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Adjusting in Stages. The Reality.

Question (black font) and answer (blue font):

Dear Mark, Hello Antonio

Firstly hope everything is OK as you don’t write too frequently in the blog. I am writing much less these days, and most of that appears in my column.

Maybe you remember me Sure I remember you because throughout the years I have done some questions and also was in the premium forum a few months. I got out because it coincided with a strong work time and also left trading because of the poor results.

I came back to the idea of ​​the Iron Condor and re-reading some post I would like you to validate this system and give me your opinion about it.

The idea is to adjust risk by closing in stages as you suggest and I explore the numbers.

In these low volatility times, it seems to make an IC by generating a 3$ credit is very difficult. 2.5$ could be easier with delta 15 ~ It’s a different world today, and we must adapt to current market conditions. Just be certain that you truly like (i.e., you are comfortable owning) the positions you are trading — and not merely following a formula for deciding which iron condors to trade. For example, when IV is low, 15-delta iron condors would be less far out of the money than they used to be. Perhaps you would be more comfortable with a lower delta…maybe 12. That is a personal decision, but I want you to think about it. Do you want a smaller premium coupled with a higher chance of success? It is very difficult to answer that question.

Scenario: I trade 3-month iron condors.

Closing the not-adjusted (i.e., profitable) spread 3 weeks before exp at an estimated cost of 0.50$

I trade 6-lots of the iron condor, collecting 2.50$ in premium for each. Total cash collected is 1,500$.

First adjustment: Close ~20% position (1-lot). losing 100$. I would close only the threatened half of the IC. I encourage exiting the whole iron condor.

Second adj: close ~30% position. losing $ 150 per iron condor (2 contracts) = 300 loss.

Third adj. close remaining 50% position. losing $ 250 (3 contracts) = 750 loss.

Let’s examine the worst (or at least a very bad) scenario: we would have to adjust every month of the year: This is very harsh. This scenario should seldom — if ever — come to pass.

  • Six times: 3 adjustments, exiting entire position.
  • Six times we make only 2 adjustments.
  • Assume that we NEVER get to earn the maximum possible profit (zero adjustments)


3 adjustments:
1500-100-300-750-300 (spread value not threatened $50×6) – 60 (commission) = $ -10 [i.e., we lose $10 for the trade]

2 adjustments:
1500-100-300-300 (spread value not threatened 0.5×6) – 60 (commission) = + $ 740

a) Lose $10 six times per year: = -60

b) Gain 740 six times = 4,560 ….. ….. 4500$ year ….
Total Annual Performance = 4500/18000 = 25%
This would be a very satisfactory result.
Unfortunately the math is very flawed.

***You are assuming that it costs $100 to exit at the first adjustment, but that is the LOSS, not the cash required. To exit one iron condor at a loss of $100 costs $350 to exit.

Similarly, when you exit after two adjustments (at a $150 loss per IC, it actually costs $800 cash – i.e., your original $500 plus $300 in losses).

Exiting after three adjustments costs the $750 loss plus the original $750 premium. Total cost is $1,500.

Thus your numbers should be:
a) The 6 times when three adjustments are required: collect $1,500, pay $350 for adj #1, pay $800 for adj #2, pay $1,500 for adj #3, pay $60 in commissions: Loss = $1,210.

b) The 6 times that two adjustments are required: collect 1500, pay $350; pay $800, and pay $150 later to exit the three winning spreads; pay $60 commissions. Net profit is $140.

The Discussion

As I say I’d appreciate an opinion as deep as possible, because regardless of other possible adjustments we can make, I think the way you handle the IC goes here.

One practical difficulty is this: How aggressively do you try to exit when adjustment time arrives? If you do not bid aggressively to exit the position, the loss may get much higher than $100 before your trade is executed. If you bid very aggressively, then you may be paying too much to exit positions that have not yet reached the adjustment stage. You must think about this.

Honestly I pulled away from trading because i was not getting good results, but I continue thinking that IC are great and that your way is one of the best to do it. Please remember that no method is ever good enough – unless you feel comfortable when trading. Why? Because discomfort leads to poor decisions. Also: When you examine the correct numbers (above), you will see that you cannot make any money when you anticipate making three adjustments approximately 6 times per year. Adjustments are expensive and we make them to be certain that we keep our losses small. However, you must expect to make one or fewer adjustments — most of the time — for the iron condor strategy to be viable.

Please tell me if there is some way to communicate privately. Thank you. Send email and we can discuss. rookies (at) mdwoptions (dot) com



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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.

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Iron Condor Spread Strategies: Book Review

Jared Woodard, my partner at Expiring Monthly, has produced an outstanding essay published in book format.

Iron Condor Spread Strategies: Timing, Structuring, and Managing Profitable Options Trades $8.99

It cuts to the heart of iron condor trading. With no wasted words, Woodard makes a significant contribution.

