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Zero Risk with Iron Condors: Can I Have my Cake and Eat it Too?

The following question is slightly edited.  The original question is elsewhere.

To provide a meaningful reply, I
requested more information.  Norm has been trading iron condors (with
real money) for five months.

Hi Mark,

"I am trying to come up with a strategy that involves zero risk of a
sudden downswing in the market because of a terrorist act or other
negative developments. You mention in previous blogs that one strategy
is to reduce your overall iron condor position size, but this would
still leave me with the possibility of losing the maximum for outstanding trades."

Hello Norm,

I'm sure you
understand that risk and reward go together.  If you truly want zero
risk for a specific market event, the best play is not to have any
position that loses in the unlikely event that your scenario comes to
pass. This means you will be out of the market (or part of the market)
with no potential losses, but that comes with zero reward potential.  Thus, this is not an easy decision – but
apparently you have made yours.

"Insurance for the downside is, as you have pointed out, too expensive
now, and it creates the risk of having to close a position at
unfavorable prices when the insurance expires."

Every trade you make has the possibility
of your being forced (prudently) to cover at unfavorable prices.

There are
trades that profit on a market collapse – the event you fear.  Those
plays are not iron condors, nor are they plays in which you have theta
(time decay) on your side.  As mentioned, IV is relatively high right
now, although it has been falling in recent days.

I don't know whether insurance is too expensive right now.  It's more than I want to pay, but my current positions are much less risky that they have been at other times.  For me, and the fact that I do not need insurance, I can state that it's too costly.

However, you are much more worried than I and perhaps insurance would be cheap with your mindset.  Let me clarify: I believe there is a realistic chance that the market may fall from its own weight.  It's the terrorist attack that I am forced to ignore.  Otherwise I would be unable to trade.

The very best play to
protect your portfolio is to buy some out of the money puts (yes, at what appears
to be exorbitant prices).

The most likely outcome is that the puts will
expire worthless (as does most insurance).  However, by investing
whatever amount of cash you are willing to place at risk, you can
prosper on a huge decline.  Is it worth it?  That's a personal decision.  Do you believe you can afford to own some puts and still earn a reasonable return?  If yes, go for it.  But it will be difficult, and you don't have enough of a track record to begin to make a reasonable (or otherwise) guess as to how well you would do.

"Consequently, I am considering limiting my trades to call credit spreads
which would have a bearish basis. My concern here is that if I try to
limit my losses to 1.5 times my average monthly earnings, this limit
could be reached fairly quickly with an upswing in the market because I
would not have the put spread income initially offsetting some of the
loss on the call spreads."

Also, my not having received the premium from
both the call and put side of the iron condor could limit my ability to
make a kite adjustment." 

Here is my
major problem with your questions/comments:  You jump form one example to another with no consistency.  You are worried about everything that occurs to you.  I understand that you want to be certain that major risk is covered, and you don't want to be trading in the blind.  Truly, the best way to cover your bases is to trade small while you are learning.  I understand that you do not want to trade small and that you want to earn money.  However, there are three truths that must be faced:

  • Trading with little risk is an excellent investing choice.  But accept the fact that it goes hand in hand with modest (at best) profits
  • You are moving too quickly.  You can learn and I can reply to questions.  However, there is just so much information that cannot be put into simple answers.  You want some experience trading and making decisions.  And that takes time.
  • You are trying to accumulate a large amount of data – and then base future trade decisions on those data. You must keep a detailed journal/diary of your trades, your thoughts, your decisions (even when the decision is to 'do nothing'), and the results.  Reread those journal entries often and see if they speak to you.  See if you can get some nuggets out of the data

I acknowledge that the more you can
understand the better trader you will be.  However, there is a limit as
to how quickly you can gain meaningful experience, but five months is not enough.  Not even close. Why? 

You must experience all kinds of trading decisions before you can know how well you handle them.  It's easy to trade an iron condor and then cover at a big profit.  It's easy to make a minor adjustment when a trade makes you slightly uncomfortable.  It's more difficult to see a big move in one direction – make a trade to account for that, and then have the market make another good-sized move.  That second move can be in either direction.  How well will you handle that?  Or are you willing to take your chances and make the discovery at the time it happens?

You write of average monthly earnings.  You have no idea what your average monthly earnings are going to look like over the longer term.  You don't yet know whether you can earn anything as an iron condor trader.  I am NOT being negative.  I am telling you that you are worrying about minute details when the big picture is an untouched canvas. 

Keep in mind that you plan to sell call credit spreads.  It may be similar, but it is not trading iron condors.  Thus, you have ZERO months of earnings from which to determine your 'average.'

Data from a
few months is worse than meaningless.  Yes, worse.  You have not
experienced enough different market types to know what that average is. 
Have you made enough adjustment/hold/exit decisions to have a good feel
for how skillful you are going to be in that area?

