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Profit and Loss Targets when Trading Options

The beginning

This detailed discussion began here, in the comments section.

Roberto is asking about profit and stop loss targets for an iron condor and also for a ‘classic’ credit spread.

Where we are now

Thanks Mark.

But I still don’t understand why you prefer to set a stop loss around $300 in a trade (10-point credit spread) where $800 can be the maximum loss.

In a classical vertical spread, $200 credit and $800 risk, we agreed that the take profit should be around $150 but we disagree about the stop loss. Can you do a statistical example of why, over the long term, using a stop loss in $300 area, its better than a stop loss in $75 area?

Thanks again

Roberto

***

Hi Roberto,

I do not set a $300 stop loss for all trades that have a maximum loss of $800. That’s not how risk management works. There are many factors to consider.

A huge part of the problem in understanding my original comments stems from the fact that you changed the conditions

I was talking about an iron condor. You switched to discussing half of the iron condor position (credit spread), believing that the situations are similar. They are very different trades, with very different factors that go into choosing the profit and loss limits.

Why is that difference so important? In your classic credit spread, one way to profit occurs when the stock moves much higher (Selling the put spread is a bullish position). When that happens, there is a very good possibility of being able to close the position and take your target profit. Thus, selling a credit spread gives you two ways to win: The passage of time and the correct market move. Those two profit possibilities play a large role in the probability of earning a profit

With the iron condor, there are no profits when the stock moves higher. It just means that the call portion is in trouble rather than the put portion. There are no profits under those circumstances. There is no possibility of taking profits quickly. This position requires the passage of time before the trade can reach its profit target. It is important that you recognize that changes the probability of success by so much, that no matter how you set the risk/reward ratio for a credit spread, it must be set very differently for the iron condor. The iron condor is where this discussion began.

I hope that’s clear to you. The credit spread wins far more often than the iron condor. If you ask: Why not trade the credit spread instead, the reply is that I don’t know whether to sell a call spread or a put spread.

Time out for an important issue

Experienced traders may recognize that there is another big factor that has been ignored: The effect of implied volatility. When trading an iron condor, a big volatility increase can result in being stopped out of the trade quickly. It is true that credit spreads are also short vega, but only half as much as an iron condor. When you establish a relatively small stop loss, you can get forced out of the trade, even when the underlying asset does not make a threatening move – just because IV rose by enough to make the position hit your stop loss target.

That factor alone – the possibility of being forced to exit by a spike in implied volatility is the major reason why I would never use a small dollar value as a stop loss point. To me it is far too risky to stop yourself out of trades that quickly. I don’t believe you can stay in those trades long enough, often enough, to claim your profit. Thus, I choose a larger stop loss and know that my edge is that I’ll be stopped less frequently than you. Is that enough to make my method better? For me, yes. For you? I cannot know that answer.

End of time out

I make trade decisions by doing what I believe gives me the best chance to make money when combining my chosen strategy with my personal risk management decisions.

You must understand that we do not disagree on anything. I believe that a stop loss at $300 is better for me than a stop loss near $75. You believe that a $75 stop loss will be effective for you. We must each trade according to our comfort zones. Neither one of us is wrong. I allow for a larger loss to reduce the possibility that a change in IV will force an early exit.

I can understand why you may believe that one of us must be correct and the other person must be making a mistake. However, neither one of us is wrong. Here’s my best explanation of why believe that no one is wrong here.”

  • If you own the position and the loss reaches $100, or $150, you may become very uncomfortable holding onto the position. You may become upset and feel ill. You may lose sleep. A trader cannot allow that to happen. Even if we are investors and not traders, it’s the same situation. It is wrong to hold positions that make us nervous because it means that too much money is at risk. It is also very unhealthy. Losing money is part of the trading game, and if it’s going to upset you – then you are correct to cut losses before you reach that point.
  • It is far better if we can do a statistical evaluation of the trading plan. However, that’s impossible
    • We have no volatility estimate for the stock in question. I assume that you recognize that a very volatile stock will lose that $75 far more often than a non-volatile stock. And it will take a longer time for the profit level to reach $150 because options of volatile stocks hold their premium longer than options of non-volatile stocks. If you get stopped often and if it more time to make the profit, how can that be a profitable plan?
    • When dealing with statistics, time remaining is a crucial factor – and the time remaining before expiration arrives is unknown in our example trade
  • The single fact that we collected $200 credit trading that ‘classic’ credit spread is not enough information to solve this problem.

Statistics

Lacking enough information to solve the problem, and ignoring trading costs, we know this much:

  • The $75 stop loss and the $150 profit target
    • You can afford to lose twice as often as you win to break even
    • Thus, the probability of the spread reaching the stop loss point must be less than two in three (win once, lose twice, zero gain)
  • The $300 stop loss and the $150 profit target
    • I must win twice as often as I lose to break even
    • Thus, the probability of the spread reaching the stop loss point must be no more than one in three (win twice, lose once, zero gain)
  • You choose $150 as the profit target and $75 as the stop loss because those numbers have proven to be effective, and you have the profits to prove it. The other choice is that you have no such evidence but believe these numbers will be effective. However, using that 2:1 ratio as a strict guideline is a huge mistake. I guarantee that. If you use a ratio, it must change when trading more volatile stocks. It must change when the strategy changes. It may have been useful when trading stocks, but it’s worthless (in my opinion) when trading options

Setting stop losses is necessary. Choosing the price at which to set them is a crucial decision, and no simple formula is going to be satisfactory.