Iron Condor Spread Strategies by Jared Woodard

  • Don’t have a lot of time? – this book is short
  • Already know the basics? This book builds on what you already know
  • Want your trades to perform better? This information is valuable

From the introduction:

Iron condors have become popular, but there is little detailed or quantitative information about the best way to employ them. As participants in 2008’s crash and 2010’s bull market can attest, “set it and forget it” is not ideal. I’ll discuss when to enter a condor spread, introduce key structuring techniques and considerations, and present back-tested returns for selected strategy variations

Direct quotes

Instead of taking the approach (as I admit that I often do) that the iron condor is your trustworthy friend, Woodard lets you know that the trade is speculative in nature and that there must be a reason for initiating the trade:

Objective, statistically-significant indications that some asset is likely to be range-bound in the future, provide an excellent justification for a speculative condor trade.

Woodard issues an alert:

The characterization of iron condors or any other option spreads as “income-oriented” is misleading. A given iron condor trade will conclude with a net profit for the trader only if the thesis of the trade proves correct… In this respect, option spreads are no different from any other form of speculation.

I highly recommend this e-book.

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Iron Condors: Introduction to Risk Management

One of my oft-repeated messages to option traders is that it is easy to make money when trading options and the difficult part is keeping those earnings. Many of the income-producing strategies win a majority of the time. They are designed to produce more wins than losses.

The problem arises when the stubborn trader, doing whatever he/she can to avoid taking a loss turns a position into a giant loss. That’s the path towards blowing up a trading account. We all say that it will never happen to us because we are too smart, or too disciplined, or too anything else that you want to include.

The fact is that you must be able to apply that discipline when the pressure is on. That means when losses are mounting, the market is not moving your way, and you are pleased with neither what you own nor the chances of salvaging the position. If you cannot pull the trigger when that’s what must be done, then you are in trouble. Warning: pulling that trigger far too early – just to prove you can do it – is also ineffective.

With that as background, a discussion of risk management is necessary for option traders.

Introduction to risk management

Today’s video is a basic introduction to the concept of risk management. It’s 8 minutes of background and general advice, with no specific trade suggestions.

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Less Costly Method: Hedging with put options

I’ve joined the impressive group of writers who publish their thoughts at the new CBOE blog

The following excerpts comes from a recent post by the (Surly Trader)

Put Spreads as an Attractive Hedge

Hedging equity positions [with puts] can be fairly expensive, but there are very attractive ways to mitigate that cost.

Bearish Diagonal Put Spread

I like the (bearish/reverse?) diagonal put spread strategy for a number of reasons: [MDW: I would call it ‘reverse’]

I am purchasing implied volatility at much lower levels by buying the short dated put, making the short dated downside protection fairly inexpensive.

I am selling implied volatility that not only takes advantage of the steep skew, but also takes advantage of the fact that longer dated options are trading at higher implied volatilities than short dated options.

I hope this brings some new ideas to your option trading strategies.

My all-time favorite hedge is one step removed from here – a bearish ratio diagonal put spread in which I buy short dated put options and sell a larger number of far out of the money longer dated put options….

He (ST) is advocating buying a front-month, less expensive, put option and selling extra longer-term, farther OTM puts. Two points:

  • Less expensive because it is front month an d has much less time value (obviously), but also
  • Less expensive because it has a higher strike price and thus a lower (becasue of skew) implied volatility

    I like part of this plan, but prefer not to sell naked options.

      Example, Surly Trader’s play may be:

        XYX is trading ~520 to 540

        Buy 10 XYZ Jun 500 P
        Sell 30 XYX Nov 420 P

    I’ve previously written about a similar plan. It’s the coward’s version. He sells naked options and I sell option spreads. But we both suggest owning the short-dated options. I encouraged that idea as a risk management method for adjusting iron condor positions in The Rookie’s Guide to Options.

    In the coward’s version, I sell 30 or 40 put spreads (vs.10 puts bought): It’s not easy to know which strikes because so much depends on IV. Yet a reasonable guess is the 420/430 P spread or the 430/440s.

    If the market makes a steep decline, My long put will prove to be very profitable – perhaps explosively so due to a much larger IV increase (as measured by IV points, not in $) in the front month options . This represents a situation in which positive gamma becomes our ally – and there is no worry about fighting negative gamma.

    The shorts are spreads, with limited losses. Profitability for the whole trade depends more on how far the market moves and how much time remains in our long options (time value can be significant, even during the last few days prior to expiration) than on the price of the short spreads.

    This reverse ratio diagonal spread produces favorable results when:

    • Rally occurs with volatility decline. Longs expire, Cover shorts cheaply
    • Large, rapid decline
    • Time passes, longs expire, but shorts decline by enough to turn the whole position profitable. This is the result of owning cheap Jun options (and not costly Nov options) as protection against the Nov shorts

    This trade is uncomfortable for many traders because they know must buy new protection, or exit the trade.

