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



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.


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.



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9 Responses to Establishing a Maximim Loss for a Trade

  1. Edgardo 10/05/2010 at 6:35 AM #

    Hi Mark:
    I usually set my IC at $3, with a mental exit if the price reaches 5 or 5.5
    I had an October position (shorts at 540-690)
    End of september, like 20 days remaining, and RUT flirting with 680, and my IC was near 4
    sept 30 RUT opened at 685, IC at 4.5, and midday it touched 670, IC at 3.35 and I exited
    It never touched my 5 to 5.5, but out of my “comfort zone” 🙂
    Maybe I should have exited 20 days after open it, when it was 1.8, or 30 days at 1.7, after 2 days earlier it was 3, but who knows, it was well in my comfort zone then. I think my market prognosticator kicked in, telling me that the market “must” come down, or as you called it, coming from a few months of perfect IC conditions.
    If I were one of those gurus giving advise, I could advertise it as another winning trade, collecting 3.05 to enter, and reaching 1.7, 20% in a month, thats 800% anual compounded!!!! You could turn 12000 in a million in just 2 years! just pay me 100 a month 🙂

  2. Mark Wolfinger 10/05/2010 at 7:34 AM #

    Thanks for sharing.
    A good example of neither waiting for maximum loss nor the big profit.

  3. Marty 10/05/2010 at 10:25 AM #

    I’m a data-driven trader, so one piece of advice I’d give Antonio is to get all the historical price data he can for the underlying as well as the options themselves. One thing I need to establish my comfort zone is an idea of the average HV (historical volatility) of the underlying. Many years of historical stock prices are available for free on Yahoo or Google Finance, he can easily start playing with the data in Excel and build the probability distributions you mentioned earlier. Knowing how far the underlying will move on average in a given period of time is very helpful for me.
    Another good free tool is at the CBOE website – it’s called “IV Index” and shows HV and IV for any underlying symbol on the exchange. Looking at those charts helps me determine if current volatility is unusually high or low compared to past values.
    Using those two ‘tools’ is usually enough to help me find a comfort zone for an iron condor trade.

  4. Mark Wolfinger 10/05/2010 at 11:07 AM #

    Thanks for sharing.
    Tools and data. Those along with patience can be very helpful.
    I agree that deciding on boundaries or limits for a trade is truly part of discovering your comfort zone boundaries.

  5. Steve B 10/05/2010 at 11:41 AM #

    I would recommend reading “Trade your Way to Financial Freedom” by Van Tharpe. This book dives into this very topic specifically in a number of ways. I just read the book and it opened my eyes to this very subject.
    Lets take the example Mark gave above of trading a 10 point spread, with a max profit of $100 and a max loss of $900. If you were to tell someone you had a system that makes $100 per trade and you win 90% of the time, that is awesome! BUT… if that 1 loss out of 10 is $900… at the end of the day you end up with nothing. So what happens if that 1 loss out of 10 comes 3 trades in a row? Can your account handle that?
    It is a very in depth book and provides great insight on setting up your own maximum loss threshold. Highly recommend it.

  6. Mark Wolfinger 10/05/2010 at 12:42 PM #

    Steve B,
    Not familiar with this book. I will look into finding a copy.

  7. Antonio 10/06/2010 at 3:03 AM #

    Hi Mark
    Edgard, Marty, Steve, of corse Mark, thanks a lot for your responses. Sincerely, this has been one of the most useful post to me. Risk management is all¡¡

  8. Martin P. 10/08/2010 at 5:41 AM #

    Hi everybody,
    I like to take trading as a system and I prefer systematic approach. Before I enter any position I want to know what
    1. Setup your entry and exit rules accurately (what day to enter, what conditions do you prefer, when not to enter, exit price stop / profit target / time stop / change in trend etc.) Setup also maximum SL.
    2. Backtest your rules on historical data (you can use Thinkorswim platform for free, there are tools for backtesting)
    3. Evaluate results – backtest gives you following numbers: number of winning and loosing trades, number of consecutive losts and win trades, average profit/loss on one trade. Backtest also give you hypotetical equity curve.
    4. Adjust your ruler and backtest it again You can decide, that such a system you designed at the beginning is out of your comfort zone but not as a trade but as a system, because time to time it can give you eg. 2-5 consecutive losses and this is hard to handle. But you can also decide to take smaller credits and maybe win more frequently. Or you can try to close your position if you get 85% of credit, or you can try to setup a time based exit. You will see what it will make with your historical equity.
    This is what I love on trading. The possibility to test it before I bet my money and know what I can expect from some trading approach.
    My hint is: Dont search for comfort zone for one trade, but for all the tested system.

  9. Mark Wolfinger 10/08/2010 at 8:29 AM #

    1) I strongly agree with the bottom line: It takes far more than one trade to know what will work and what where your comfort zone lies.
    2) I do not believe the setup is that important when you plan to hold an iron condor trade for 3 to 13 weeks. I may delay entering by a couple of days just because I don’t like the premium available. Why must one know, in advance, when to open the trade?
    Trends change. Markets make unexpected moves. What does the set-up do to help with that?
    3) I do not believe the average investor gets any useful information by back-testing iron condor trades. The most important factor in the success of an iron condor is whether the market remains calm.
    When time passes and options fade into near oblivion (and bought back), profits are relatively gigantic. The trader can, in these ideal conditions make 20% in a single month. Not often, but it does happen.
    When the market moves and adjustments are made, then results depend on how talented the trader is as a risk manager, when adjustments are made, which adjustments are chosen etc.
    How can backtesting help with that? If the trader tests a single adjustment method, the results can easily depend on the calendar and when the adjustment is made.
    I don’t back-test, so I may simply be unaware of how useful it can be. But trading iron condors, credit spreads, even butterflys – the set-up is not important as it is when picking a stock to rally or fall. It is far different. At least in my opinion
    Thanks for sharing. I appreciate the discussion.