Recommended Option Strategies: Decisions to Make Before Trading an Iron Condor. Part III

This is an important post because it contains
information seldom discussed elsewhere – information that is essential if you
want to understand how adopting the iron condor strategy results in gains and
losses.

Strike Prices and Premium Collected

Choosing the strike prices
for your iron condor position – and deciding how much cash credit you are
willing to accept for taking on the risk involved – are irrevocably linked. Thus, I’ll discuss them together.

Assume the call spread and
put spread are each 10-points wide.

For
example:
(RUT is the (Russell
2000 index)

Sell
10 RUT Sep 620 put

Buy
10 RUT Sep 610 put

Sell
10 RUT Sep 760 call

Buy
10 RUT Sep 770 call

  • Market bias

Most
of the time that you open an iron condor, you have a neutral opinion, i.e., you
have no expectation that the stock is going to move in one direction as opposed
to the other. As a result, you tend to choose a call spread and a put
spread that are equally out of the money. To put it simply – the call and put you sell will each be approximately
the same number of points away from the price of the underlying security. In
our example above, If RUT is trading near 690, the 620 put and the 760 call are
each 70 points out of the money, and the position is ‘distance neutral.’

There
are other methods you can use to have a position that is ‘neutral.’ Instead of equally far out of the money, you
may choose to sell spreads that bring in the same amount of cash. This is ‘dollar neutral,’ a method seldom
used.

If
you understand the term delta (we’ll get to it eventually) you may choose to
sell spreads with equal delta. I don’t
recommend this method for iron condors, although ‘delta neutral’ trading has a
great deal to recommend it under different circumstances.

If you are
bullish, you can choose to sell put spreads that bring in more cash, attempting
to profit if the stock or index does move higher, per your expectation.

If you are
bearish, you can choose to sell call spreads that bring in more cash,
attempting to profit if the stock or index does move lower, per your
expectation.

 

  • How far out of the money

Most
investors believe that the further out of the money the options they sell, the
‘safer’ their position and the less risk they have. That's one way to look at ‘safety.’

Probability
vs. Maximum loss
. If you sell the RUT 580/590 put spread
instead of the 610/620 put spread, there is a higher probability that the options
you sell will expire worthless, allowing you to earn the maximum profit that trading this iron condor allows.

I
believe that is intuitively obvious, but for those who don’t see it, consider
this (and for the purposes of this discussion, assume you hold this position
until the options expire): Most of the time the options expire worthless, but
part of the time, RUT moves far enough below 620, resulting in a loss. Part of the time that RUT is below 620 at
expiration, it is also below 590. But,
the probability that it’s below 590 must be less than the probability that it’s
below 620 because part of the time RUT is going to be between 590 and 620. Thus, you lose money less often, when you sell options that are further out of the
money. That fits the first definition of
‘safer’.

But,
you can also look at it this way. When
you sell the 580/590 put spread, you collect less cash than when you sell the 610/620
put spread. This is always true: the more distant the options are from the market price of the underlying stock or
index, the less premium you collect when selling single options or option
spreads.

This
is why it’s so important to find your comfort zone when choosing the options
that make up your iron condor.

o You can trade
options that are very far out of the money. 

§ These positions have a very small chance of losing
money. You can easily find iron condors with
a 90% (or even higher) probability of being winners.

§ However, the cash you collect may be too little to
make the trade worthwhile. Some
investors are willing to sell iron condors and collect between $0.25 and $0.50
for each spread, netting them $50 to $100 per iron condor. If that makes you comfortable, then it’s okay
for you to trade this way. For my taste,
the monetary reward is too small. NOTE:
Selling a spread for $0.40 translates into $40 cash, and the possibility of losing $960.

§ Remember that the maximum loss is very high, and one
giant loss can wipe out years of gains. The maximum loss is $950 per iron condor, when you only collect $50 to
initiate the trade.

o You can trade
options that are far out of the money, but not so far that the premium you
collect is too small.

§ You still have a high probability of owning a winning
position.

§ You have the potential to earn more money because you
collected more cash upfront.

§ The maximum loss is reduced, and some consider this position ‘safer.’  That fits the second definition
of safety.

o You can sell options
that are closer to the money

§ This reduces your chances of having a comfortable ride
through expiration, and increases the chances of losing money.

§ In return for that reduced probability of success, potential
profits are significantly higher. You
may decide to collect $400 or $500 per iron condor.

§ The maximum loss is much smaller, and again, that fits
the second definition of owning a safer position.

