Iron Condor Question

From a reader

Consider following 2 Iron Condors:

Sell X index march 6600 Call
Buy X index march 6700 Call
Sell X index march 5800 Put
Buy X index march 5700 Put

Sell X index march 6600 Call
Buy X index march 6800 Call
Sell X index march 5800 Put
Buy X index march 5600 Put

Underlying:6200 for both.
Lot size 50

**(see below) Maximum risk: $5,000 for trade-1: $10,000 for trade-2

** Premium collected: Approximately $1,700 ($5,000/3) in trade-1 & slightly less than $3,300 ($10,000/3) in trade-2.

Considering only the trades allowed to expire, it requires 2 winning trades for each lost trade with either iron condor. But earnings potential in trade-2 is almost double.

Considering overall risk factors which trade is preferred & why?

Excellent questions because it is common to think about a pair of similar-looking iron condors in this manner. And the truly important question is how does a trader decide which of the two spreads better suits his or her needs.

The first iron condor has strikes that are 100 points apart and the second uses strikes twice as far apart. Even though the widths in this example are extreme, the principles that I want to discuss remain relevant.

** But first:

    –The spreads are 100 points wide (not 1 point) and the risk per spread is $10,000, not $100.

    –Thus, 50-lots of the first spread is a humongous position with a risk of nearly $500,000. The second, wider iron condor, places $1,000,000 (less the premium collected) at risk.

    –Instead of collecting $1,700 (and $3,300) the true premium collected would be $170,000 and $333,000.

We can discuss the relative merits of the two iron condors, using your numbers for the cash premium and risk. We do that by changing the index price to $62 from $6,200.

Comparing the 2-point iron condor with the 1-point iron condor

When examining the wider spread, or the 56/58 put spread or the 66/68 call spread, the first thing to understand is that selling these spreads is exactly equivalent to selling each of the more narrow spreads contained within. For example:

    Buy 56 put; sell 57 put coupled with
    Buy 57 put; sell 58 put

    gives you the same position as

    Buy 56 put; sell 58 put.

We prefer to sell the 56/58 put directly because it involves only one trade instead of two. That not only saves cash on commissions, but it also is more efficient to make the trade. Remember that every time we place an order, we must face slippage, or the cost of buying an option at a price that is nearer to the asking price than the bid price; plus the cost of selling an option at a price that is nearer the bid than the ask. This cannot be avoided and is the cost of doing business. But we can be smart about it and when we want to sell the 56/58 put spread, we enter an order to do exactly that. We never sell the 56/57 spread and follow that trade by selling the 57/58 spread.

Trade size: Profit potential vs. risk

Yes, the profit potential of the second spread is almost double that for the first spread.

However, it is mandatory to understand why that is true. First the potential loss is twice as large and we should not be surprised that more risky positions provide for the opportunity to both earn a larger profit or incur a larger loss.

Second, the first trade is truly 50-lots of a 1-point iron condor whereas the second trade is truly 50-lots of EACH of two different one-point iron condors, or 100- lots total.

Thus, there is neither an advantage nor a disadvantage to trading the wider spread.
But, if you choose the wider, then it is essential to trade only one-half as many contracts (25-lot) when the iron condors are twice as wide. That is how we manage risk. We must not fall into the trap of believing that 50 spreads is the same as 50 different spreads. We should chose the size of our individual trades based on keeping risk at nearly equal levels. Thus, 50-lots of the 1-point IC is very nearly the same as trading 25-lots of the 2-point iron condor.

So, how do we decide between trade-1 and trade-2?

Once you understand that the trade consists of 50 one-point iron condors, then the decision becomes relatively simple.

Look at the 57/58 and the 56/57 put spreads. Which one is more appealing? The former provides a larger premium, and that is attractive when selling the spread. However, the options are also closer-to-the money, and that means there is an increased probability of incurring a loss on the trade.

The bottom line becomes: Do you feel more comfortable with the higher probability of losing money coupled with the higher reward when the trade works as hoped? Or do you prefer a bit less premium in return for a slightly greater chance of earning some profit from the trade? that is the choice and that is how you should go about deciding which trade to make.

If you like the 57/58P spread better, then trade a one-point iron condor. Go ahead and compare the two call spreads with each other and chose the one that you prefer to sell. Trade either of these iron condors: 57/58P//66/67C; or 5758P//67/78C.

If you prefer the 56/57P spread, then trade a one-point iron condor that includes that put spread and one of the call spreads: 56/57P//67/68C; or 56/57P//66/67C.

When you cannot decide; when either of these iron condors appeals to you, that is the time to trade half as many of each, or 25-lots of the two-point iron condor: 56/58P//66/68C.

Longer-term break even

It is not correct to look at the long-term situation as winning trades will always earn the maximum amount (the $1,700 credit) and that losing trades will always lose the maximum amount ($3,300) because

    –Sometimes the underlying is between the strikes (i.e., 56.25) when expiration arrives and the loss is less than the max. This does not happen often.

    –The prudent iron condor trader actively manages risk and does not allow his fate to be determined by luck. It is seldom a good idea to hold these positions until expiration arrives. Part of the time we take a large, but less than maximum profit early. At other times, we take a loss early, as a defensive measure when the risk of holding becomes too high.

One Response to Iron Condor Question

  1. josh 06/14/2014 at 6:45 PM #

    Can you explain how you would get more slippage in a 1-point spread versus a 2-point? You’re going to have slippage with either, and I don’t see how the 1-point would be any less than the 2-point. And when comparing the two spreads, you generally make slightly more with the 1-point spread(and twice as many contracts) than the 2-point.

    Hello Josh,

    Yes, we have slippage with all trades. When the bid/ask spreads are tight, slippage is not an issue. However, when spreads are wider, it is usually a big problem. Under the reasonable assumption that you, the trader of 1-point spreads will trade twice as many contracts as the 2-point spread trader (as you said that you would), you must overcome that wide spread twice as often.

    The 2-point spread may be a bit wider — say for example $0.30 rather than $0.25, is not going to be twice as wide. The 1-point trader may have to give up $0.05 to $0.10 to that midpoint, but the 2-point trader will be able to get a fill at least as good (giving up no more than 10 cents to the midpoint as slippage, but will almost never be forced to pay as much ($0.20 away from midpoint). Over a number of trades, that 2-point trader will lose fewer dollars to slippage. In some instances, the slippage per trade can be equal. In other words, the 2-point trader may be able to get his order filled @ $0.05 from midpoint while the 1-point trader would pay that $0.05 ‘cost-of-doing-business penalty’ twice.

    As to ‘generally making more’ for the 2-contracts of the more narrow spread than for for one-contract of the wider spread, that is (I hope) obviously always true — BUT IT DOES NOT MEAN THAT THE TRADE IS A BETTER CHOICE.

    If the underlying is priced at $200, let’s say that your preferred options to sell are the $196 put (and $204 call. When you buy the $195P and $205C (making the 1-point spread TWO times) vs. buying the $194P and $206 call (making the 2-point spread ONE time), the premium MUST be higher because the 2-point trade includes one lot of the same 1=point spread, PLUS one-lot of the $195/196P//$204/205C spread). The latter is farther OTM and carries a lower premium.

    You should NOT choose the 2-point spread unless you truly want to own 1-lot of each of those two spreads. If your preference is trade the $195/196P//204/205C spread – then you should trade two of those. However, in deciding which position to trade, part of that decision has to include the reduced slippage and reduced commission cost for trading the 2-point spread. Just be aware that those reduced costs are not always sufficient to decide on the two-point spread.

    I tried to keep this reply short. Please let me know if this answer works for you.

    I wish you good trading.