Iron Condor Strategy for Retirement Accounts

Why Trade an Iron Condor?

This article describes the overall strategy for entering and exiting an iron condor trade as well as the mechanics of adjusting the trade when necessary. The approach we present here can be applied to unrestricted money accounts, or retirement accounts, but the risk mitigation element of this strategy is specifically aimed at retirement account investors. But let’s start by answering a basic question – why are we trading the iron condor (IC) in the first place? If we follow established guidelines for the IC, which will be detailed later, we can realize the following benefits of the IC: 1) a trade that is relatively low risk, 2) a trade that has a high probability of success, 3) a trade that puts you on the winning side of time decay and volatility, and 4) a “limited” or “defined” risk trade that is allowed in retirement accounts (depending on broker).

Basic Definition of an Iron Condor

Let’s start with a simple definition of an IC. An IC is a credit spread where one strangle is sold closer to the strike price, and another is bought further from the strike price, thereby constraining the risk of the sold strangle. While this definition is accurate, a better way to think about an IC is to focus on the two sides of the trade – the higher call side and the lower put side. A notional example would be as follows:

• The Russel 2000 (RUT) is currently at 1000

• We sell a call 100 points higher than the current RUT mark, and buy another call a further 10 points higher

• We sell a put 100 points lower than the current RUT mark, and buy another put a further 10 points lower

• The resulting IC looks like this:

o Bought call @ 1110

o Sold call @ 1100

o Sold put @ 900

o Bought put @ 890

Note that you receive a credit for this trade, and though I have described selling the two wings separately, it will be easiest for the beginner to sell the IC in one trade. Another crucial point is that, depending on your broker, you should be able to utilize the margin for one wing to count towards both wings. Thus the above trade would have a margin requirement of 10, not 20, as the trade could not possibly expire in two places. If you cannot combine the margin for the two wings, we recommend you use a different broker.

Margin at Risk, Credit Received, and Potential Loss

Using the example above, let us describe the margin at risk, credit received, and potential loss if the trade goes against us. We will assume this is a trade of 10 contracts (actually 10 for each bought or sold option), with each worth $1000 of margin. This means that our trade has a margin effect of 10x$1000, or $10,000. We will assume you receive $1 credit for each contract, which really means $1 multiplied by 100 (number of options per contract), or $100 per contract. Multiply that $100 by 10 (the number of contracts) and we have $1000 of credit received. If this trade expired in the money (i.e, above 1100 or below 900) your total loss would be margin at risk minus credit received, or $10,000 – $1000. In other words your potential loss could be as high as $9000. We propose using strategies to mitigate risk, such that this will hopefully never occur, but it is important that traders understand what they are risking when entering any trade.

How Most People Trade Condors

Now let us look at how ICs are typically described and traded especially in unrestricted cash accounts. After this description we will emphasize the differences of our approach for retirement accounts and why we think it’s safer, and has greater returns over the long run. In general ICs are sold approximately one month from expiration, with the expectation of either letting the options expire (with hopefully a credit to your account) or with the an exit made within the last week of the trade. The frequency of trades is generally once per month, giving you 12 trades per year. The sold wings will have a delta (percent chance of expiring in the money) of between .5 and.15 (from now on I will drop the period and simply use whole numbers, in this case “5 or 15”). Meaning that on the day they are sold, they will have a 5-15 percent chance of expiring in the money (something the trader DOES NOT WANT) on either side of the trade at expiration. The credit generated will be lower for lower delta trades and higher for higher delta trades.

Now to the disadvantages of this approach. The biggest disadvantage of trading one month from expiration is that you have little ability to adjust your position (vertically rolling trades up or down for the same expiration month) if it goes against you, especially as you approach the last two weeks towards expiration. A second disadvantage is that the trade is done without consideration of market conditions. Are we in a strongly uptrending or downtrending market? Are we at a five year high or low? Is volatility relatively high or low? Where are our wings relative to support or resistance levels? When our primary criterion for entering a trade is the date from expiration, other considerations by definition become secondary.

How Our Approach is Different

First, we DO NOT recommend trading ICs one month from expiration as violent market movements in the last month before expiration often cannot be mitigated. Rather, we recommend trading 7-12 weeks from expiration. Though time decay (i.e., theta) degrades more slowly at this distance from expiration, and volatility may move against your position, you still have the ability to adjust and sufficient time to achieve a winning trade, or at least break even. It is also worth noting that with more time we are able to create larger wing spreads for our ICs.

Second, we ARE NOT looking for home runs. We do not intend to realize all of the credit or even half. If we receive a credit of 15% of margin ten weeks from expiration, and are able to make 5% within two weeks (33% of the total credit), we will gladly take that 5% and call it a day. It is tempting to stay in the trade, but what might happen if you stay in this trade? Suppose you go from being up 5% to down 5% within the next two weeks, meaning six weeks from expiration. You would be kicking yourself for not having taken profits earlier. Remember that you can’t go broke making a profit!

Third, we WILL NOT make trades according to the calendar date. This means we do not expect to make 12 trades per year, or any other specific number for that matter. When we trade will depend on market conditions, especially volatility. As a general rule, if we see volatility break above two standard deviations from the 30 day simple moving average, we will consider entering a trade. This means we will be entering trades on “down days.” The heightened volatility is beneficial because it will provide you a greater credit and broadens the “wing-span” of the trade. If volatility reverts to the mean, you may be able to quickly exit the trade, perhaps within just a day or two. If volatility increases (the market continues to goes down) you will, with the time remaining before expiration, be able to adjust if necessary and hopefully ride out further market turbulence.

