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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9 Responses to Iron Condors: Introduction to Risk Management

  1. Mike S. 05/13/2011 at 9:56 PM #

    In your excellent book, The Rookies Guide to Trading Options, you devoted a chapter to credit spreads, i.e. selling a spread. However, you barely mentioned debit spreads. Why not? I was also under the impression that credit spreads were riskier than debit spreads. Is this true? Finally, with credit spreads, is the greatest risk the chance you could get assigned and be forced to buy the stock at an undesirable price? Thanks,

    Mike

    • Mark D Wolfinger 05/14/2011 at 9:15 AM #

      Mike,

      I “barely mentioned debit spreads.” Guilty as charged. When I did mention debit spreads, I carefully described how debit spreads and credit spreads are equivalent. If the trader buys a call debit spread or sells a put credit spread -WITH THE SAME STRIKE PRICES AND EXPIRATION DATES – then the trades are essentially identical in risk, reward, profit and loss.

      You are mistaken. Neither spread is riskier than the other.

      Finally:

      a) With a credit spread, yes there is a chance of being assigned an exercise notice. But that requires that you be very careless as a risk manager because that only happens when the option is relatively deep in the money. Anyone managing risk would no longer be holding the position in that situation. It is much smarter to exit and take the loss rather than risk seeing the trade to go to the maximum possible loss.

      b) You are concerned about getting assigned and buying stock. Why do you do that? That only applies to put spreads. Credit spreads can also be traded using calls.

      c) I don’t understand what you mean by being forced to ‘buy stock at an unfavorable price.’ When you initiate the trade bu selling a put or put spread, you are accepting the potential obligation to buy stock at the strike price of the option sold. If you deem that to be ‘unfavorable’ then don’t sell that option. Choose a spread for which the strike price is not unfavorable. Or at least choose a price you are wiling to pay to own shares.

      But none of that is important. If you do not allow your short option to move deep ITM, you will not be assigned an exercise notice. What can be easier than that?

      More than that, option owners seldom exercise prior to expiration, so you have plenty of time to exit the trade.

      Last, but not least: what is so bad about being assigned an exercise notice? You can easily get rid of the stock and sell your long option. That gets you out of the spread.

      Fear of exercise is just absurd. If you fear exercise don’t sell options or at least don’t allow them to more into the money. You are allowed to repurchase options that you sold – before that happens. You cannot expect to earn a profit from every trade, and sometimes taking a loss is the best move because it prevents a much larger loss. And in your situation, it prevents that ‘dreaded’ assignment notice.

      • Mike S. 05/14/2011 at 9:43 AM #

        Thank you very much, that clears up my confusion!

        Mike

  2. Noam A 05/15/2011 at 3:58 AM #

    Hi Mark,
    I remember that you wrote a post regarding selling naked options as adjustment.
    I remember you wrote that it’s actually a very bad thing to do ad adjustment. But i can’t remember why….
    I know many traders that when the market for example climbing up, they will continue to sell more put options to raise P/L graph.
    can you post the link for that post?

    Thanks,
    Noam

    • Mark D Wolfinger 05/15/2011 at 9:55 AM #

      Noam,

      Here are the basic points:

      1) When the market is rising, selling more puts or put spreads does bring in positive delta. This is a popular strategy, used by many.

      2) Selling those puts or put spreads brings in additional cash, reducing losses when the market continues to rally

      3) For some people this is their top adjustment choice. For me it’s at the bottom of my list. In other words, I will consider it – but only when I can find nothing better to do and am wiling to accept the risk, as described below

      4) Selling those puts adds negative gamma to the portfolio. [Yes, it does add positive theta, and that the good news].

      5) The trader now faces a situation that is awkward. There is obviously upside risk, or he/she would not be making this adjustment. These put-selling trades now add downside risk. If the market turns, the trader suddenly has risk where none existed before.

      The reason this is a BIG problem is because of the puts chosen for sale. If the trader chooses to sell lower-risk, far OTM puts (or put spreads), then the cash collected is not large enough (in my opinion) to make much difference if the stock continues to rally. On the other hand, if the trader collects more cash by selling puts (or spreads) that are closer to the money, then a market reversal presents big risk to the downside.

      And consider the person who sells some puts, then more puts then more puts. If that trader does not cover the now low prices puts sold earlier, he/she faces the risk of blowing up the account should a disaster befall the market. Not worth it. Not to me.

      6) I refuse to take that downside risk in exchange for the RELATIVELY SMALL sum of cash that can be collected by selling puts. That sum is often much smaller than the risk presented from a continued upside move. In other words, if the market rallies, that cash collected is immediately overcome by the loss resulting from the current (and unadjusted) call portion of the iron condor.

      Too much risk and not enough to gain. That’s my bottom line.

      Here is one post where I mention that idea: https://blog.mdwoptions.com/options_for_rookies/traders-mindset-series-ii-always-collect-cash/

  3. Noam A 05/15/2011 at 10:26 AM #

    Thanks Mark,

    This is the post i was looking for (i asked you there more or less the same question).
    Thanks again for all of your help,

    Noam.

    • Mark D Wolfinger 05/15/2011 at 10:38 AM #

      My pleasure

  4. mark 05/23/2011 at 1:55 PM #

    What about buying put spreads to protect an iron condor as the market falls? Is this a good time to discuss that strategy?

    • Mark D Wolfinger 05/23/2011 at 3:17 PM #

      Mark,

      An excellent way – if the spread is not too expensive.
      I did discuss that in the video covering adjustments to the 110516 trade. Video 2.

      But it is always worth another discussion