The Art of Making Decisions when Trading

One of my basic tenets in teaching people how to trade options is that rules and guidelines should not be written in stone and that there are valid reasons for accepting or rejecting some of the ideas that I discuss.

When I offer a rationale or explanation or a suggest course of action, it is because I have found that this specific suggestion has worked best for me and my trading. I encourage all readers to adopt a different way of thinking when appropriate. The following message from a reader offers sound reasons for taking specif actions regarding the management of an iron condor position. My response explains why this specific reasoning is flawed (in my opinion).

The question

Hi Mark,

I have some questions on Chapter 3 (Rookie’s Guide to Options) Thought #3: “The Iron Condor is one position.”

You mentioned that the Iron Condor is one, and only one, position. The problem of thinking it as two credit spreads is that it often results in poor risk-management.

Using a similar example I (modified a little bit from the one in the book) traded one Iron Condor at $2.30 with 5 weeks to expiration:
– Sold one call spread at $1.20
– Sold one put spread at $1.10

Say, a few days later, the underlying index move higher, the Iron Condor position is at $2.50 (paper loss of $0.20):
– call spread at $2.00 (paper loss of $0.80)
– put spread at $0.50 (paper profit of $0.60)

I will lock in (i.e., buy to close) the put spread at $0.60 for the following reasons and conditions:
1. it is only a few days, the profit is more than 50% of the maximum possible profit
2. there are still 4 more weeks to expiration to gain the remaining less than 50% maximum possible profit. in fact, the remaining profit is less as I will always exit before expiration, typically at 80% of the maximum possible profit. so, there is only less than 30% of the maximum possible profit that I am risking for another 4 more weeks.
3. the hedging effect of put spread against the call spread is no longer as effective because the put spread is only at $0.50. as the underlying move higher, the call spread will gain value much faster than the put spread will loss value.

Is the above reasoning under those conditions ok? Will appreciate your view and sharing. Thank you.

My reply

Bottom line: The reasoning is OK. The principles that you follow for this example are sound.

However, the problem is that you are not seeing the bigger picture.

1. There is no paper loss on the call spread. Nor is there a paper profit on the put spread. There is only a 20-cent paper loss on the whole iron condor.

2. When trading any iron condor, the significant number is $2.30 – the entire premium collected. The price of the call and puts spreads are not relevant. In fact, these numbers should be ignored. It is not easy to convince traders of the validity of this statement, so let’s examine an example:

Assume that you enter a limit order to trade the iron condor at a cash credit of $2.30 or better. Next suppose that you cannot watch the markets for the next several hours. When you return home you note that your order was filled at $2.35 – five cents better than your limit (yes, this is possible). You also notice the following:

  • The market has declined by 1.5%.
  • Implied volatility has increased.
  • The iron condor is currently priced at $2.80.
  • Your order was filled: Call spread; $0.45; Put spread; Total credit is $2.35.

Obviously you are not happy with this situation because your iron condor is far from neutral and probably requires an adjustment. But that is beyond this today’s discussion — so let’s assume that you are not making any adjustments at the present time.

That leaves some questions

  • Do you manage this iron condor as one with a net credit of $2.35? [I hope so]
  • Do you prefer use to the trade-execution prices?

If you choose the “$2.35” iron condor, it is easy to understand that this is an out-of-balance position and may require an adjustment.

If you choose the “45-cent call spread and $1.90 put spread” then the market has not moved too far from your original trade prices, making it far less likely that any adjustment may be necessary.

In other words, it does not matter whether you collected $2.00, $1.50, $1.20, $1.00, or $0.80 for the put spread. All that matters is that you have an iron condor with a net credit of $2.35.

3. You should consider covering either the call spread, or the put spread, when the prices reaches a low level. You are correct in concluding that there is little hedge remaining when the price of one of the spreads is “low.” You are correct is deciding that it is not a good strategy to wait for a “long time” to collect the small remaining premium.

If you decide that $0.60 is the proper price at which to cover one of the short positions, then by all means, cover at that point. (I tend to wait for a lower price).

If you want to pay more to cover the “low-priced” portion of the iron condor when you get a chance to do so quickly, there is nothing wrong with that. However, do not assume that covering quickly is necessarily a good strategy because that leaves you with (in your example) a short call spread — and you no longer own an iron condor. If YOU are willing to do that by paying 60 cents, then so be it. It is always a sound decision to exit one part of the iron condor when you deem it to be a good risk-management decision. But, do not make this trade simply because it happened so quickly or that you expect the market to reverse direction. If you are suddenly bearish, there are much better plays for you to consider other than buying back the specific put spread that you sold earlier.

4. The differences in your alternatives are subtle and neither is “right’ nor ‘wrong.”

The main lesson here is developing the correct mindset because your way of thinking about each specific problem should be based on your collective experience as a trader.

Your actions above are reasonable. However, it is more effective for the market-neutral trader to own an iron condor than to be short a call or put spread.

