enough residual profit potential in that original put spread to risk leaving it uncovered. That is the reason it pays to cover when selling a newer spread.

    –If you are trading with a market-neutral bias, then the adjustment should return your position nearer to delta neutral than it was before the adjustment. In other words, when you do not have a market bias, try to avoid using the adjustment to recover lost money. Don’t suddenly decide to trade an iron condor that tries to take advantage of the current market trend. In general, iron condors are not suitable for traders with a market bias (unless it is a small bias).

    –If none of those situations apply, if you provide an example or two that describes what went wrong, I will try to provide some insight on your trade. Remember that every losing trade does not mean that the trader made any mistakes.

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Roll a Position: A Risk Management Tool

When trading, risk management is an essential skill. There are many ways to control risk and it is difficult (if not impossible) to compile a complete list. However, at the top of the list is one easy-to-understand concept: Position size. That means that traders should always be aware of what can go wrong with every position and be certain that your account can survive the worst-case scenario.

Roll Strategy

One very popular strategy for handling a position gone awry is the “roll”.

Rolling occurs when a trader covers the existing position and sells another position. The new position resembles the first — but the strike price of the option(s) and (sometimes) the expiration date change.

Rolling is used to avoid closing the position and taking a loss. However, it is necessary to understand that some positions cannot be saved. Thus, be prepared to exit and accept a loss whenever you cannot find a suitable roll. Translation: If you cannot roll the position into one that you truly want as part of your portfolio, then do not roll. It is always a bad idea to create a new position that does not fit within your comfort zone.

Rolling is a good technique when the trader understands how to manage risk. Too often position size increases after the roll. In general, creating a larger position is a bad choice because the money at risk also increases.

Here are a few articles that I recently published at about.com. Each discusses one aspect of rolling a position.

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New eBook: Iron Condors

I’m very pleased to announce that I just published my new eBook, Iron Condors.

Also available at iTunes, Barnes & Noble or your favorite bookseller.

IronCondorsVOL2

This is not your ordinary “How to trade an option strategy” book. Read the full description below.

To celebrate the launch, I’m offering a special promotion to anyone on my e-mail list. If you are not already on the list, subscribe now and become eligible for the promotion.

So what’s the deal?

Buy either version of Iron Condors by Mark D Wolfinger and I’ll give you an eBook of your choice from the list below.
Offer expires 8/31/2014.

Here’s what to do

  1. Buy the eBook. No matter where you buy it, you will receive a receipt.
  2. Forward that receipt via e-mail to: books (at) mdwoptions (dot) com
  3. In the message, tell me which of the four eBooks (below) you prefer — and also the format: Kindle (.mobi) or ePub.
  4. I’ll send the eBook via e-mail

4Books

Book Description

Iron Condors is the third book in the “Best Option Strategies” series and each offers a hands-on education for some of the most useful option strategies. It is intended to be very different from all other books about iron condors.

Expect to learn the basic concepts of trading iron condors: (1) How to decide which options are suitable for your iron condor. Know in advance that there is seldom a single ‘best’ position that suits all traders; (2) Ideas — with specific examples — on how to manage risk; (3) Figuring out when to exit. We’ll discuss the pros and cons of locking in profits quickly (not a good idea) vs. holding longer (but not too long).

There is more that makes this book so special. It is not just a “how to” book because I share lessons learned from a lifetime of trading options (starting in 1977 when I became a CBOE market maker). I share my philosophy on iron condor trading and ideas on how a winning trader thinks. The goal is to offer guidance that allows you to develop good trade habits and an intelligent way of thinking about trading. We all learn as we gain experience, but some experience can be destructive when mindsets — that are dangerous to your longevity as a trader — become ingrained habits. This book helps traders avoid developing a difficult-to-break way of thinking.

This book was prepared for an audience that already understands the most basic concepts about options. Although some of the material is suitable for rookies. If you do not understand the difference between a put and call or have zero trading experience, I encourage you to begin with the most basic concepts about options before continuing. There are numerous sources of information, but I recommend my recently updated (2013) The Rookie’s Guide to Options, 2nd edition.

Another decision involves the pre-planned (I encourage preparation of a trade plan for each trade) exit when the target profit is achieved. If you have no profit target, then you will be hard pressed to exit when the trade continues to earn money. As profits accumulate, it becomes a daily decision: hold or exit. It is important to recognize when there is too little remaining profit potential for the prudent trader to hold. The trade plan helps with making good and timely decisions — and that makes you a more disciplined trader.

Closing the position could also be a gut-wrenching decision that locks in a loss and is made because it has become essential to take risk-reducing action. The book offers a solid introduction to risk management for iron condor traders.

The following points represent the foundation of my beliefs, and the book is written accordingly: (1)The ability to manage risk is the most important skill for any trader; (2) Take time to learn about the Greeks. It is not difficult, and it allows you to recognize the risk (and reward) potential for any position; (3) Discipline is necessary when managing risk. It is one thing to say that you understand what risk management is all about, but it is another to put it into practice; (4) Let another trader earn the last nickel or dime on the call and put spreads that comprise the iron condor. Pay a small sum to exit, lock in profits, and eliminate all risk.

The iron condor is most often traded as a single transaction, consisting of four legs. However, it is managed as if it were two positions. This is not a contradiction. This mindset is covered in detail.

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