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Risk Management: Are Rules of Thumb Applicable?

Don asked:

I recently ran into trouble with some high probability iron condors on
RUT. I know this has been a difficult month but would like to know
“rules of thumb” to apply to these type of trades.



I don't believe there is a generic set of rules or generalizations that works for everyone. 

I know this rule of thumb is important:

Don't allow the position to move outside your comfort zone.

However, that's not a useful rule. To begin, there's no way for anyone to understand where your comfort zone lies.  It's even difficult for you to know. You'll know when the position upsets you or makes you nervous – but by that time you are already beyond your boundaries.  Thus, you must have a way to 'do something' before that happens.  Not so easy when you cannot recognize when the zone boundaries are about to be breached.

One way to make that 'stay withing the zone' rule easier to achieve is to adjust trades early, rather than late.  What will that do for you?  It makes the position less risky, making it less likely the position will reach the point of making you uncomfortable.  The problem with that idea is that many adjustments result in a loss – possible through a poor choice of which adjustment to make – but why spend money on insurance – unless that's your preferred approach?

But, there are side effects.  It makes you adjust more frequently.  Is that a good thing for your situation?  How can anyone know?  Why should you take a more conservative view just because it's not easy to determine when it's the proper time to make that adjustment?  

The point is that there is no suitable rule of thumb.  By definition, that's supposed to be a general rule, or one that applies to almost everyone.

How about this as a rule of thumb?

High probability iron condors are not your friends

That doesn't seem right, does it.  More than that, what is high probability?  Is it 95% or 90% or 80%?  The way you define the term is probably nothing similar to the way others define it. 

If you choose 98% probability iron condors (that means there's a 2% chance, if held to expiration, that one of the options will finish in the money), the low premium makes this methodology unsuitable for the majority .  The delta for each short option in the iron condor is 0.01 – and that means a low premium.

Why unsuitable for most?  Because undisciplined traders cannot bring themselves to adjust, or exit, a position to lock in a loss.  When you trade 98% iron condors, any adjustment is likely to lock in a loss.  That makes trading them a losing strategy for most investors.

The problem is, can that rule of thumb be used?  I don't think so.  Especially for anyone who considers a 75% to 80% chance of success to be a high probability.

You can use this rule of thumb.  I know it will help with the problem.

Trade smaller size

The easiest method for managing money (and thus, managing risk) is to be certain the size of the position is not too large.  Imagine a gap opening that makes one side of the iron condor completely ITM.  If the amount lost would hurt, then the position is too large.  Trade smaller.

Don, if you manage money properly, the position will not be too risky.  That already helps when the markets don't behave.  Outside of that rule, I'd suggest that you look into becoming a bit less aggressive and consider making small adjustments earlier than you do now.  Even an early one-lot can make a difference.


Unsolicited comment from Don: "the author is an experienced floor trader who replied to all questions asked. If you are inclined to purchase $2000+ in software and another
$2000-5000+ in so called "training" or "education", please save your
money and seed your options trading account with it instead. But before
making ANY trades, nail down what this book teaches. It is all you need."


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