Iron Condors: Trading Rules and Profit Targets. Part I

Trading rules are part of the game for seasoned traders.  Even long-term investors can benefit by having rules in place.  Those trading rules cover many aspects of trading, some of which are appropriate for option traders while others apply only to specific markets (stock, forex etc.).  Because I believe that becoming a successful investor/trader over the long term requires the ability to avoid taking large losses, any rule that helps you exit a trade that’s not working well is at the top of my list of ‘most important’ rules.  But when to take a loss, and move on, is not today’s topic. 

How important is an equivalent rule for profitable trades?  Do successful traders use such rules, including exiting a position once a specific profit level is achieved?  Or, are the rules more flexible?  Today’s blog begins a discussion of whether ‘profit taking rules’ are a good idea.  Please share your opinion or experience.

For those readers who are new to investing, let me be clear.  No laws are involved.  These ‘rules’ are self-imposed and no one (except yourself) is going to punish you  for breaking the rules. 

 

I’ve discussed the trading of iron condors frequently in this blog, but there are some questions not previously considered: 

When buying iron condors, do you think in terms of earning a specific profit from the trade?  Or do you always plan to hold the iron condor through expiration, hoping to earn the maximum possible profit - when all options expire worthless?

Do you have a rule that tells you to exit when a specific amount (or percentage of the money at risk) has been earned, regardless of how attractive the current position looks?   Or is it more efficient and profitable for you to manage positions by making decisions (including whether to close) on an ongoing basis? 

Should you have an exit ‘rule’ and stick to it?  Or should there be some soft rule that tells you when to cover the profitable iron condor – perhaps when you can close by paying $0.20 or $0.30?

If you have a method that’s been working for you, there’s no need to make any changes.  But you may want to think about establishing an exit rule.  That’s where I sit – working on that decision.

I’ve always relied on a current analysis of my portfolio to make decisions.  I feel I ‘know’ when to hold em’ and when to ‘fold ‘em – based on the current risk/reward potential.  I’m wondering whether it would be better to take specific profits when achieved - to remove all risk of losing those gains.  I believe this is another ‘comfort zone decision.’

Let’s consider a trader who decides that earning $1,000 per month (substitute any number that’s suitable for you) is the goal.  The strategy: buy iron condors on the Russell 2000 Index (RUT).  If it’s easier to think in terms of percentages, then consider that this trader has $10,000 at risk (i.e., that’s the maximum loss) and the goal is to earn 10% per month.  If that feels too aggressive, then perhaps the account can risk $20,000 with a goal of earning 5%.  The principles are the same, and you can choose an account size, position size, portfolio value at risk, and profit objectives to suit your individual comfort zone.

The account is large enough to handle the alternatives listed below, and margin requirements are not an issue.  

Contrary to the hype of Internet scammers, buying iron condors is not a guaranteed path to a making fortune.  But when played carefully, your chances of making good money over time, are excellent. 

 

Decisions:

.        When buying iron condors, is the goal to earn $1,000 this month, or is the goal to average $1,000 per month (ignoring any attempt to compound those earnings) over an extended period?

·        How do you correct for the fact that you know you cannot meet your target every month?  In fact, part of the time you will lose money.  Should your monthly target be raised to compensate for those losses? Should you increase size (trade more contracts) only after a loss, in an attempt to make up for that loss?  There is no best answer for every trader, but I strongly suggest NOT increasing size after a loss.  A consistent approach is better, and a higher monthly target ($1,200?) may enable you to meet your annual profit target.

·        How do you choose which iron condor to trade, to meet your goal on a consistent basis?  Without a rigorous mathematical analysis, I don’t believe it’s easy to decide.  That's where I believe ‘comfort zone’ comes into play.  My gut tells me to select the iron condor that’s most comfortable for me to trade – and that’s what I already do.  The only change in methodology is to take profits early and trade the correct size for the desired profit. 

·        When choosing your iron condor, it’s basically a compromise between

o   iron condors that have the highest probability of success (far OTM options), but which offer smaller profits; or

o   iron condors with a lower probability of success (options are less far OTM), but with less money at risk.

To be continued…