Managing the CTM Iron Condor

[Kim 7,943]

From Mark Wolfinger, Options For Rookies

Yesterday I wrote a guest column for Barron’s

Mark,

I have a suggestion and a couple of questions. First the suggestion:

Since some brokers (like mine: TOS) calculate as margin requirement the full margin amount (ie $1000 for a 10 pt IC) do you think is a good idea to stick to the following terminology:

margin=full margin amount,
max theoretical loss (or max risk) = margin – credit received

Now the questions: (I fully understand that the targets set are not very strict and there is flexibility in your plan):

1. What is your plan if you make a quick profit, for example in the traditional IC, of 30-40% of credit received in less than five trading days?

2. What is the logic behind the very high target profit for the CTM IC? If we use the above suggested terminology, the target profit for the traditional IC is 150/1000=15% ROM and for the CTM IC is from 215/1000=21.5% to 265/1000=26.5% ROM.

My thinking is that the target profit for the CTM IC should be the same or less than the traditional IC, for two reasons:

a. With the CTM IC our max risk is lower (less risk, less reward)

b. Since the short strikes are closer to the money and our target exit date is four weeks before expiration, in the best scenario (no touching), the short strikes will remain close to the money during that period, hence, most of the time, it is not realistic to expect to reach a profit >$200. (time decay is more linear for OTM strikes but in this case they are CTM so most of time decay will take place in the last four weeks)

Thank you,

Dimitrios

Margin Requirements

Some brokers (Fidelity) charge margin on each half of an iron condor. They do the same for the short spread in a butterfly. What nonsense! Thus, your $1,000 margin is $2,000 for Fidelity customers. No matter which margin requirement I choose, it is not going to be ‘correct’ for some members. If readers want to voice an opinion, I will abide by the majority. In my, opinion, ROM (return on margin) is a nice number to know, but it does not really affect my trade decisions. When the trade works well, the return is outstanding, regardless of how we measure it. I ask: If we are risk-conscious traders and do not use maximum margin, does this really make any difference?

When it comes to ‘maximum theoretical loss’ I use that term to describe a position held to expiration. Why? Because the theoretical max loss occurs when the trader covers one side at $10 and then covers the other side at $10. I know no one who understand how to trade options would do that, but some traders do take a big loss on one half and then suffer the same fate on the other half. Thus, the max theoretical loss is far more than $1,000 (less premium). I choose to ignore the possibility of paying $2,000 to exit – assuming sane risk management – to calculate a meaningful return on risk.

Answers

1. I decide whether to exit based on how well I like the current position – and risk/reward are very much a part of that decision. If one week passes, the market is steady, and IV gets crushed (especially when the crush is even larger for the expiration date of our position) there is a good chance I will choose the exit.

In truth, it depends on more than only the nice, quick profit. It also depends on dollars earned. If I collect only $0.80 for an iron condor and earn a quick $0.32, I am not going to be anxious to exit. Commissions eat up too much of the gains. However, if it were a typical (for me) $300 iron condor, and if I earned north of $100 in one week, I would be far more likely to take the quick profit.

If there is nothing else to trade; if I cannot find another iron condor or position using a different strategy; if being on the sidelines does not feel like the best plan for myself, then I am likely to hold – looking for the volatility crush to continue. My bottom line is that I want an opportunity to use my judgment, rather than depend on a ‘rule.’

That said, in your scenario, I think it very likely that I would exit quickly with a smile and a big ‘thank you.’

2. I look at the CTM this way: Although it is very unlikely that it will happen, one of the benefits of adopting the CTM approach to iron condor (or credit spread) trading is thepossibility of earning a large profit. To allow for that possibility, I must be willing to hold. It’s a tradeoff. Not seeking that bigger gain allows for an early exit – and the safety that it brings.