You are doing the right thing by exiting one portion of the condor at some “low” price, and that price may differ from trade to trade. But deciding to cover when it reaches a specific percentage of the premium collected is not appropriate for managing iron condors.

,

2 Responses to The Art of Making Decisions when Trading

  1. Tony 01/17/2015 at 8:00 PM #

    Hi Mark,

    Thanks for sharing.

    The entry was unfortunately bad. I will try to not let that happen. With $0.45 on the Call Spread, it is simply too low for the risk to take on the call side. Let’s not discuss entry in this article.

    I don’t really manage the iron condor as one (that is my problem of not able to see the big picture).

    In fact, for adjustment, I don’t usually use price as a primary factor.

    The “$2.35” icon condor will not tell me whether it is out-of-balance or whether it requires adjustment. So are the “45-cent call spread and $1.90 put spread”.

    The primary factor/criteria for my adjustment is the delta. I usually enter the call spread and put spread at about delta 10. My adjustment point is at about delta 25.

    It is the delta of the individual call spread and put spread that tells me whether I need an adjustment. The collective delta of iron condor cannot tell me that.

    You see, for adjustment, I still manage it at call/put spread level, two positions. I don’t really manage it at iron condor level, one position.

    I only use price for taking profit. I usually target for 70-80% of the maximum possible profit. I will always exit before expiration. For taking profit at 50% of the maximum possible profit, it is for those rare occasion when the days in trade is only a few days and the days to expiration is many weeks away. Typically, it happen when I sold the spreads on a big down day where IV is high. When it reverse up, the put spread will loss more value because IV drop a lot when underlying reverse up fast.

    When I own an iron condor, I would say I am not really market neutral or delta neutral. I set up the wings of the iron condor by identifying where I think the underlying will not go, using standard deviation, support and resistance, previous high/low. I am with the view that the underlying will fluctuate within the wings of my iron condor.

    For call, I believe the underlying will not go up to the strike price by expiration; for put, the underlying will stay above the strike price by expiration.

    So, if I really close the put spread in this example, I am comfortable to own the call spread and manage from there. Because, my opinion (when I opened the position) is that the underlying will not go above the call strike by expiration. If the underlying keep going up, then I will exit the position and accept the loss. I simply have to accept that I am wrong with my prior opinion that the underlying will not go above my strike price, be it as an iron condor or as an call spread.

    So, again, I am still managing the iron condor at the call/put spread level, as two positions. Not one position.

    I am worried that I am not seeing the big picture. I hope I can learn from your extensive experience and sharing.

    Many thanks.

