Q & A. Iron Condors, Choosing the Strike Prices

Hi Mark,  Hello JB,

I’ve been reading your blog
and started looking at iron condors. I
believe there was a reference to a methodology of looking out 90 days and
targeting 30% – 40% of the spread for a return. If I understand this– on a $10.00 spread one would look for $3.00 –
$4.00 premium from both sides of the condor. Is this correct?  Yes.

Using RUT (Russell 2000
Index), on 08/02/2008, RUT Price is 716.14, and October expiration:

In going out 1 standard deviation
(64 points) for each side, 640/650 & 780/790, we can collect a $4.20 premium.
However the delta of .42 (.254 for the
780 call + .17 for the 650 put) is high for me. I am assuming this means there is a 42% chance of NOT being between the
short strikes. Is the correct way to
read the delta? CORRECTED: Yes.

To get a more comfortable
(for me) delta on the call side, using the 820/830 call spread, reduces the
premium collected to $2.70, but the total delta for the short strikes is .304
(.17+.134). 

To get a 24% annual return
with this strategy means collecting a $0.60 premium per 10 point spread every 3
months. Correct? Yes, ignoring commissions.  That’s earning 6% every 3 months. $0.60 premium doesn’t look that hard to
do. Am I missing something?

No.  Sixty cents
is not difficult to earn.  And you will make it fairly consistently. But, if you
buy an iron condor (buying = sell call spread and sell put spread), collecting
only $0.60, there’s no room to buy in the position early.  If you can get 90 cents, then you have room to
pay 15 cents per side to close early.  Why close early? Because holding
longer translates into more risk.  These volatile markets can
turn on a dime and I don't recommend taking the risk of earning the last few
nickels, when the risk/reward ratio is so bad. 

When the spread gets cheap (I start closing when I can
pay 30 cents for either the call or put spread with 6 weeks or more to go),
there's too much risk for too little reward (to suit my comfort zone).  In
other words, I'm closing at 60 cents when you'd be opening!!!  AND there's this: the tails of the curve occur
more often than the bell curve predicts.  That means unexpected events occur more often than expected (the two recent '500-year floods' in the US, for example).  Every once in awhile you may
lose something near the maximum $9.40 loss.  That's 16 months of
profits. 

'Risk' does not have a consistent meaning for investors:  Some prefer to buy the IC for a higher premium and win
less often; others prefer to buy and collect a much lower premium – and win almost all the time.  It's
choosing a level of risk (considering the reward) that's comfortable for you that matters.  Each investor should trade
within his or her individual comfort zone. Perhaps doing fewer iron condors at
one time may be all it takes you make you more comfortable.  I don't have
that answer.

So to earn $600 I risk
$10,000. $9,400 This
obviously doesn’t look so good. I would
need to need to win the $ 600 at least 17 times to cover 1 total loss. That’s the problem
when collecting such a small premium.  But remember – not all losses are for the
maximum.  Good risk management skill is required to be a successful buyer
of iron condors.  The bottom line is YOU must be in your comfort zone of
risk vs. reward.  I found my zone, but there’s no reason why that should
be anywhere near yours.  You obviously want to collect less than my
$3+.  And you appear to feel that 60 cents is too little.  There's
lots of room in between.  And you may feel better with a 60-day time
frame.  If not certain, don't be afraid to paper trade a bunch of
different spreads simultaneously and try to see which ones 'feel' best.
Not which ones work best – but the ones that leave you unconcerned about your
portfolio.

Thanks. My pleasure.

Mark

53

All the best to you,

JB

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