That trading philosophy leaves me holding a CTM iron condor when the reward to risk ratio has changed from (for example) $500/$500 to $350/$650. [in other words, the spread has earned $150. If I am not pleased with that ratio under the then current market conditions, I will take the big profit and quit. But I may not want to do that. That is why I allow for a higher reward as my target, along with the longer holding period (exit 4 weeks before expiration).

A target is a ‘goal.’ I am not required to hold until I earn that target. That’s a point many traders miss. They believe that the trade plan’s target is a mandatory price and accepting a smaller profit means that the trade was a failure. That’s why the the target too low. I prefer to write that big target profit in my trade plan.

I also want to exit if I earn the target. By setting it high (not foolishly high), I allow myself to go for it – or to quit earlier with a smaller profit.

i) ‘Less risk, less reward’ makes sense. I may choose to exit with a smaller profit. But I want to give myself a chance. With iron condor trading, the big money comes from the big wins coupled with the small losses. We never want to get greedy.

Here is my suggestion: If it makes you more comfortable to sit on the sidelines (with a nice gain in your pocket) until it is time to enter a new trade, then that should be your choice.

However, if your expectations for any given trade are good enough to ‘hold for one more day’ then do it. Make a new decision the next day. Do not lock yourself into generating trading rules that you are not happy to follow.

ii) Our CTM options are not ATM, but if they were, we would expect to earn one half of the time premium after 75% of the initial # of days to expiration have passed. That means we would expect a 4-month (120 day) iron condor to lose half of its value when 30 days remain. So in that respect you are correct, we do not expect to earn $200 in only 60 days (2/3 of the option’s lifetime).

However, our credit may be nearer to $450 or $500. We plan to hold until 25 days remain before expiration (Monday following the previous monthly expiration is my target). Those numerical changes do make it reasonable to hope for $200. But don’t forget that $180 or $190 is essentially the same target – especially when we look at it when writing the trade plan. If that’s a better target for you, and if you are comfortable holding to seek that target, then choose accordingly.

I am NOT suggesting that everyone hold that long or have the high goal. I truly suggest that you follow your own profit objectives. I do not want you to exit a comfort zone that has been working well for you. When tracking a trade or making decisions in my personal account, I do what I believe is best for myself at that precise moment in time. I know that it would not necessarily be the correct decision for other traders.

Mark Wolfinger

Options For Rookies

[ffarron 0]

I don't see a prompt to ask questions??

I'd like to know what a CTM Iron condor is?

Help?

ffarron

[Kim 7,943]

CTM - Close To The Money. We are talking about IC with short strikes deltas around ~25, as compared to more "traditional" ICs with deltas of ~15 or less.

[crwood 4]

At what point do you get a volume crush to make a traditional IC worth taking on other than playing it around earnings? And at that point you're taking on just as much risk as buying and holding through earnings. If you have an IC and the stock makes a big move after hours you can easily be gapped the next morning for a huge loss.

I've had much better success selling far OTM IC's (typically 5 to 10% away from the stocks current price) about 10 to 14 days from expiration and just letting the time decay work in my favor where they expire worthless. It's not possible to make huge gains doing this (because position sizing and higher margin requirement really limits you), but if I can make 10 to 12% and only have commissions on one end of the trade I can technically outperform SO just merely by not having commissions to exit the position.

However, if I can identify IC's that may be a bit closer to the strike but I'm holding for shorter duration with the same ROM or better I'm interested. I just haven't been able to find them short of doing them around earnings where your risk profile increases dramatically. And I really don't understand the concept of CTM IC's. You'll have to hold them much longer and the longer you hold them the greater the odds the prices moves hard at one of your wings or beyond the short side at which point you'll have a sizable loss.

Currently I have an IC on RUT. The chances it moves 60 points between now and Friday are remote. Granted I'm only going to make about $220 on $2000 margin, but I have high extremely high confidence I'm going to make that $220 come Friday without having to pay another $30 in commissions to exit the position.