The end

When trading an iron condor, I often give up on the trade when one of the 10-point spreads reaches a price between $500 and $550. Thus, my stop loss is not based on the number of dollars lost. Is that heresy? If I collect $300 for the position, then my stop loss is about $250 (plus the cost to cover the profitable side of the trade). If I collect only $250 in premium, then my stop loss is about $300 (plus the cost to cover the winning side).

I exit the trade when I believe risk has reached the point at which I am not willing to lose any more on that trade. It has nothing to do with my profit target. That is the reason I do not use a risk/reward ratio, and I hope this explanation makes sense. You don’t have to agree with my conclusions, but you should understand the reasoning behind them.

I never said that it is ‘better’ to set the stop loss at $300. I said that is where I am comfortable setting it.

We each have different comfort levels and must trade accordingly. When I trade an iron condor (or credit spread) I am not willing to set exit points as low as you set them. That does not make either of us ‘wrong.’

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Setting Profit Targets When Trading Iron Condor

Mark,

What is your personal definition of success in IC trading
represented by percentage return.

For an account that is trading over a 12 month
period what would you consider to be a good vs. superior return?

And
would these same numbers be representative on a year to year basis?


Thanks,

Don

***

This is a question that reappears at regular intervals.  I cannot offer a good answer for option traders.  More than that, I believe the question is inappropriate. What I deem 'good,' someone else may not.  In addition:

  • You are not in competition with anyone
  • You are not playing by the same (self-imposed) rules as others
  • You chose different spreads at different times and at different prices
  • You adjust more quickly or more slowly than others
  • You have a different investment goal
  • You have a different plan
  • You are more aggressive or more conservative
  • You trade big or small size
  • You max out your available margin, or you maintain plenty in reserve

How can anyone define a good return for each and every one of these (and more) possibilities?  Yes, I know you asked about my personal definition, but unless you know where on stand on the issues raised in the above list, how can the number that I give you have any relevance?

***

Don,

You must understand that my personal definition is very dependent on my style of trading, so I ask: How can this answer
have any value to you?

If you are a risk-taker, you must seek a high reward. I would
classify that as 4-5% per month.
If you are very conservative, then 1% per month would be an outstanding
return. Very conservative investors would be ecstatic to earn a return of 12%.

As for me, I'd be happy to average 2% per month on a continuing basis.
That includes allowing for negative months.  That meets my definition of 'good.'

As for year to year return, it's the same 2% per month, which is 24% per
year. However, if I were not withdrawing funds and wanted to compound
earnings, then 2% per month compounded is almost 27% per year.
As I said, I don't see how that tells you anything useful.

From my perspective, superior returns are a matter of good luck. Many months I
earn over 10% without doing anything different.  That's because no adjustments are needed and the options
just fade away – until I repurchase. No skill is required on my part. No
special trades are made to increase results. Just good luck. If I collect $300 premium on a 10-point iron condor and exit by paying $50, then I make $250 when using $700 margin.  That's a 36% return.  And that is a superior result – regardless of whether that takes one, two, or even three months.  It's also far more than I planned to earn when entering into the trade.

I have zero control over how often that happens.  I have no control over how much I may earn when everything is perfect.  All I can control is when to exit or adjust a trade and how much of a loss to take before closing.

My conclusion: Extraordinary returns for an iron condor trader are based on good fortune and such gains are needed on occasion, to cancel losing months.  But if you play for these great results and ignore risk, you will have situations in which the trade mentioned above will lose $700 instead of earning $250.  You cannot achieve superior results when taking such chances.

I define superior as better than 'good.' If you earn 35% per year, consider that to be superior to outstanding – if you do it on a consistent basis. It doesn't signify anything if you do it once.

Don, I hate to see you, or anyone, focus on these numbers. When you
trade iron condors, the actual results are going to be determined by
whether you  exit trades at a loss, or whether you get to ride the
position for a big profit. You can control when to take losses, but have no control over being allowed to comfortably do nothing.

What you can control is how greedy you are and when you cover winning
trades.

What you can control is determining the point at which you make
adjustments.

Do you give up some profits to adjust early, or do you wait until your IC has moved ITM? These alternatives
make a huge difference in your results.
By focusing on earning a specific 'number of dollars,' you may delay when it's important to make an adjustment.  Although it can go either way, this is likely to be a costly error.

If you ignore the numbers and only look at
them after the fact (position closed), then you can decide whether you are meeting your
goals.
If you are not earning enough to please yourself, look at your trades,
your trade plan, your trade journal, and try to figure out what you can change to increase rewards without taking unnecessary risk.  I surely cannot tell you what will work for you. 

Everyone wants to earn a fortune when things are going well, and
increasing position size by 10% may be a reasonable thing to do.  However, be careful not to get too greedy.

When it hits the fan, you must be prepared to earn less, or even lose money, and concentrate on protecting your
assets – assuming you continue to trade iron condors in a volatile market.

I understand your anguish.  I get it when you want profit targets.  To me, trading is working with statistics.  You know your future contains some periods of time that are devastating for uninsured iron condor traders.  You also know that sometimes the markets move up and down, yet remain within your safe range.  In my opinion, this is a matter of luck.  However, if you are a trader who uses technical analysis to choose strike prices, and believe that it works, then good luck may be the result of skillfully selecting appropriate strike prices.

Your job is to make a good trade (based on conditions at the time) and to manage it well.  If you do that, you will not need targets to see that you have been successful.

738

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