Trading Iron Condors. More Risk Reducing Investment Ideas

Yesterday I blogged about why it's important for a trader to be flexible and be ready to change strategies (at least temporarily) when the market is not being kind to your current methods.

I also covered some ideas for protecting portfolios that contain negative gamma.  Negative gamma causes positions to become more bullish as the market slides, and more bearish as it rises.  Obviously that's not the path to profits when the markets are making significant moves. 

Today let's look at a different idea for buying insurance to protect against large losses.  This can be used as a standalone bullish strategy, or as as adjustment to an existing position.  When one of your short spread positions is becoming uncomfortable to hold, it time to make a Stage I adjustment.

RUT, the Russell 2000 Index, is currently trading near 502 (2 hours before the close on 5/6/2009).  Let's say you have an iron condor position in which you are short the Jun 530/540 call spread.  The 530 call is more than 5% out of the money, but it has a 37 delta, and that's outside the comfort zone of many iron condor traders.  whether you have already made an adjustment to your original position or not, this idea is applicable.

If you own a similar position and decide to buy protection against an upside loss, one obvious choice is to begin to buy back a portion of that spread to reduce exposure.

Here's an alternative:

Buy one Jun 530 call and sell three Jun 560/570 spreads.  This trade gains 25 delta for each 1 x 3 unit.  At current prices it costs about $1,100 in cash.  That's a costly adjustment, but it's roughly the same cost as buying three Jun 530/540 spreads; and I'd rather spend a few extra dollars to make this trade.

Are you worried about buying one call and selling three spreads?  Don't be.  The fact that you gain one call option each time you make this trade enhances your upside.  If RUT moves over 570, the three spreads will be worth $3,000 at expiration.  But the 530 call will be at least 40 points ITM, and thus worth at least $4,000.  This trade cannot add to your upside woes, and makes sense for some traders. If this trade is attractive, you can use it as a separate position.

This type of trade is flexible and you can sell a different call spread or use a different ratio.  But be careful:  If you want to reduce cost and thus, sell too many spreads, then upside profits are no longer unlimited (at least over a reasonable price range).

Buying a call you are short, instead of buying a short spread, provides interesting upside possibilities for a portfolio that faces upside risk. 

The equivalent trades can be made with puts.


6 Responses to Trading Iron Condors. More Risk Reducing Investment Ideas

  1. kbluck 05/07/2009 at 10:48 AM #

    Just to be sure I understand you; if one is uncomfortably short a 530/540 call spread, as I understand it you are saying one could buy back the short 530 call and offset the cost somewhat by selling additional further OTM verticals. In your narrative above, when you said “the 530 call will be at least 40 points ITM,” did you mean the now-naked long 540 call? Or are you suggesting to actually go net long the 530 call?

  2. Mark Wolfinger 05/07/2009 at 11:45 AM #

    I was NOT suggesting that you buy enough 530s to become net long that call. Very good question.
    It really depends on how you choose to identify your positions. Assume you began with 10 530/540 spreads and then bought two 530s and sold 6 of some further OTM call spread.
    a) You can ‘pretend’ you are still short 10 530/540 spreads and long two 530 calls against being short 6 new spreads.
    b) Or you can say your position is short only 8 530/540 spreads, and long two 540 calls against the same spreads.
    They are equivalent and you should manage the risk in an identical manner. But one of those choices may better suit your record-keeping style.
    Investors have quirks on how they like to keep their trading records. And some trades are avoided just to allow record-keeping to be smooth. I don’t like that idea. If one specific trade seems best to you under the given circumstances, I’d hate to see you make a different trade just to keep your books neater.
    With the either/or interpretation of the position, each investor ought to be able to find a satisfactory method for keeping records. The trade – and risk management – is more important than keeping records in one specific manner. There are satisfactory alternatives for record-keeping. Keep you eyes on the prize by making good trading decisions.

  3. Gil 05/07/2009 at 9:23 PM #

    Hi Mark,
    There is something which I don’t understand: presumably you own 530/540 bear calls (as an upper part of IC). When selling 1 530 C you’ll cover a previously sold 530 C and will stay with an extra 540 C!
    I don’t say that this is bad or so, however your analysis refers to owning a 530 C, rather than a 540 C.
    >>> the 530 call will be at least 40 points ITM
    Please explain

  4. Mark Wolfinger 05/07/2009 at 9:47 PM #

    See reply above

  5. rluser 05/08/2009 at 8:09 PM #

    How apropos. I grew uncomfortable today with a Jul 540/550 (1 lot) call spread. I looked at the possibility of buying some Jun or Jul IWM 540 calls financed with some 570/580 Jul or Jun RUT call spreads. I did not find anything attractive. It does not help that IWM is relatively expensive compared to RUT. I also looked at the possibility of buying lower strike calls, buying the calls alone, and selling some put spreads to (partially) pay for the calls. None of that looked particularly appetizing. With the relatively low theta of this spread I did not think anything in May to be worthwhile as protection. I also did not consider diagonals as part of a new position because the thought of going out to Sep does not appeal to me at all now. In the end I decided I still like Jul enough to keep a bear call spread there, but bought my 540/550 and sold a 570/580. If it is threatened again soon, I think I will have to abandon Jul until some other time, if at all.
    Did you have a position similar to the one you described? If so, could you describe specifically how you dealt with it yesterday or today? Thanks.

  6. Mark Wolfinger 05/08/2009 at 10:12 PM #

    The position I described is the one I have – short the Jun 530/540 call spread. Here’s what I did – although not all today:
    a) Bought back a small number of the 530/540 spread
    b) Bought 530/540 spread, sold Jun 560/570 call spread 1 x 2
    c) Bought 530 calls and sold 560/570 spread 1 x 3
    d) Covered some OTM June put spreads by paying between 25 and thirty cents.
    e) In small size, I bought Jul 590 calls and sold Jun 540 calls 2 x 1
    I’ve made adjustments in three stages and am still not in love with the positions. But by making the adjustment described here, my upside picture is firmly under control and for now, risk is minimal. And in fact, I have unlimited profit potential if this rally never ends.
    And here’s the new part: This position is no longer short vega.
    Of course the picture changes as time passes, and I’ll see what else, if anything needs to be done.
    Your plan for the July position seems reasonable to me. As you know, this is not an exact science and we manage risk as we see fit. Being out of the market (if it comes to that) is one acceptable method.