Norm – you are at the beginner stage
and no
amount of data that has been collected to date is any more than a hint
of what you can do.  You do not have any 'useful' average monthly

If you want to
establish a maximum monthly loss – and you should do so – then base it
on the size of your bankroll and the probability (as best you can guess
it) of taking the loss.  Don't base it on how much you earned when
trading iron condors – especially when you now plan to trade half iron condors.  the entire strategy is different – similar, yes – but
it's different.  You have different rules in place.  Rallies with
shrinking IV are less frightening than declines with expanding IV.  You
will have to use a different adjustment plan.  The point is your average
IC earnings are meaningless.

Yes, you can
avoid selling put spreads and sell only calls.  That does what you
seem to have established as your primary objective: No significant loss
if the rare event occurs.  My question to you is:  Which of the
following is going to produce more money in your account with an
acceptable risk level?

  • Sell a reduced number of put spreads,
    presumably earning a small sum, on average, on a continuing basis – but ever fearful
  • Avoiding puts altogether – until
    after the disaster.  Earning less, but without worry

This is a question, and you should take the time to figure out the answer: 
If you are that afraid of the loss, have you considered how much that
loss would be?  Have you taken an option calculator and determined the
value of a typical spread that you would sell – if the market gapped lower by
(perhaps) 25% one morning?  Assume IV triples, or make some other
assumption.  What would that spread be worth?  How much real cash would
you lose?

Do the same for the calls spreads and remember to subtract these gains (if any) from the put losses.

You may be surprised at just
how little of your portfolio is at risk.  What I am asking is: 
You are afraid of a specific scenario.  Do you know how much you would
lose in that scenario?  If you don't – and you clearly do not – how can you fear the scenario?  How can you make intelligent trade decisions when you don't know how much is at risk?  Your assumption that you could not exit the put spreads at any meaningful discount from their maximum value is incorrect.

Once you do the math (arithmetic), then if you decide that zero risk is the sweet spot
for you, then it will be an informed decision.  Right now it is a decision based on fear.  Do not misunderstand:  Fear is a great reason for avoiding a trade.  But don't you want a realistic estimate of how much would be at risk?

That brings us back to the question: Can you sell only call
spreads, and the answer is yes.  But to do that, you should not be a
bullish investor.  You don't want to wager against your
anticipated direction for the market.  So, do you prefer to sell only
call spreads?  The reply may be 'yes,' and if so, you are trading
reasonably.  If the answer is 'no' but you feel forced into doing it, I'd suggest you find an alternative strategy.

"Also, my not having received the
premium from
both the call and put side of the iron condor could limit my ability to
make a kite adjustment."

Regarding kite spreads;

a) You don't have to use kites.  There is
nothing magical about them.

b) Nothing hinders your
ability to use the kite strategy  If you want to use it, use it.  You
seem to have convinced yourself that if the credit collected when
opening your call spreads is too small, that kites are precluded. 
Nonsense.  If you decide not to sell credit spreads and pay too much for
insurance (any type), that's a decision.  It has nothing to do with
using kites.

Keep in mind
that kites are not a simple slap in on and forget it strategy, although
that's how it appears. 

Perhaps with only a few months experience, and
with IV remaining elevated, you ought to think about more useful
techniques than kites.  I also believe that you have far more to worry
about than kites.  You are new to this game.  Concentrate on learning
things that are important to your profitability – and one strategy for
managing risk is not at the top of that list (as long as you have some
plan in mind for reducing risk – when necessary).

"I realize that in the event of a sudden upswing
in the market due to some government action I would still have the
exposure of losing the maximum, but this scenario appears to be much less likely than a
similar scenario on the downside.
Given my concerns, is it reasonable for me to expect to be profitable if
I limit my trades to call credit spreads?"

Norm, I cannot answer this question.  Sure a meltup occurs less often and moves more slowly than a meltdown.  You want my opinion on how well you will do by trading short?   I don't know where the market is headed.  I don't know how far OTM you plan to sell the spreads.  I don't know how quickly (or slowly) you plan to adjust, nor do I know your adjustment plan.  I have absolutely no idea if it is reasonable to expect to make money based on what I know.

If you are bearish, then it's a very viable trading plan.  Go for it. 

If you are market neutral with a crash fear, it may be okay to trade this plan.  But I would not be happy camper if I were in your shoes and would choose to trade smaller size. 

If you are bullish, it's a death wish.

"Also, would it be too
personal a question to ask how you made out with your iron condor trades
during 911 and during the recent sudden drop in the market?"


Yes, it is far too personal.  I don't remember 2001.  I was not trading iron condors at that time.  I did much
better than average in 2008, with a small loss for the year and did
worse than average during all of 2009. 

The recent drop worked very well for me.  I had no problems for two reasons: My shorts were far enough OTM and I covered some put spreads on the rally.  Trading reduced size also made it easy.

I believe you have too much on your mind.  You must go after the more important stuff at this stage of your career.  I appreciate your need to understand the details, if you have the time to work on them.  But spend your energy on finding a suitable strategy and figuring out how to deal with your market fears.  There are inexpensive ways to play for a crash.


June 2010 Expiring Monthly.  Table of contents


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