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The Hidden Dangers of Iron Condors


Ever seen those ads about making 5% per month with Iron Condors? It’s certainly possible, but you would have to be a bit naïve to think making a 60% per year return is simple. Most professional money managers cannot achieve those returns, so why would a retail trader be able to achieve it?

Unfortunately, most people are being misled when it comes to Iron Condors. The potential gains are certainly amazing, but the risks are high as well.

 

Anyone trying to achieve a 5% per month return is likely taking on a lot more risk than they realize.

 

I’ve heard this story from beginner traders too many times to remember – “everything was going great, I was making loads of money with my weekly condors, and then WHAM, I lost 6 months’ worth of gains in 1 week”.

 

Those are the risks when it comes to Iron Condors, and the shorter the timeframe you are trading, the more likely you are to suffer a catastrophic loss at some point.

 

Early February was a prime example. Anyone trading weekly Iron Condor would have been killed.

 

GAMMA RISK

 

Short-term Iron Condors have a huge amount of Gamma risk. Gamma risk is effectively price risk.

 

Trades with negative gamma will suffer from a big move in the underlying stock. Iron Condors as you might have guessed, are short gamma.

 

Short-term Iron Condors have a lot more negative gamma (or price risk) than longer term Iron Condors.

 

Let’s evaluate two theoretical examples set up just before the recent selloff.

 

SHORT-TERM IRON CONDOR

 

This short term Condor could have been set up towards the close on Thursday February 1st when RUT was trading at 1575.

 

image.png

 

image.png

 

LONG-TERM IRON CONDOR

 

This longer-term Condor could have also been set up late on Thursday the 1st of February. Notice that between the two examples, Delta and Vega and almost the same, but the longer-term trade has almost no Gamma.

 

The trade off is lower Theta as Gamma and Theta go hand in hand.

 

image.png

 

image.png

 

ONE WEEK LATER

 

Let’s fast forward to the close of trading on Monday February 12th and RUT has dropped nearly 100 points to 1496.

 

The short-term Condor has been well and truly crushed and is down over $10,0000.

 

In comparison, the long-term Iron Condor is actually in profit to the tune of $100!

 

SHORT-TERM CONDOR

 

image.png

 

LONG-TERM CONDOR

 

image.png

 

I hope you enjoyed this case study, if you want to learn more about how to manage Iron Condors, join me for a live training session coming up soon.

Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. He likes to focus on short volatility strategies. Gavin has written 5 books on options trading, 3 of which were bestsellers. He launched Options Trading IQ in 2010 to teach people how to trade options and eliminate all the Bullsh*t that’s out there. You can follow Gavin on Twitter.

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We want to hear from you!


 

The article demonstrates how the short term IC loses $10k in the first week, while the long term IC is just fine. 

I don't understand how the two ICs are comparable, given that the long term IC is much wider. Is it that they have the same delta that makes them comparable? If yes, then why?

 

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Yes. And this is the whole point actually - when you go further in time, same delta allows you to construct much wider IC for very similar credit. This is why longer term ICs are much safer - they have smaller negative gamma and it takes much bigger move to put them in danger.

If you want to do shorter term IC for with wider wings, you will have to go with much lower deltas, giving you much smaller credit.

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3 hours ago, Javier said:

Similar credit but quite different expiration. I neither see the fair comparison.

Again, you compare 2 different setups that have similar deltas and similar credits. This is what makes them fair comparison.

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Guest James

Posted

How can you just compare the credit and say it's fair comparison? On annualised basis, the short term is higher return in exchange for the higher risk.

And you gave a scenario where RUT drops 100 points one week after. What if RUT drops 100 points only after Feb 16? The short term IC would have taken home the profits while the long term IC would still be exposed to the downside risk.

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James,

You are absolutely right that the potential return is higher for the short term trade on annualised basis. But this higher potential return also comes with higher risk. This is because the negative gamma is much higher for short term condor. It's a fact that you need to accept. Ignoring the risks of shorter term trades would not end well.

Here are typical returns of short term condors (this screenshot is taken from performance page of one of the services that trade weekly condors):

image.png

They might return 5-7% for most weeks, but when it goes against you, the losses are brutal. 

The longer term condors are more conservative trades. They are easier to defend and you can limit the losses.

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I agree with Kim, the article was simply meant to demonstrate the two different trading styles. Shorter-term is high risk / high return while longer term is lower risk / lower return.

Each trader needs to decide what is right for them.

 

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Guest Guest

Posted

When do you close out your long-term IC (3-4 months to expiration) and what kind of monthly returns have you seen from these?

I think some of us would be willing to give up the higher returns for the downside protection and a better sleep, especially with the current market environment.

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