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Managing Iron Condors: The Worst Adjustment

My oft-stated belief is that it is almost impossible to become a successful options trader without becoming a skilled risk manager.

When it comes time to decide how to reduce the risk of holding a position, there are many choices. The alternatives are too numerous to describe, however, the basic choices are

  • Do nothing. This is not risk management. This is wishful thinking
  • Adjust the trade to reduce risk
  • Cut position size by exiting all or part of the position

The best decision

making a decision

I believe that adjusting the trade represents the best choice, with the following stipulation: Once the position has been adjusted, the trader likes what he/she owns; believes it is likely to earn profits going forward; is no longer too risky to own, and satisfies the psychological needs of the trader. That last phrase simply means that it is comfortable to own the position and is not being held for the sole purpose of recovering a loss.

When it comes to adjusting, there are always going to be alternative trades from which to choose. Today I want to discuss one specific type of trade. I know that many traders like to adopt the example that I’ve chosen to highlight Despite that fact, I believe it is the worst possible choice.

The worst choice

    Assumptions: We opened an iron condor position and the market has declined to a point where the put spread has become worrisome. For this discussion, it doesn’t matter whether the put spread is 5% OTM (far too early to be concerned in my opinion); 3% OTM or ATM. The point is that the underlying asset has moved to a point at which the specific trader who made the trade is uncomfortable holding the position as is, and wants to make an adjustment.

    Let’s assume that the position is long 300 delta.

There is one adjustment method that I avoid discussing – just to minimize the possibility that it would occur to any reader to experiment with this trade idea. Keep in mind that the ONLY reason for making an adjustment is to reduce risk – as long as the new position is worth holding. We do not reduce risk to crate a position that we do not WANT to own.

So what is this adjustment that I think is so terrible?

It’s the sale of call spreads to add some negative delta to the portfolio. (Or put spreads when the market has been rising and the portfolio is delta short.) Selling call spreads accomplishes some noble goals: It move the position nearer to delta neutral. When trading with no market bias, that’s a good thing. It also adds more cash to the trader’s account, increasing the potential profit, and we all like to earn more money.

One other benefit of adopting this strategy is that it seems to work so often. Much of the time the market continues to drift lower, making this adjustment profitable. Of course the put situation has gotten worse. That’s not a real problem when the trader is on top of the situation and is taking steps to manage risk. However, all too often the steps taken include the sale of even more call spreads. Once again, taking in cash and reducing the immediate delta risk.

I must admit that this strategy works very nicely when it works. Sometimes the cash from the call sales is sufficient to cover all losses from the put side of the iron condor and the trader may eventually earn a profit. Sometimes the market stops moving lower and the trader not only earns the original cash collected when initiating the iron condor trade, but is rewarded with extra profits derived from the call sale.

That’s the good news.

However, the primary (if not the only) purpose of making the adjustment is to reduce risk. This method does reduce delta risk (temporarily), but it adds negative gamma and a significant downside risk. when selling those additional call spreads, too often the trader sells a cheap spread (so it is reasonably far OTM). That does notr add very much cash to the kitty, and adds major risk of loss – if the market turns – for very little cash. If the trader makes the better (but still terrible) choice of selling calls spreads that generate a ‘decent’ amount of cash, then there is at last a reward worth earning for taking the risk.

But that’s the point. Adjustments are risk-reducing trades (or should be). The idea that lessening delta risk makes for a good adjustment is not the way a successful or experienced executes adjustments. I understand how powerfully profitable this plan looks. But it only takes one large and sudden market reversal to blow up an account with far too much loss exposure.

But there are two potential disasters that await. I believe that the sole purpose of adjusting a position is to reduce risk – not to seek extra profits. [I am not against earning extra profits, but the primary purpose is to make the current position safer and worthwhile to hold.]
When extra call spreads are sold,nothing is done to reduce the risk presented by those put spreads.

Problem number One: If the market continues lower, the loss form the puts is going to increase rapidly. The sale of call spreads is not going to generate enough cash to offset these losses. Thus, the primary purpose of making an adjustment – to keep risk of loss at a reasonable level. Once those puts move into the money, it becomes far more difficult to manage the entire position. Not only are the put spreads problematic, but the continuing sale of call spreads can result in blowing up the trading account if there is a sudden market reversal.

Problem number Two: When keeping risk in line is not the MAJOR (it should be the only) consideration when making an adjustment, far too often risk builds and goes unnoticed. The type of trader who employes this ‘sell more calls’ method of risk management seldom bothers to buy back those now, far OTM call spreads. It’s bad enough to create downside risk – where none existed before – but to not buy back the cheap options creates a scenario in which a traders account can disappear overnight.

