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Q & A. Iron Condor and Butterfly Spreads


This was originally posted as a comment.  I made minor changes for clarity.

Hi Mark,

I've enjoyed the lightning round and the quizzes. I am
reading about IC and DD and have condensed what I believe you have been teaching
about adjustments and I want to see if these are your thoughts and basic
tenets.

1. Any position that is uncomfortable has too much risk

Not necessarily.  It could have too little reward.  Or no longer suit your trading style – I assume it suited when position was initiated.

2. When
looking at adjustments examine whether or not the new position is one that you
want to be in.

3. Sometimes closing is the best option.

4. IC benefits when
Vega drops after the initial purchase and DD benefit when Vega increases.

Vega is a property of the option and it's value changes as the price of the underlying asset changes,  The term you meant to use in place of 'vega' is 'implied volatility.'

5.
Typically 13 weeks before expiry is a good purchase time and attempting to be
out 2 weeks prior.

No.  This is what makes me comfortable (most of the time).  I never recommended that anyone else adopt this idea.  I talk about it so that others can consider this as one alternative.



My question today revolves around Iron Condors that you want to hold, but one of your inside (sold) legs is being threatened (moving too near its strike).

You mention buying an ATM Put or Call [I recommend buying OTM options – but they should be closer to being in the money than your short option]  as
applicable to minimize risk.

How do you figure how many to buy?  For example if
you have a 1-lot (meaning all 4 legs X1) or a 10-lot, 10 point RUT IC, is
there an equation or some other information in the Greeks that would assist
in providing how many you would buy as protection?

The Greeks, coupled with the P/L graphs provided by your broker should be all the information required.

How many to buy?  I do not use rules.  You could arbitrarily decide to cut delta by X %.  Or decrease negative gamma by X  %.  If you are adjusting late (short is almost ATM), then X is a higher number than if you begin adjusting in stages

I think cutting delta and gamma by 20% is enough – when the adjustment is made early (early is a flexible term and depends on how YOU look at the position).  If you don't adjust until the short option is already ATM, that's 'late' in my opinion and 20% is not going to be good enough.

One other aspect of 'how many' depends on which strike you choose.  If short 10 of the 800 calls and decide to buy calls, I might buy one 770, but would want at least 2 of the 790s – again assuming this is a stage I (early; not in trouble yet) adjustment.

You can also buy insurance when it's not needed (I do that frequently).  I buy put protection on rallies and call protection on dips.  Then I am not pressured (as much) when the market moves against my position.  Because there is little urgency, if I were holding a 10-lot IC, buying 1-lot would be good enough.  Then I'd buy another, if available, at a better price later.

How much to spend on these adjustments is usually a consideration.  I don't dwell on the credit collected from the original iron condor.  I buy portfolio protection when the price is right and see some portfolio risk.  Again, no rules.  No guidance I can offer – other than to post my trades and discuss as time passes.  But right now, I don't want to do that.

Also, I read on another web site about IC's that are traded for a  $1.00 premium.   But even at a 90% win rate, if you don't
adjust or exit, or consider your max potential loss, one month could wipe out
the year's profits.  Why would they settle for such a low premium -or is this personal
preference?

You know that everyone looks at investing/trading from an individual perspective.  The $1.00 IC trader may be very happy with a 90+% win rate.  We don't know if he/she ever adjusts, or whether he closes his eyes and hopes for the best.  My point is: just because he collects only $1.00, it does not mean he is careless with risk management. But it's very likely that he doesn't cover early and holds to expiration in an attempt to collect each penny.  Not the risk I take, but that does not make it 'wrong' or a poor investment style.

Lastly, what are your thoughts on using a butterfly to extend your break-even
in the event one of your legs is threatened? For example you have a 550/560 Put
spread and see movement towards the short 560 strike.  You could take that out with a
540/550/560 butterfly and push that leg out-just wondering if this is an
adjustment that you consider?

Butterflys also seem to have a high reward to risk, do you ever use these as
a part of a short month IC, for instance looking at November?

Like to hear your thoughts.

I do occasionally buy a butterfly to move my short options from one strike to another.  But not often.  It really does depend on two major factors: 

a) How much does the fly cost and are you willing to pay that much for a TINY (TINY TINY) bit of protection.  Remember that 10 points is essentially nothing in a $600 index.  To me, the butterfly is often just too expensive.  I'd pay $0.25, but not $1.00.  You may be willing to pay more.

b) Does this adjustment move you from uncomfortable to comfortable?  I don't think that's possible.  It's just 10 points.  If you were to buy a condor (see tomorrow's post) instead of a butterfly, you could move the short strike more than 10 points – and that could easily be worthwhile – at the right price.

You obviously just discovered butterfly spreads.  I get that you want to learn more about them.  But, as with any new toy, you cannot expect to jump right in and use it with maximum efficiency.

By coincidence, I already prepared the blog post for tomorrow and it's about butterflies and condors.

I do not trade butterflys as part of a front month plan.  What I used to do, when I needed FOTM protection, is bid 15 or 20 cents for a FOTM  butterfly – but only if I needed protection.  Example, with RUT near 570, if my downside looked bad, I would bid 15 cents for the 450/460/470 Jan or Dec fly.  Probably would not get filled.

Yes, good risk/reward.  But VERY low probability of collecting anything resembling the maximum reward.

Thanks,

Don

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