    > Hi Mark,
    >
    > Thanks for sharing.
    >
    > The entry was unfortunately bad. I will try to not let that happen. When you cannot watch the markets, it is best not to have open orders for a new position waiting to be filled. Orders to exit from a trade can still be entered. With $0.45 on the Call Spread, it is simply too low for the risk to take on the call side. Let’s not discuss entry in this article. Right you are. It is too little. But suppose you were filled at your prices ($1.10 and $1.20) and THEN the market moved. If the options were priced at $0.45 and $1.90 at day’s end — should that really make any difference? You have an IC position that you probably want to adjust – regardless of how much you collected for the call spread. In my opinion, only the toal premium matters. In other words, whether you traded before the market moved, or after the market moved, your situation is the same (other than the small 5-cent difference in the premium collected).
    >
    > I don’t really manage the iron condor as one (that is my problem of not able to see the big picture).
    >
    > In fact, for adjustment, I don’t usually use price as a primary factor.
    >
    > The “$2.35” icon condor will not tell me whether it is out-of-balance or whether it requires adjustment. But the deltas will tell you. The current risk graph will show you. So are the “45-cent call spread and $1.90 put spread”. Agree, but those prices do tell you that the IC was not market neutral when the trade was executed.
    >
    > The primary factor/criteria for my adjustment is the delta. Good. I usually enter the call spread and put spread at about delta 10. My adjustment point is at about delta 25. Very reasonable guidelines.
    >
    > It is the delta of the individual call spread and put spread that tells me whether I need an adjustment. The collective delta of iron condor cannot tell me that. Yes it can. The brand new positon has a total delta near zero. The out of balance IC may make you long 200 delta – and that tells you to expect to lose ~$200 for every one point decline. This is a good number for measuring imminent (anticipated) risk. You do not have to make decisions on that number, but it is useful when it comes to estimating how much money is at risk right now.
    >
    > You see, for adjustment, I still manage it at call/put spread level, two positions. I agree that there is nothing wrong with this idea. In fact it works well. But the point I want to emphasize is that you should not think of buying back one of the two spreads as “locking in a profit.” That is all I am trying to say. When to cover one part of the iron condor is a personal decision. I prefer to do it when the remaining reward potential is just too small for the risk involved. So to me, when I collect roughly $2.30 for an IC, I do not think of paying 60-cents as “low enough.” I want to pay less – because when the spread is still 60-cents, it provides enough of a hedge for me. If it does not provide enough of a hedge for you, then you should cover.
    > I don’t really manage it at iron condor level, one position. It is a matter of semantics and mindset. When you buy back one spread because it does not offer enough hedge, then you are truly thinking of the whole IC. When you think of buying back one spread to lock in a profit (when there is no true profit), then you are not managing the whole iron condor.
    >
    > I only use price for taking profit. I get it. But you do understand that there is no profit don’t you? You would never sell a call spread and sell your long option after the market rallies – would you? That would leave you naked short a call option. Isn’t that essentially what you are doing by covering one part of the IC – except that risk is limited because you are short a spread and not a single option.
    >
    > I usually target for 70-80% of the maximum possible profit. That is good. In the example, you suggested a number near 50%. I will always exit before expiration. Good. For taking profit at 50% of the maximum possible profit, it is for those rare occasion when the days in trade is only a few days and the days to expiration is many weeks away. OK> But,I would do that only when I can exit the entire iron condor — not when I can exit one portion. This is a rare occurrence and happens when IV suddenly declines. Typically, it happen when I sold the spreads on a big down day where IV is high. Good time to enter an IC trade. But it is an IC trade, and not just the sale of one call spread and one put spread. When it reverse up, the p
    > ut spread will loss more value because IV drop a lot when underlying reverse up fast. If you want to wager on a market reversal, then just sell the put spread. You are not obligated to trade and IC.
    >
    > When I own an iron condor, I would say I am not really market neutral or delta neutral.But your position is near neutral, regardless of how you think about it. I set up the wings of the iron condor by identifying where I think the underlying will not go, using standard deviation, support and resistance, previous high/low. I am with the view that the underlying will fluctuate within the wings of my iron condor. That is not standard behavior because then (as you state) the position is not truly neutral. Most traders sell options of equal (in your case 10) delta to initiate the trade. if you modify that by your market expectations, that is a fine idea (as long as your track record when predicting is better than random).
    >
    > For call, I believe the underlying will not go up to the strike price by expiration; for put, the underlying will stay above the strike price by expiration.
    >
    > So, if I really close the put spread in this example, I am comfortable to own the call spread and manage from there. Aha!! That is the key that has been missing in the previous discussion. I had assumed that you want to maintain some sort of neutralish position. If you are comfortable taking legs, then by all means, continue to do so. Because, my opinion (when I opened the position) is that the underlying will not go above the call strike by expiration. If the underlying keep going up, then I will exit the position and accept the loss. I simply have to accept that I am wrong with my prior opinion that the underlying will not go above my strike price, be it as an iron condor or as an call spread. Sound thinking. But let me offer this: Let’s say the market rallies and you want to cover the put spread. Let’s stipulate that you pay $0.60 for 10 spreads. My question to you is this: If you suddenly want to turn bearish and cover the put spread, isn’t there a better way to invest $600 so that you can make some money on a market decline? Surely covering the speciic put spread that you sold is not the most desirable way to “invest” $600. NOTE: If you buy the spread for a lower price, such as 20 or 25 cents, then this does not apply. At some LOW price, there is no need to look for a better investment because you cannot get much for so little cash. This is a different mindsete. This is not an argum,ent. I am sharing how I thing and encouraging you to decide how you want to thingk . I am not encouraging you to agree with me. Just giving you food for thought.
    >
    > So, again, I am still managing the iron condor at the call/put spread level, as two positions. Not one position.
    >
    > I am worried that I am not seeing the big picture. The big picture can be seen in more than one way. As stated, I am showing you another and you should not blindly follow my method. You should decide which makes more sense to you now. As you get more experienced, your mindset (on some aspects of trading) will change.
    > I hope I can learn from your extensive experience and sharing. Me too – but only if it feels logical to you.
    > Best regards,
    > Mark
    >
    > Many thanks. I did not proofread for typos. Please excuse any.

    • Tony 01/20/2015 at 6:34 PM #

      Hi Mark,

      Thanks for your reply.

      I only use price for taking profit. I get it. But you do understand that there is no profit don’t you? You would never sell a call spread and sell your long option after the market rallies – would you? NEVER! But closing half of the iron condor is essentially the same – except for the risk of the residual position. So if you would never sell the long option in call spread, why would you get rid of one part of the IC? Isn’t the principle the same?

      This strikes me hard. I have never looked at the spread (call or put) as separate position. Though there are two options in the spread. But I have always treat them as one single position. As you should. The spread is one position.

      I also never look at the profit/loss of each option separately. The P&L is always on the spread, not the individual option. Yes. Exactly my point. And the thinking should be the same for an iron condor. It way look like two spreads, but it is not – it is one position with four legs.

      I will need to rethink why I don’t manage iron condor like how I manage spread. Yes. Do that. And I remind you once again – I am offering you an idea of how to think about the IC. I am not telling you that your current mindset is incorrect. I just believe it is less efficient. The final decision is yours.

      Many thanks.