How
do you decide? There is no ‘best’
choice. You goal should be to find iron
condors that places you well within your comfort zone. And if you are unsure of how your comfort
zone is defined, use a paper trading account to practice trading iron condors (or any other strategy). I know that real money is not at risk, but if
take the positions seriously, you can determine which iron condors
leave you a bit uneasy and which ‘feel’ ok. Advice: Don’t make the decisions about
comfort based on which trades are profitable. Base the decision on which iron condors make you nervous about potential
losses both when you open the position and as the risk changes over time.

It’s
easy to randomly open positions and hope they work. But it’s better to open positions that fall
within your comfort zone.

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Recommended Option Strategies: Decisions to Make Before Trading an Iron Condor. Part II

Timing

Some investors believe they
have a ‘feel’ for the market, or individual stocks and ‘know’ when that stock
is going to make a large move. If you
are one of them, then don’t open an iron condor position unless you believe the
stock is NOT going to make such a move before the options expire. As an alternative you can have an iron condor
position with a bullish or bearish bias. You do that by choosing appropriate strike prices for the options
spreads you choose.

Many investors (that includes
me) cannot predict the future and are willing to own positions that profit when
the market holds steady, trades within a range that’s not too wide, or if the
market does move significantly in one direction, does so at a slow and steady
pace.

 

Underlying

It’s generally safer to trade
iron condors on indexes because you never have to be concerned with a single
stock issuing unexpected news that results in a gap of 20% or more. True that can happen with an index if there
is world-shattering news – but it’s a much less likely event.

Most indexes in the U.S. are
European style vs. American style. That
means they cannot be exercised before expiration – and that’s to your
advantage. We’ll discuss the differences
between these option ‘styles’ another day.

 

Expiration Month

Most iron condor traders
prefer to have positions that expire in the front month (options with the least
time remaining before they expire). These options have the most rapid time decay, and when you are a seller
of option premium (when you collect cash for your positions as opposed to
paying cash), the passage of time is your ally and rapid time decay is a
positive attribute for your position.

However, there are negative
factors associated with front-month options:

  • With less time remaining,
    iron condor positions are worth less than if there were more time remaining. here were more time remaining,mma chanes
    gamma.ma, it'iiton. which money is lost more time remaining, and you collect less ca
    Thus, you collect
    less cash when you open the position.
  • If the index
    undergoes a substantial price change, the rate at which money is lost is
    significantly greater when you have a front-month option position. It’s too early in your education to discuss
    why this is true in detail, but it’s because they gain or lose value more
    rapidly than options with longer lifetimes. This is effect of gamma, one of the ‘Greeks’ used to quantify risk when
    trading options. Because there are so
    many topics to discuss, I will not be getting to the Greeks for quite awhile.
  • When you sell
    options that expire in the 2nd or 3rd month, you collect
    higher cash premiums (good), have positions that lose less when something bad
    happens (good), but there is more time for something bad to happen (bad). When you have iron condor positions, you
    don’t want to see something bad (and that’s a big market move). The more time remaining before the options expire,
    the greater the chance that something bad happens. That’s why traders who sell* iron condors are willing to pay you a higher
    price for them.

*Optionspeak (the language of options) comes into play
here. It may not appear to be
reasonable, but when you sell the call spread and sell the put spread, you are
BUYING the iron condor.

Summary: Here’s a statement I am going to make
repeatedly when discussing options trading: There is no ‘right’ choice. As an
investor, you want to hold positions that are comfortable for you. The best way to discover your comfort zone is to trade. But, please use a practice account and do not
use real money until you truly understand how iron condors (or any other
strategy) work. Some traders always trade
the near-term (front-month) options, while others (myself included) prefer
options that expire in two, three, or even four months.

Continued

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Recommended Option Strategies: Decisions to Make Before Trading an Iron Condor. Part I

Note to readers:

When reading this blog, you will notice that I provide a great more detail than most people care to read. Options are not a get-rich-quick investment tool and it’s important to understand what you are doing and how a specific strategy can be used to make money. It’s also vital to understand the risks involved with any investment, and to know what to do if things don’t work out as expected.

Those details are for your benefit. I appreciate the fact that rookies are anxious to begin trading and making money,but in my experience (>30 years) as a professional options trader, I’ve seen people put their money on the line by trading before they were ready. Some were lucky, but most were not. That’s simply the wrong way to go. If you have a bit of patience and take the time to understand what you are trying to accomplish with a given strategy before you start trading, you will make far more money over the years.

I believe in educating investors on how options work, how to use options, and how to manage risk. Managing risk is the key skill required to give you the best chance of long-term success. My goal is to help you learn both risk management and how to choose (and use) options strategies that are appropriate for you and your tolerance for risk. The objective is to help you meet your investment goals. That’s the approach taken when I wrote my books, and that’s the style of this blog.

