Tag Archives | Mr. Spock

Iron Condors: Emotions, Psychology, and Risk Management

Andy made a very important comment, including questions. 

"I've been in the trenches the past month. Unfortunately, the experience has been costly. Started trading iron condors late
last year and  was losing money every month while everyone else was having fun riding the market higher.

You can probably guess where this story goes… I loaded up on MAY bull put spreads
and sold cash-covered puts (with the subliminal goal of
earning all the money I had lost with one fell
swoop). As everyone knows, a few weeks later, the market 'correction'
occurs, and I reluctantly closed some spreads early, but miserably
waited until the bitter end for many of my other contracts (I was in
shell-shock by that time). Indeed, I lost a lot of
money."

Andy,

It's appropriate that you commented on a post discussing trader psychology.  I know that you made trades that you considered to be reasonable at the time – at least when you began with iron condors.  However, I'm certain you recognize the 'one fell swoop' play was a high risk gamble.  Sure it could have worked, but alas, it didn't. 

I know the last thing you want to hear is a string of 'should haves.'  But let's get that part out in the open before going further.

The life lessons to be learned are

  • It's very important to trade without emotions.  That said, I recognize that many people cannot do that.  I'm sure it's far too early in your trading career to know if you are in that group or whether this is a skill you can learn

If, for now, you cannot trade without making emotional decisions, the lesson is to avoid positions that are large enough to frighten you (when danger looms).  Trading when afraid leads to panic decisions.  Panic is not 100% bad – it will save you from going broke, but it usually leads to terrible results

  • Size kills.  It's important to properly size all trades as the first step in managing risk, and especially when emotions may come into play when making decisions
  • Getting even is never an appropriate trading goal.  Earning money is your goal, and maintaining risk at an appropriate level is the path to follow
  • Managing risk is a full time job.  I've been there.  I've held positions that I hated, just waiting for expiration to take them off my hands.  It's important to avoid losing a bunch of extra money, just hoping to recover.  Money not lost is every bit as valuable as money earned.  Conclusion: Don't hold onto hated positions.

***

"I haven't given up on trading… and, hopefully, will be able to
recoup a good portion of my losses over the next year (or two). In one
of your posts a while back, you mention how difficult it is to teach
risk management to a new trader, and that most people will go on to
learn their lessons from their own experiences.


Here are a few things that stuck with me:


1) If you get to the point where you have to adjust a condor, it's
hard to come out ahead. My condors were simple: close them whenever the
index came within 30 points of either leg. One major thing I learned
about this: the money you lose from the 'close' leg far outweighs the
money you gain from the 'far' leg. For a while, when the market was
moving singularly upwards, I simply tried selling fewer short legs (ie: 4
bull put spreads and 2 bear call spreads) and selling the short leg
further out of the money than the long legs. Eventually I just decided
to sell the long legs and scrap the short legs."

[Exiting when 30 points OTM is one choice.  But to tell the truth, '30 points' is not a term that tells me anything.  In RUT it's almost 5% OTM while in SPX it's only 3% OTM]

I don't agree with your premise. 
Obviously it's best if we never have to adjust an iron condor and get to
watch as it fades into the sunset.

Adjusting is not something to fear.  It's an opportunity to convert a risky trade into something better.  Not only do you reduce (not eliminate) the risk of further loss, but you improve the position.  If you cannot make the position good enough that you want to hold it – then it's best to take the loss and exit.  Then use your trading capital to own a position that you believe is good enough to hold.

The above paragraph is so important (in my opinion) that I want to shout it from the rooftops.  If you accept the premise that you are trading to earn money, then I ask: Don't you want to hold a portfolio of positions that you believe will be profitable?  Positions whose prospects (for whatever reason) you like?  Why devote your time and resources to defend a bad – or at least not good enough to hold – position?

The psychological need to defend a bad trade or to take extra risk to get back the lost money is based on emotion, not logic.  Mr. Spock would not approve.

Spock

I suggest that you make a change to your adjustment technique.  If you can comment with a SHORT description of which index you trade, when you tend to make the first adjustment (% OTM), and the strategy you use (i.e. reduce size, roll, buy extra options etc), perhaps I can help.  If it's a lengthy reply, send it by e-mail instead. For the options you sell, include either delta, or how far OTM they are.

In my experience, the adjustment gives the trade a good opportunity to do better that it would without the adjustment.  That's the reason I don't accept your premise.

Your next observation is disconcerting.  The losing side had a larger delta and a higher gamma.  Of course it moves more than the winning side.  But surely you already knew that.

Your plan of opening unbalanced iron condors is viable.  It demonstrates a market bias.  I'm surprised that even with those two modifications you still ran into trouble.

And even when you only sold the put spreads, if you kept to your standards and not increased size (selling naked puts is surely extra size) it would not have been so bad.  That was an emotional trade and I hope you have it out of your system.

Note:  It's fine to take a market stance and it's okay to increase size (modestly), but there must be a good trading reason to do it.  Seeking revenge is too emotional and not valid. 

No losing trade is a complete waste if you learn something useful.

***

2)  Sell your spreads for at least 1 dollar. Way out of the money for
25 cents seems nice, but then you have to hold onto your spread to near
expiration to make any profit. You'll probably find it much easier to
sell a spread for 1.25 and close it for a 1.00 if you're far from
expiration
.


I agree that selling spreads for small premium is not a good idea.  But each person has to set his/her own minimum.  There is nothing magical about $1.  You could just as easily have said $0.95 or $1.50.

I don't believe the risk/reward is justified if you plan to exit when a 10-point iron condor earns $0.25.

***



3)  For every trade you make, there is another person out there who
thinks otherwise (who do you think is buying/selling your spreads?). So,
what makes my judgment any better than his? By this reasoning, this
should be a 'zero sum game'. I've been pondering that the only reason
people generally make money from the stock market is that the influx of
new investors outweighs the outflux of retiring investors, thus the
market generally floats upwards (like a pyramid scheme). Thus, doesn't
it only make sense for the non-prognosticator to invest long, and never
short?

You do not always get filled by another person who thinks as you suggest.  Sometimes you get filled on each leg by trading with an individual investor.  Also, a market maker makes a two-sided market.  He/she does not have an opinion on the small trade made with your order.  Bid enough and the MM sells; offer low enough and the same MM buys.  The MM does not have an opinion on your iron condor, nor does that MM hold the trade as an iron condor.  It is hedged in a flash and then forgotten.

No.  It does not make sense to always invest long.  That's what the masses do.  They buy mutual funds, getting screwed by the management team who charge far too much for doing far too little. 

Markets do not always rise.  Invest as you see fit.  If that's 'always long,' then go for it.  But don't do it based on the rationale given here.  If your picture of the market holds true and if you believe in that pyramid scheme,
then what is going to happen when baby boomers withdraw their savings to
cover living expenses?

When you get over the shock of what happened, you will recognize that you can only earn money at the rate that is available to you.  That rate is dictated by the size of your bankroll and the risk you are willing to take.  I urge you to trade with risk you can afford – especially until you have proven than you can control emotions when trading.

I wish you good trading.

720


 

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