    Despite the apparent ‘backwardness’ of this trade, at times it can be the best choice – if not as a stand alone trade, then as an adjustment for a credit spread gone awry. I would not make this my strategy of choice. But it has enough going for it that it is always a consideration. And it is ST’s favorite.

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Managing Iron Condors with Imagination

This post is based on the very thoughtful comment/questions posed by Chris O.

Dear Mark,

I have been thinking lately, If one always exits an IC early, say one month before expiry on an IC that was opened three months before expiry, is it useful to do the following:

As the short legs of the IC ought to be closed one month early and I want to discipline my self to do so, why don’t I select my protection, the long legs of the IC, at one month earlier expiration.

Such wings of the Condor are cheaper to buy. The wings of an IC chosen the normal way, extending to the same expiration, are mostly worthless when I sell them one month before expiration, together with buying back the short legs of the IC.

So using shorter duration long legs on the IC takes away any hapless covering of the entire IC, and allows me to make more money?
Looks like Free lunch = I must be overlooking something.

Not so free lunch

This is not a free lunch, and there is likely to be significant margin problems. However, the strategy has a great deal to recommend it.

You envision an iron condor similar to the following:

Buy X INDX Jul 1050 calls
Sell X INDX Aug 1040 calls

Buy X INDX Jul 880 puts
Sell X INDX Aug 890 puts

Your long options expire before the short options. This has a lot going for it, per your description above. However, the margin gods don’t like such positions. When the long option expires after the short, they are considered to be naked short. That uses up a ton of margin for the average investor.

Portfolio margin

However, if your account uses portfolio margin, you are granted many special advantages regarding margin. Such accounts are margined by looking at the overall risk associated with the portfolio – and not by looking at each individual position. The bad news for many is that the account must be at least $100,000 to qualify. But readers should ask their broker about portfolio margin, just in case they do something different. [IB follows the rules mentioned here]

Forced exit

If you want to ‘discipline yourself’ to exit one month early, this is certainly a good way to do it. However, do keep in mind that when INDX is near 880 or 1050 (the strikes of your long options), the longs are going to expire worthless and it is going to cost a lot of money to buy back your shorts.

Nevertheless, that specific result will not occur very often and over the longer-term this may well be a winning play. This trade allows the position to be opened for a large cash credit, and there are obvious benefits in doing that.

1) one spread, put or call, might be too close to the money and have to be bought back at a loss or a additional wing must be bought for that side to cover a short position during this last month. Does not make sense as an argument, I want to stick to the rule of closing the short legs on month before expiration, so closing at a loss is “biting the bullet”. I definitely don’t want to stick around in a high gamma last month environment with a short option close to the money, even when it has a long option covering to the final month.

Yes, it makes sense to me. However, I urge you to take the worst case scenario, estimate an implied volatility for the August calls, and get yourself a good estimate of how much can be lost. If you size this trade properly (that loss is acceptable, not devastating), then you will be in good shape when using strategy.

It’s easy to back-test, if you have the data. Or you can accumulate data in a paper trading account. To gain data quickly, do three different indexes simultaneously.

2) IV might have jumped on the underlying, and both short options may have higher value than I collected – even with one month to go. Does not matter? If IV is so high I don’t want to remain in the last month when gamma is also high. Wild swings can happen. So again, why bother buying wings on an IC when the plan is to carry the IC to the final expiration?

Are long legs of an IC carrying to to the last expiration date worth anything, one month before expiration at a high IV?

Yes, it matters. Yes, IV may become a problem. And yes, those one-month options would have a very high value in your high IV scenario.

However, a low IV offers an occasional extra profit. The key to survival here is being very careful about position size.

There is a point you are missing. If you own the traditional iron condor in a high IV environment, one month prior to expiration, your remaining long call would significantly cut the loss when exiting. But, as you say, your plan is to earn extra profit all those times when IV is not extra costly and your long option is not near the stock price. Probability is important for a good analysis of this play, and having he ability to back-test this method for a bunch of years would be helpful.

3) I am trying with a small position, now running until final expiration in May, at Interactive Brokers and see little effect on margin requirements. No argument either.

Can you shed some light?

Thanks a lot for your efforts

I don’t understand why there is no problem with margin. Please let me know if you are using portfolio margin.

Do keep in mind that there is little to be learned from a single example. You can develop some novel adjustment ideas, but this study requires a good deal of data.


P.S. On Options for Rookies Premium, is the planned content difficult to organize for people in a very different time-zone than yours?

[Visit the link above for a short video that describes live meetings (and the problem of time zones), one of the important features for Gold Members. You must become a free member (Bronze) to gain access to the video]

Yes, different time zones present a problem when planning live meetings. We already have members from Hong Kong, Singapore, and the Netherlands. Therefore, I am requesting that members suggest times that are best for them and I’ll do what I can to make it convenient for as many as possible. If necessary, I’ll add extra sessions. For now, I’m promising four live sessions per month, but I suspect it will have to be more than that.

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