When adopting an iron condor strategy, there are several decisions to make:

  • Decide if now is a good time to adopt the iron condor strategy.

Note: when the markets are very volatile and moving higher and/or lower in big chunks, iron condors are more risky.

But you don’t have to sit on the sidelines. Other option strategies are available if you decide iron condors are not appropriate.

  • Choose the underlying stock or index
  • Choose an expiration month
  • Choose strike prices
  • Decide how much cash you want to collect when opening the position. This will be your maximum profit for the trade

Is this enough profit potential to compensate you for the risk you are taking?

NOTE: Don’t be frightened by my frequent use of the word ‘risk.’ All investments have some degree of risk. The purpose of posing the question is to be certain that you can earn enough money for a given trade to justify the risk. Would you make a trade in which your maximum profit was $20 and the maximum loss was $5,000? That wouldn’t make much sense, no matter the odds of winning

To Be Continued…

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Recommended Option Strategies: Iron Condors

Yesterday I responded to a reader’s question regarding iron condors. This may be an appropriate time to introduce this strategy. Keep in mind this is only an introduction.

Before being prepared to trade iron condors, it’s important to have a good understanding of credit spreads and debit spreads, and an understanding of why you would want to own such a position, what you have to gain, and the risks.  But for now, let’s skip ahead with a brief discussion of the iron condor. We’ll return for a discussion of the prerequisite material soon.

Iron Condors

1. A market neutral strategy.

 

a. These positions perform best when the market does NOT make a significant move in either direction.

 

b. These positions are in danger of incurring significant losses when the underlying stock or index makes big moves in either direction.

 

c. The passage time is your friend when you have an iron condor position.

 

2. Iron condors consist of two separate spread positions, but you must have both spreads or you are not trading an iron condor.

 

a. A spread is a position consisting of two (sometimes more, but not in this case) individual options: both puts, or both calls.

 

 i. A call spread is (as you may have assumed) a position with two calls

 

 ii. A put spread is a position with two puts.

 

b. Sell a call spread and sell a put spread. Collect a cash premium for each spread.  Typically, all four options are out of the money.

 

 i. Sell a call spread: Sell one call option and buy another. The option sold has a lower strike price and has a higher price (premium) than the call you buy.

 

 ii. Sell a put spread: Sell one put option and buy another.  The option sold has a higher strike price and has a higher price (premium) than the put you buy.

 

c. All four options expire in the same month.

 

3. How do you make money?

As time passes, the value of each option deceases. But, the options you sold were higher priced than the options you bought and they will lose time value faster. Thus, the passage of time makes the position worth less and less. When it reaches a price that is low enough (no hard and fast rule; you must decide for yourself), you close out the position by selling out the options you own and buying back the options you sold. As an alternative, you may hold the position longer (risky) and perhaps each of the options will expire worthless.

4. How do you lose money?

If the underlying stock or index moves too far in either direction, one of the options you sold increases in value much faster than the option you bought. Thus, either the call spread (if the market is higher) or the put spread (if the market is lower) is worth much more than the price for which you sold it. That means you have a loss. You may hold this position, hoping that the stock reverses direction, but that is very risky because a continued move in the same direction rapidly increases your losses.

5. Your main goal as an option trader is to manage risk. That means preventing large losses. Thus, it’s not smart to simply hold a losing position and hope. It’s better to take your loss and find another trade.

 

This is a very abbreviated description of an iron condor. If you believe that this is a strategy you want to learn, you can read about the strategy or begin by practice trading in a paper trading account. Please don’t jump in using real money if this is your first introduction to iron condors. You have much more to learn first.

 

Continued

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Questions from readers

Mark

Thanks for an excellent comment. This was very timely reading for me (post entitled 'Get Even").

I am trying to learn about iron condors and I loved the explanations you provided in your book "The Rookies Guide to Options". It was my first introduction to what I think could be a great options strategy for me in the future.

I have been surfing the web on IC's and trying to pick up additional knowledge. I don't want to jump in too fast. I am starting to paper trade, but I feel like I am not even ready to paper trade yet, because I want to be clear on my personal game plan for how to use IC's

I think I more or less get the piece on the starting position. I like your idea of trying to collect about 30% – 40% of the spread in total premium when the options expire in about 90 days. I may even be more comfortable going further OTM and looking for 20% in premium.

What I am not sure about is adjusting the position (I suspect skilled adjusting is probably the key success factor for investors who make money over the long term). A couple of web forums have recommended having a game plan defined – when I will adjust and how I will adjust. I feel I don't have clue as to how to come up with this game plan.

