Establishing a Maximim Loss for a Trade

Hi Mark

I know you always refer to the comfort zone to decide when to exit a losing trade, but to me, that concept is too vague.

If possible, I'd like to know if there is some ratio that allows the approximate calculation of the maximum price you can repurchase a spread (considering the other half of the iron condor is cheap) when the market is attacking the strike price.

Sorry to be insistent, but I have the idea that to be successful in long term, your losses   shouldn't be too big.   The underlying price usually touches one of the short strikes of the iron condor when you open a new position every month.

Anyway I'd like to know what is the amount you consider as the limit to repurchase one spread – if threatened out of your comfort zone -  to compensate with good trades.   I don't need you to say a particular number, I'm asking about the way of calculating the maximum losses to benefit in long term.

Yours, Antonio

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Antonio,


I re-worded a portion of your question for clarity.  I hope you don't mind.

I truly have no good reply, but will offer the following advice:

Let's assume I make an almost identical iron condor trade every month.

There is no easily calculated set number that represents my maximum loss.  Here are some reasons:

1) If I trade one 10-point iron condor and collect $100, I can lose as much as $900.

If my plan is to make $100 most of the time, I cannot afford to take a loss of $900, even if it occurrs only once per year.  The remaining profit would be too small.  So far I know you agree.

Considerations

I must set my maximum loss at a price that takes into consideration the following:

  • If I exit when the price reaches $300, I will never lose more than $200 per trade
  • If I exit at $300, I will not collect my $100 profit as frequently
    • I cannot know in advance how often my spread will reach that $300 exit price
    • I cannot know, in advance, how often to expect to earn my $100
  • I must gather data by paper trading and make this trade many times before I know the best exit price to choose.

    • This can be done, but it takes time and patience
    • Simultaneously, I would experiment with different exit prices
    • One year's worth of data may be enough to begin trading with real money, but I would want to continue the paper trading experiment to collect more data.  I may discover that $300 is not a good exit price.


2) If I collect $350 for my monthly iron condor, I will earn the maximum $350 less often than I would earn the $100 above. I still must know how often this trade will be successful.  I cannot use probability statistics because I don't know how often the iron condor will reach my exit price. 

If I decide to cap losses at the same $200, that means I would not allow the position to move beyond $550. Without a bunch of trades as history, I don't know how often to expect to exit, nor do I know how many times per year I would earn my $350 (or less if I decide to exit early at a low price)

3) Next consider this additional problem that must be considered to get the reply you want.  How much of the exit price do I reserve for the call and how much for the put spread?  When paying $550, clearly the spread in trouble is going to eat up most of that premium , but if I don't reserve enough for the spread that is not in trouble, I'm going to be forced to pay more or else remain short that spread – with little to gain and lots to lose.

4) Next consider this.  What hapepens when the market gets very volatile.  Say -3% one day, up 4% the next and then down 5% again.  The iron condor is not in any trouble.  It has probably moved only 2% (especially if it is a broad based index).  It is far from both strike prices and you feel calm (for the moment).

However, no one else is calm and the implied volatility of the options that comprise your iron condor has increased by 15 to 20 points.  That spread you traded for $100 is now priced at $300.  You are forced to exit by your methods at a time when you are not really in trouble.

It is true that it may be wise to exit an iron condor in a volatile market.  But if you prefer to hold, what can be your excuse?  What would your new exit price be?

5) Here's another situation for which it is difficult to use a formula. If you collect $400 for an iron condor, then the maximum loss is established at $600.  Would you really want to exit any lower than that?  You surely don't want to pay $8 for that iron condor when the risk is only $200 and the potential reward is up to $800.  So how can you make an intelligent stop loss decision?  Perhaps setting it at $200 would work, but I'd be afraid of reaching that point fairly often when collecting as much as $400.  As you know, when the premium is that high, the options cannot be very far out of the money.

Rule vs. Judgment

6) If you use a rule to make these decisions, you don't have much room to exercise your judgment as a trader.  If you want such a rule, I'd suggest the following – but please understand that this is my guess. 

Exit when your loss is between $150 and $200 if you trade iron condors at approximately $1 for a 10-point spread.  If you trade near $2, I suggest a maximum loss equal to the premium or perhaps $50 higher.  If you collect $300, my guess is that $250 – $300 should be the maximum loss.

However, market conditions affect my decisions.  I don't know about yours.


A different strategy

7) How about another strategy.  Let's say you buy a butterfly or an out of the money debit spread and pay $0.50.  Isn't that 50 cent maximum loss good enough?  Or would you feel forced to exit if it drops to 10 cents?  For that last 10 cents (you would have to pay commissions, so you would collect even less), doesn't it pay to take a chance and just hold the position?  There's almost nothing to lose, and every once in awhile a miracle happens.

My point is, there is no reason to establish a maximum loss when the cost is very low.  And yes, it's a very good idea to establish a maximum loss when potential losses are too high for you. Think about that: the loss is too large for you.  What does that mean?

That means the loss is outside your comfort zone.  If that remains too vague, by all means, establish a maximum dollar amount.  Perhaps that maximum will be based on a ratio that depends on the premium collected.  Perhaps it will be based on a specific dollar amount.

I do believe this is something you must work out for yourself. 

Unless some readers have ideas or experiences to share.  I'd love to hear from you.

803

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