Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

This is the third installment for our Real-World Trading series on an iron condor. In our last article, we chose to use the S&P 500 ($SPX) in our mock trade to show how this strategy works using an index. We like to use indices when trading sideways trading strategies to avoid the sharp moves that can be seen with individual stocks. This week, we are going to look at our mock trade and how it has fared and I also want to dive into a method of determining the risk associated with similar trades.

In review, an iron condor has the same risk graph as a regular condor. The only difference is that with an iron condor, we are using a bull put a spread and a bear call spread. This provides us with a credit instead of a debit, but the reward to risk ratio is usually very similar. One would use an iron condor if a slightly better entry can be achieved as opposed to a condor trade. We like to use front month options because it provides the greatest theta decay and gives the underlying security less time to move out of our profit zone.

Below is the data for our mock trade, along with the risk data and risk graph:

Nov. 18

SPX @ 1109.80
Buy 1040 Dec Put @ 6.85 (IV-24.6)
Sell 1080 Dec Put @ 14.75 (IV-22.3)
Sell 1120 Dec Put @19.10 (IV-18.7)
Buy 1160 Dec Put @ 5.55 (IV-17.2)
Credit = $2,145
Max Risk = $1,855
Downside Breakeven = 1058.55
Upside Breakeven = 1141.45

Nov. 27
SPX @ 1091.49
Long 1040 Dec Put @ 8.60 (IV-27.2)
Short 1080 Dec Put @ 18.70 (IV-23.9)
Short 1120 Dec Put @ 9.20 (IV-19.5)
Long 1160 Dec Put @ 2.17 (IV-19.4)
Credit = $2,145
Max Risk = $1,855
Current Profit (Loss) = $432.00
Downside Breakeven = 1058.55
Upside Breakeven = 1141.45

Figure 1, below, is the risk graph and data for this trade created in Platinum:

Figure 1: Risk Data for SPX Iron Condor

Figure 2: Risk Graph of SPX Iron Condor

We have only been following this trade since Nov. 18, but the profit is already at $432. IV has increased on the options in the trade, which has taken away from the current profits, but we need to understand something about this. The idea with an iron condor is that we are staying in until expiration to take full advantage of theta decay. This means that the change in IV after we enter the trade isn't much of a concern. At the moment, Vega is showing a figure of $-70.66. This means for each point gain in IV, the trade will lose $70.66. If we wanted to get out early, this change could have an impact, but when trading an index, IV doesn't tend to change too dramatically in a short period of time. The "greek" that we like to follow with an iron condor is theta. When we opened the trade, theta was at $24.96, but it currently sits at $31.47. This means that for each passing day, the trade will gain $31.47 due to theta decay alone. As we approach expiration, this figure will rise sharply if the stock stays within the profit zone.

One common question about sideways trades has to do with how do we know what strikes to use. For the most part, we tend to stick with strikes that are the same distance apart. The key is to surround the trading range with the inside strike prices. Thus, in our trade, we used the 1040-1080-1120-1160 strike, which the max profit achieved if the SPX closes between 1080 and 1120 at expiration. Below I am going to talk about a way of comparing trades and finding the most appropriate strikes.

Optionetics Platinum can be used to view risk graphs, which provide the insight needed to choose the appropriate strategy. However, there also is a tool called the Probability Calculator that can be used in conjunction with the risk graph. By inputting the appropriate information, this calculator will tells us the odds of the underlying being at a certain price at a given time. Below is what this calculator looks like:

Figure 3: Screenshot of Probability Calculator

The above picture shows the data put in for the SPX trade when it was started on Nov. 18. The price targets can be used so that we find the appropriate probability given our breakevens and max loss points. We can find an expected profit by using this information. The formula for getting this figure is as follows:

(Max reward X probability of profit) - (Max risk X probability of loss) = Expected profit

I don't have space here to show every step, but let me show the how this works. With the trade we showed, the data is as follows:

Max reward (2145) X probability of profit (31.1%) = $667.10
Max risk (1855) X probability of max risk (23.8%) = $441.49

The difference between these two figures is $225.61, which is our expected profit. If we plug this data in for varying strikes, we can figure which work best as far as expected profit is concerned. All you need is the risk data found on the Risk Graph I screen, along with the probability calculator. A couple different calculations need to be performed, but it doesn't take long and can provide traders with a specific expected profit figure. Obviously, the trade that provides the better expected profit figure is usually deemed the best trade to enter. Take the time to experiment with these tools. Not all tools are for all traders, as each trader has their own risk tolerance and trading methods. However, for those more analytical, these tools can lower the emotion of entering a trade.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• March 17, 2010
  Closing Wrap-Up, March 17
• March 17, 2010
  Morning Watch, March 17
• March 16, 2010
  Closing Wrap-Up, March 16
• March 16, 2010
  Real-World Trading: The Debit Spread, Part IV
• March 16, 2010
  Morning Watch, March 16