This is unacceptable risk (Obviously an pinion and not a statement of fact). But it is a tempting methodology. It works most of the time. It can lead to extra profits. It’s easy to fall in love with this strategy. But good luck does not hood forever. Markets do get volatile again, and despite promises that the trader makes to him/herself to act in plenty of time – f necessary – the personality that sells those extra spreads to bring in more cash – is not the right personality type to be able to rush in to cover those call spreads when the market turns. In fact he sale of additional put spread would probably be the trade of choice.

This is a disaster waiting to happen. I feel it is the worst possible adjustment chocei and would go as far as to say that if you are considering this play – selling more calls without buying back the original call position – it’s better to exit and take the loss, rather than to build risk to unacceptable levels.

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What you trade matters

Thursday, Apr 28 I will be answering options questions: live via Twitterfeed. 1:30 PM ET. Submit questions to #smartoptions


Traders love to tell people that they can trade anything. That if you have the skills to be a trader, the specific item traded is unimportant. That may be true for some professional traders who are skilled technicians. However, it’s very different for gullible amateurs.

Consider the following (excerpts) by Nathaniel Popper from the Los Angeles Times. It describes how easy it is to find suckers when using hype to trap the unwary.

Foreign currency trading is easy — an easy way to lose money
More and more Americans are dabbling in currency trading and losing in spectacular fashion. Experts say the structure of the currency market makes it hard for amateurs to beat the house.

D.O. began trading foreign currencies after seeing a TV commercial touting it as a way to make extra money…

“The ads made me think, ‘This is easy,'” said the 52 year-old administrator with a Texas, police department.

She used her credit card to fund an account with an online currency broker. Within a few weeks of swapping dollars for yen and euros, she said, her $3,000 of borrowed money was gone.

She made two mistakes: investing on credit and trying to make a buck by predicting changes in currency exchange rates, something best left to professionals, according to personal finance experts. But she has plenty of company.

An estimated 615,000 Americans are dabbling in foreign currency trading, encouraged by advertising from the two biggest U.S. brokers, FXCM Inc. and Gain Capital Holdings Inc., both based in New York.

These customers are losing money in spectacular fashion.

At FXCM, 75% to 77% of customers lost money each quarter last year. At Gain, the number of unprofitable customers hovered between 72% and 79% every quarter last year.

As if those statistics weren’t scary enough, the rules of currency trading allow 50 to 1 leverage.

The losses have triggered recent lawsuits and regulatory scrutiny — but haven’t stopped the swift growth of the industry, which barely existed a decade ago. Gain and FXCM went public on the New York Stock Exchange last December.

Executives with both firms say that they simply provide a conduit for people who want to trade currency, and that customers are given full disclosure of the risk. [MDW: If you believe this, you are as gullible as their customers]

“The majority of people today are not doing well,” said FXCM’s chief executive. “There’s lots of education: ‘Here’s how to do it right.’ … Do most people heed the advice? No, of course not.”

It’s a bit ludicrous to suggest that the novice can ‘Do it right.’ For individual traders, forex represents gambling and speculation, and it’s the strongest reason that I have for recommending options as a trading vehicle.

Options allow the trader to measure risk (using the greeks). They allow the trader to understand reward and loss potential. The vast majority of traders have a basic understanding of how a stock market works. That cannot be said for the currency markets.

I have a (biased) opinion that options afford risk management techniques simply not available with stocks, futures, currencies, bonds…The ability to measure and manage risk represents a huge difference between trading options and other stuff. However, when opitons are used for speculation, those advantages disappear.

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The Big Loss

At his blog, Joey offers his perspective on the top reason that so many trader wannabes are not, and will not, become profitable traders (downtowntrader). His post is titled:

Learn to Lose Money to Make Money

Excerpts:

The majority of people reading this are not profitable traders. If I could single out the most common culprit for sabotaging your trading it would have to be not being able to take a loss. This is especially prevalent amongst new traders… out-sized losses are what cripple your account and push you into the negative column. You will never be a successful trader, EVER, until you learn how to take a loss.

The problem is that many traders equate a losing trade with making a mistake. This is simply the wrong way to look at it. A trader should judge his trades by grading the process, not the results. There are simply too many unpredictable variables impacting whether a trade is successful or not. [MDW: I’ve said this repeatedly]

Doubling down or holding on to a losing position for fear of taking a loss will eventually lead to your ruin. This will work at times… However, the problem is that the few times it doesn’t work out will lead to huge losses. Some stocks DO go to zero and stocks dropping over 20% in a day are not really uncommon.

Stocks don’t always come back and even if they eventually do, you could have been better off looking for a better opportunity. You wouldn’t keep your money in a shoe box so why keep it in a stock that’s going nowhere? Traders should focus on the process and in striving for perfection in the mechanics of a trade instead of worrying about the results. Make sure you have a plan and execute it flawlessly every time. This means only entering a trade for which you know you have an edge and then exiting at a predetermined price or condition when it goes against you.

