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Using Risk/Reward Ratio to Plan Iron Condor Trades. Good Idea?

When trading iron condors, or credit spreads (half an iron condor), the risk/reward ratio is usually unattractive. For example, if you sell a 10-point spread and collect $200, the maximum loss is $800 – for a risk reward of 4:1. Most traders shy away from trades when the ratio is that high. Yet, when trading these iron condors, we recognize that good risk management means that we will never incur the maximum loss and that the true risk/reward (r/r) ratio is much lower. And that allows more traders to adopt the iron condor strategy.

For those traders, it may be necessary to establish a maximum loss for the spread. To be certain there is no confusion: it's traders whose comfort zone requires a maximum risk/reward ratio who would establish this maximum loss as an exit point. Those of us who use different risk management techniques would probably not establish a maximum loss as a mandatory exit point.  [Delta of short option or % that short strike is OTM are two reasonable alternatives]

It's not always easy to determine the true r/r for these trades. If your plan is always to carry positions through expiration (far too risky in my world) then the maximum gain is the total premium collected. If you exit early, it's not always clear how much you will pay to exit. However, if you are an r/r based trader, it's necessary to establish a theoretical profit goal โ€“ even when it's flexible.

Example

You trade a 7-week iron condor and collect $200 (These are 10-point put and call spreads). You plan to pay $1.00 to cover. Thus your maximum gain is $100, and you are unwilling to accept a maximum loss of $800, so you must decide on an exit point.

If you want an r/r = 1, then you must exit when the iron condor increases in value to $300 ($200 + $100)

If you are willing to accept an r/r of 2, then you can afford to hold on longer and hope it does not reach a price of $400 ($200 + 100 + 100)

 

Question: Is this a viable strategy?

To me, there is no doubt that iron condors should not be allowed to reach the area of maximum loss, but I don't have a specific exit price. Often, adjustments provide a superior alternative to exiting. Nevertheless, not every trader prefers adjustments and some want to establish a maximum possible loss. The purpose of this post is to determine the practicality of setting mental stops for iron condor trades.

 

Answer

There are two risks when trading iron condors.

  • Big market move with negative gamma results in being far too long on a decline and far too short on a rally

     

  • Surge in implied volatility results in big loss because both the call spread and the put spread increase in value

     

The combination of a significant down move, coupled with an increase in implied volatility wreaks havoc with an iron condor position.

Let's look at one example from recent history.

On Friday May 7, RUT had a trading range of 24 points or 3.6% of it's opening price ($571). RVX, which tracks implied volatility (IV) of RUT options (just as VIX tracks SPX options) ranged from 36 to 46. That's a very large range and certainly atypical.

Here's a typical iron condor: RUT: Jun 550/560P; 740/750C

When IV is 36 (ignoring volatility skew), the position is worth $1.62

When IV is 46, the position is worth $3.50

Any trader who happened to initiate the position near the low IV of the day, and who was seeking to earn a $1 profit would have been quickly stopped out of the trade when the desired r/r = 1. That method would have required exiting the IC position at a price near $2.60 – $2.65.

Even the trader who requires that risk/reward be 2 would be almost at his/her mandatory exit point of $3.60 – $3.65

This is a very unusual IV range for one day, but with RUT moving from 671 to 647, there is no reason to be forced out of the trade just because IV increased dramatically. There are other reasons for getting out, but an increase in IV should not seal your fate.

Yet, if you establish a specific unrealized loss as a target exit point, you must realize that the target may be reached quickly โ€“ even without the big market move.

Market volatility may have frightened you. That's all the reason needed to sit on the sidelines. There is the chance of a huge collapse and there is a chance that this entire loss will be quickly recovered. I doubt either is going to happen, but if the possibility makes you afraid to own iron condor positions, then it's right to be out of the market. Of course, you may prefer to find a positive gamma position to trade โ€“ if you are willing to pay the cost of owning gamma these days (I'm referring to simple strategies, not very complex, or high margin, positive gamma methods).

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