[Marco 223]

Kim describes the strategy in detail here

but the idea is basically to start with a CTM IC for say 4.75 credit (on a 10$ spread) and deltas of the short strike of ~25. So the odds of the index (not sure if I'd apply this strategy for stocks) going to or trough the short strike are ~50% so you have a relatively high probability of the need to adjust the trade. If you eventually do adjust and roll either the call spread or the put spread and pay say 1.5 - 2$ to do so, you end up with only 2.75 credit and the strikes (and probably ~ the same credit) had you initiated a IC with wider strikes in the 1st place HOWEVER there is also a ~50% chance the index doesn't move enough to trigger an adjustment and then the CTM IC has a much higher reward (in % of initial margin) that the OTM IC. So all you need is a quiet period once in a while and your IC to give you a much higher return so make this strategy to outperform.

I personally prefer it to the OTM IC also because the higher initial credit (I look for 4.50$+ on a 10$ spread) limits my risk in case of a big move better than a 1$ credit for a 10$ spread. If the market drops 10% in a day or two and IV jumps, both IC will be in bad shape but for one I got 4.50 credit so the max loss is 5.50 while the other one will cost me 9$.

If you trade IC's long enough and pretty regularly you WILL get to a period where the market is just moving rapidly trough your short strikes (usually happens quicker if market drops) and then it's all about damage limitation and the question is how much of you previous gains do you give up then.

If you trade 1$ credit spreads with 2 weeks to maturity one bad trade will easily wipe out 4 months+ of gains (assuming you kept all the credit on the previous trades) as you'll have little time to react/adjust before you hit the max loss. With CTM IC and closing them ~3-4 weeks ahead of expiry (having them opened 8-7 weeks before expiry) the price moves from maybe 4.50 to 7 if the market drops sharply - much easier to stomach than the 1$ IC moving to 9$+ for the same move.

Having said that you'll find other members here who love the OTM IC and seem to trade them successfully over a large no of trades - so its all about how you manage them.

[Kim 7,943]

Thanks Marco,

Only one correction: the 50% probability of touching the short strike refers to probability on expiration. During the life of the options, the probability is much higher. So depending on the adjustment rules, the adjustment is needed much more often than 50% of the time. But if we can do the trade without any adjustment even 1-2 times per year, the profits will be well worth it. I had few trades gaining 40-60%. In all other cases, you start after the adjustment in a similar position as "traditional" 15 delta IC.

[crwood 4]

Thanks for the explanations guys. What do you consider appropriate indexes to play this on?

[Marco 223]

Thanks for the explanations guys. What do you consider appropriate indexes to play this on?

I like RUT for that, has a) a higher IV and b ) is usually a bit 'richer' (higher spread IV-HV) than say SPY and c) trading at 800+ $/points makes it cheap for commission

[Kim 7,943]

Definitely RUT, for both reasons Marco mentioned.

[chemfire 0]

Are you considering SPXPM? It's SP500 index options. PM settled Electronic exchange. http://www.cboe.com/micro/spxpm/default.aspx

RUT moves wilder than SPX. So I am thinking maybe this one maybe better for IC trade?

[Marco 223]

Are you considering SPXPM? It's SP500 index options. PM settled Electronic exchange. http://www.cboe.com/...pm/default.aspx

RUT moves wilder than SPX. So I am thinking maybe this one maybe better for IC trade?

RUT is more volatile than SPX but thats reflected in the higher IV and most of the time RUT seems to have a IV premium above that. In a sidewards market (what you are hoping for with an IC) daily volatility is not that important if RUT zig zags with 2% a day rather than 1% a day like SPX but both end the month ~ unch. you do better with RUT due to the higher initial IV.

[tjlocke99 18]

Has anyone held ICs during the 2000 or 2008 market disasters and can comment on them?

I assumed they were bad periods for ICs, but now I wonder with the large dips, ICs done during that period may have had larger credits and/or distances between the wings and thus maybe they actually did better.

Thanks!