If you take your losses religiously and focus all your effort on minimizing the mistakes in your trading process, you will undoubtedly improve as a trader. In fact, it would be damned hard to be a losing trader if you truly embraced this simple rule. Remember that taking a loss doesn’t mean you were wrong. The probabilities simply didn’t work out in your favor.

Joey is talking about stock trading, but his observations apply to option trading as well. Most of us have the ability to be profitable, and those who last a long time must show some income for their efforts. But there is something about human nature that makes it difficult to accept a loss, or even recognize how dangerous a given trade has become.

A trade plan places the number in front of your eyes: the dreaded maximum permissible loss. Most traders fail to use the trade plan in the first place, and then a certain portion of those who do refuse to accept their earlier decision as the correct step to take. It’ so tempting to try to get back to even, when all you are doing is gambling.

Trading is a game of statistics. When you have an edge, you will win. When the edge disappears, as it inevitably must for some trades, then giving up and not fighting the statistical truth is the only winning action.

This philosophy is not hindsight speaking. If you regularly limit losses, many times it would have been better not to act. But that’s not the point. The point is the only way to avoid the big loss is to take that loss when it is small.


As I was finalizing this post, Darren echoed the same theme at his blog: (Attitrade-ProactiveTrading)

By simply writing out my target and stop (amongst other things) before placing a trade I became more mechanical in my trading. If my loss target was hit I moved on to the next trade then processed the losing trade later in my journal. Losing sucks but what really sucks is losing more than I should by not following my rules. The mental baggage that will be carried from knowing better yet lacking the discipline to do so, my friends, is the real damage from a loss.

I know that it’s difficult to take advice offered by others. We all feel we must learn our lessons by ourselves. Let me assure you that I would be a whole lot better off today had I bothered to pay attention to the great advice offered to me. Now it’s your chance to learn from those who have been there – or were smart enough never to have gone there.

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Exercise and Assignment: Rookie Mistakes

Certain questions never go away

I suppose that’s true because there are always new people beginning to undertake the study of options. Those rookies ask the same questions that many of us raised when we were just getting started.

Today I’m reviewing some of the most basic aspects of options, and am offering a short explanation as to why they are true. One note of caution: This post is for beginners, and if something is true 99.999% of the time, this is not the place to discuss the rare exceptions

These items all relate to the exercise/assignment process.

Let’s begin with a question submitted to Tyler at his blog (Tyler’s Trading).

1) “I know the probability of being assigned before expiration – while there is still time value left in the option – is very slim, but is there still a chance?”

The option owner has the right to exercise that option at any time prior to expiration. That means that anything is possible and that option owners can make mistakes. However, it is best to assume that any option with any time premium will NOT be exercised. Sure, you may get that surprise assignment once or twice over the years, but not often enough to give it much thought.

In fact, when assigned on a (covered) call option with remaining premium, consider it a gift when you can repurchase the stock and re-sell the call. Or, you may prefer to get an early start and sell an option that does not expire in the front month. That gives you that extra premium as a gift (as long as it’s more than enough to cover trading expenses). That is capitalizing on someone’s mistake.

This gift happens more often than anyone would suspect, especially before a dividend. Traders who should know better, exercise an option – just to collect the dividend – and then have downside risk that is far to large for the reward. And the person assigned the exercise notice takes the gift, buys stock and re-sells that option, thereby collecting a premium that is larger than the dividend.

2) Why it’s so very wrong to exercise a call option any earlier than necessary (when puts are very deep ITM, it’s reasonable to exercise the put. This is more true when interest rates are higher.)

When you own a call option, all you can lose is the value of the call. That’s one reason traders may prefer to own calls, rather than stock. The call owner pays a premium in time value when buying the call. Exercising cancels all remaining time value. Why would anyone throw away that time value? Once you exercise, you own stock and can get clobbered when the stock price tumbles. Not exercising costs nothing. The call owner participates in upside movement, and there is ZERO reason to accept all that downside risk in exchange for NOTHING. Early exercise of a call option is a very bad idea.

The one exception (worth discussing now) is that it may pay to exercise early to collect a dividend. Much of the time, it’s still wrong to make this exercise. Do it only when there is ZERO time premium in the option and its delta is 100.

3) For reasons that astound me, some rookies believe that the call owner always exercises when the stock rises and hits the strike price of the option. If you among the tiny minority who believe this is true, let me assure you that it is not. Not only does exercising destroy the large time value in the option (time value reaches its maximum when the option is at the money), but the entire cost of the option is wasted. All the trader had to do instead was place a buy stop order to buy shares if and when the stock hit the strike.

That costs zero and the option is far from free. Even better, if the stock never hits that target buy price, the trader loses zero while the option owner sees his investment become worthless.

Many mistakes are unavoidable as we grow as traders. However, there is no reason to make either of the mistakes listed above.

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