Can you give me some guidance on coming up with the game plan for trading IC's. some questions I have are: Should I plan to adjust the position as soon as the stock gets close to a a short strike price (say 1% OTM)? Is it better to wait until it goes past the short strike? When adjusting is rolling both spreads always a good option vs. closing the position completely?

Also, after reading your chapter on advanced risk management, I could not decide whether pre insurance was a good idea for maximizing long term growth (which is my personal objective). what are you thoughts on this?

TR

***

TR,

1) Paper trading is the best thing for you right now because it allows you to get comfortable choosing strike prices.  It also allows you to see how you make or lose money, depending on how the market moves. And the best part is that you cannot make mistakes.  If you see that you did something that you would do differently next time, take notes and be glad that you learned your first lesson.  To gain experience faster, open more than one or two different iron condor positions.  Use different months or different underlying indexes.

I gave a very careful, detailed explanations in the the book, but there's no substitute for hands-on experience.  And paper trading cannot cost you a dime.

2) It's good to have a personal game plan.  But, it takes some experience to know how to formulate one.  Thus, don't be concerned that you don't have one right now.  A good game plan for beginners is: "Don't allow positions to make me uncomfortable or make me afraid of losing too much.  If that happens, adjust or close the position." You will get there after some practice trades. You will learn what makes you uncomfortable, and that will dictate your game plan. 

For right now, I suggest a very broad game plan – then you will refine it as time passes.  Such a game plan might (please choose your own plan – one that fits your comfort zone) be

a) Close all big winners (one side – not the whole iron condor) when it can be bought in for $0.25 or less.

b) Close a losing position when it…

There are many possible choices, and you mentioned a couple in your question.  Closing when near the strike is very reasonable.  Holding out until the strike is breached is also okay.  If you do the latter, your losses will be larger, but there will be fewer of them.

Remember this:  There is no single 'best' method.  You have two goals when adjusting: First, to get out of positions where the risk of further loss is too high.  Note that 'too high' is a relative term and each investor must decide the place when that occurs.  That's where experience comes in and paper trading helps.

Second, don't get stubborn.  You must not allow  losses to get so large that they overwhelm your profits.  Sure adjusting is not fun, but is is essential for long-term survival.

3) 'Always' is not a good word, in my opinion.  Yes, when adjusting the losing side of an iron condor, it's often the right move to do something about the winning side.  Why?  Because if you are adjusting the puts, then the calls are probably cheap enough to buy in.  Then you can sell a new call spread to go with the new put spread and you will have a new iron condor.

4) Pre-insurance is NOT for everyone.  I'd skip it for now.  When you have been trading iron condors for several months, you can revisit this idea and decide at that time.

Mark

Afterword:  After posting, I thought it would be a good idea to add:  Because you want to maximize long-term growth, I believe it's essential for you to take the idea of risk management very seriously.  It only takes ONE disaster to wipe out months or years of earnings – depending on how much risk you take.  Those who want maximum gains tend to take more risk than the average investor.  If you decide to take that path, you must own protection against that disaster.  But, after paying for insurance month after month and noticing that it was not needed, you may decide that it's not worth the cost.  If you do, the chances are very high that you will live to regret it. 

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Getting Even

Most investors tend to trade from the long side. That’s not working well right now because this market has been in a recent downtrend. I think this is an appropriate time to share more of my trading philosophy.

 

1) To succeed over the longer-term, losses must be minimized. Thus, risk management is an essential skill for any trader.

 

2) Your trading/investing goal is to make money. You want to see your account value grow month after month.

 

3) **It does not matter from which specific stocks you earn your profits.

 

4) No specific stock ‘owes’ you a profit. If you lost money the last time you traded that stock, it doesn’t mean you should force a borderline trade in that same stock in an attempt to ‘get even.’

 

5) If you have a
losing position and if that position exits your comfort zone (too much risk
going forward):

a. Do not increase
your position size in an attempt to get even.

b. Do not hold,
hoping the stock will reverse direction, allowing you to recover your losses.

c. Do not alter
(adjust) the position just because you refuse to accept a loss.

 i. Adjust the
position ONLY if you still want to have a position in this specific stock (or
index).

 ii. Adjust the
position to a new one that suits you. That
means both the reward potential and risk must be acceptable. I’m referring to
the potential risk/reward for the future. What’s lost is lost. Don’t dwell
on it. If you cannot find a position you
want to own, then forget this stock and find another.

 

6) **It does not
matter from which specific stocks you earn your profits.

 

7) If you believe
that one stock offers a good trading opportunity, then that’s the place to invest
your money. Referring to #5 above, you
would be better served to get out of the risky position and move to one that
that you think is better. After all,
your goal is to make money for your account.

 

This is a
difficult concept for some people to grasp. The ‘need’ to recover losses from one specific stock blinds many to finding
an opportunity to make money from another stock. Which would you rather do: a) Recover losses,
even if it takes a year, or b) earn three times as much money by trading a
different stock? The answer should be
obvious to all. Remember, it does not
matter from which specific stocks you earn your profits. (This cannot be
repeated too often.)

 

Another
blogger agrees:

“You might be struggling in this market right now, and
if so, remember that there are a couple of things you can do. First, stop
trading. Close out your losing positions and clear your head for a little
while. It’ll be well worth it, both monetarily and mentally. Second, regain
your focus. Remind yourself what you’re aiming to do with your trading, what
your style consists of, and what you need to see before taking new trades. If
you don’t see it, don’t push any buttons! And finally, don’t try to “get it
back” quickly. That is the fastest way to compound your problem and double or
triple the size of the hole you find yourself in.”

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Recommended Option Strategies #1: Covered Call Writing. Part II

Choosing which option to write

Reminder: When writing covered calls, you own 100
shares of stock and sell one call option.

Important: There is never a ‘best’ option to sell. Different investors, each with his or her
investment objective, risk tolerance, and minimum profit objective can choose a
different option that is entirely appropriate for them – but which is
inappropriate for you.

 

Month: You will have at least four
different months from which to choose

· Options which
expire first (the ‘front’ month’) have the most rapid time decay. Time decay is good for option sellers.

· Options which
expire in the latest month are the most costly and thus, by selling them, you
collect the most cash (now) and have greater protection against a market
decline.

· As you gain
experience, you will learn whether front month, 2nd month or other
is more appropriate for you.

 

Strike Price: You have at least three choices. Volatile stocks have many strike prices

· In the money
options: The stock price is higher than the strike price

o The lower the
strike price, the higher the option premium, but there's less profit potential

o The higher the
strike price (remember we are talking about in the money options) the greater
the time premium

o Your maximum
profit potential is the dollar amount of the time premium in the option

 

· At the money
options: The strike price is equal to (or very near) the stock price

o These options
have more time premium than any of the other options and thus, are attractive to sell

· Out of the money
options: Strike price is higher than
stock price

o If the strike
price is too high (compared with the stock price) the premium is very
small. Don’t sell these options

o OTM options can be sold by very bullish investors who want the chance to earn large
profits.  But remember that profit only arrives when the stock rallies.  If the stock holds steady or declines, you may discover that cash premium you collected was too small to make the process worthwhile.

The
space here is too short for a more detailed discussion of how to choose a
strike price that affords a good combination of protection (if stock declines)
and time premium. That information is
available elsewhere. But paper trading
for a few months can give you a great deal of insight.

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Recommended Option Strategies #1: Covered Call Writing

There
are six strategies I recommend for option traders. There are other good strategies available,
but these are the ones I use for my own trading and each is easy to understand. At the top of the list is covered call
writing.

This
is a wonderful way for rookies to learn all about options and gain experience
buying and selling call options.

Most
option rookies already understand the stock market and have investing
experience. Thus, beginning with an
options strategy that includes stock ownership is a logical way to introduce
investors to the world of stock options.

Definition: Covered call writing – The sale of a call
option that is backed (covered) by 100 shares of stock for each option.

To
implement this strategy, buy 100 shares (or more, in multiples of 100), or use
shares you already own, and sell one call option for each 100 shares.

When
you sell a call option, you collect a cash premium that is yours to keep, no
matter what happens in the future.

When
you sell a call option

  • You become
    obligated to sell 100 shares of stock at a specific price, known as the strike
    price – but only when the option owner elects to 'exercise' the option.  You, as the option seller, have nothing to say about that decision.
  • Both you and the
    call buyer agreed upon the strike price when you sold the call option.
  • The obligation to
    sell your shares lasts for a limited time – until the expiration date. If the option owner fails to exercise when
    that date arrives, your obligation ends and the call option expires worthless.

 

When
you are assigned an exercise notice, it’s nothing to alarm you. It’s simply a report from your broker stating that the option has
been exercised and that you must sell your shares at the strike price.

 

There is much
more to this strategy. You must choose
an appropriate stock to own.  When selling an option, you must choose a strike price and expiration month. There are always at least three strike prices
and four expiration months from which to choose. It may seem complicated at first, but if you practice
in a paper trading account, you’ll learn how to select appropriate options to sell.


Part II.

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