Criteria for Entering a Trade

Now let us describe criteria, or determining factors, for entering a trade. These guidelines are not hard and fast, but if we do deviate from them it will only be by a small amount. You will never see us recommend selling an IC one month from expiration! The criteria are as follows:

• Days from Expiration – Seven to 12 weeks

• Volatility – Two standard deviations above the 30 days simple moving average

• Entry on a “Down Day” – The down day will need be two standard deviations below the 30 day simple moving average

Trade Specifications

The following are a list of specifications for the trade.

• Trade size – This is the amount of margin you are willing to put at risk. While we are focused on mitigating risk and aim to avoid losses to principal, it must be recognized that the IC is not without risk. You could theoretically lose all but the credit you receive, so please apportion the capital you put at risk accordingly.

• Credit received – For our trades, we are looking for a minimum 12% credit, hopefully more. You should not accept less.

• Delta – As a general rule we trade with a delta of 10. Depending on the state of the market (how it is trending, volatility, distance from resistance/support levels) we may recommend lower or slightly higher delta trades. We will not recommend deltas above 12 when initiating a trade.

• Trading Index – We will generally trade options on the S&P 500 Index (SPX) or the Russell 2000 (RUT) index. The SPX is less volatile and will likely require fewer adjustments, but you will also receive less credit. The opposite can be said about the RUT.

• Distance Between Bought/Sold Options – In our scenario, there was a 10 point distance between the bought and sold options. If we are trading the RUT we will likely recommend 10 or 20 points between the two options. You receive a slightly higher credit relative to margin for the 10 point differential, but if you need to make adjustments, you will be trading twice the number of contracts than using a 20 point differential (thus increasing your transaction costs). If we trade the SPX we will recommend buying/selling options at the “quarter” marks (i.e., 100, 125, 150, 175, 200…), as they are more liquid and you are likely to get better fill prices. With the SPX, the distance between sold/bought options will therefore be 25 points.

Adjusting the Trade

If things worked out perfectly, we would never need to adjust our ICs, and hopefully, using volatility and time to our advantage, adjustments will be rare. The primary condition for adjusting the trade will be when the delta for one side of the condor approaches or goes above 30. In this case we would want to vertically roll the condor down or up, depending on which side is above that point with the objective of getting our wings once again closer to deltas of 10. We may recommend adjusting the moment the wing nears , but if the market is moving quickly we may wait (though not very long) for a pullback to get a more advantageous price. We will issue alerts indicating the parameters of the roll, including the minimum or maximum amount you should receive or pay for each side. In adjusting trades our primary objective is to protect our principal and if the market is volatile we may look to exit as soon as we reach a break-even point.

Criteria for Exiting a Trade

Like our criteria for entering a trade, those for exiting a trade will not be hard and fast. They are as follows:

• Profit – Our target range for profit is 2%-6%. Note that this is a range, so depending on other factors (e.g., original credit received, market conditions), we may decide to exit at the lower or higher end of this range.

• Days from Expiration – We will always try to exit the trade at least one month before expiration.

• Principal Preservation – As previously stated, if we initiate a trade and the market goes against it, then our first priority is to protect our principal and we will generally exit the trade as soon as we approach or reach the break-even mark.

Sample Trades

Now we will describe two trades, one that went well, a “good trade”, and one that did not go well, a “bad trade.”

Good Trade

The trade, entered on March 16, 2011, satisfies our condition of starting on a “down day,” ending two standard deviations below the 30 day simple moving average as shown below:

Figure 1 – RUT on March 16, 2011 with Bollinger Bands

It also satisfies our volatility requirement to break two standard deviations above the volatility 30 day simple moving average as shown below:

Figure 2 – Russell Volatility Index (RVX) on March 16, 2011 with Bollinger Bands

On Wednesday, March 16, 2011 the RUT is closing at 781.90 and we established the following IC with a May expiration (64 days away):

o Bought call @ 900

o Sold call @ 890

o Sold put @ 630

o Bought put @ 620

The deltas on the sold calls and puts are both 9. We sell ten contracts so our margin effect is $10,000, and we receive a credit of $1,525. That’s more than 15%!

By the following Wednesday, volatility and theta decay have helped reduce the value of our IC to $1,075 and we buy it back to realize a gain of $450, that’s 4.5% of our margin with only one week of exposure to the market!

Bad Trade

Now we will analyze a trade that does not go as planned and requires adjustment. The trade, entered on Wednesday, June 17, 2011, satisfies our condition for a down day, but it DOES NOT close two standard deviations from the 30 day simple moving average.

Figure 3 – RUT on June 17, 2011 with Bollinger Bands

Volatility, on the other hand, DOES satisfy our condition for being two standard deviations of the simple moving average, but you will notice that it has been within a narrow band for some time.

Figure 4 – RVX on June 17, 2011 with Bollinger Bands

Despite conditions being sub-optimal you decide to sell an August IC with a credit of $1.33 per contract, or 13.3%. The RUT is currently at 781.75, nearly the same mark as you previous trade, and there are 62 days until expiration. Your trade details are as follows:

o Bought call @ 880

o Sold call @ 870

o Sold put @ 650

o Bought put @ 640

Like the other trade, your deltas are 9, but notice that the “wing-span” of the IC is much narrower due to lower volatility. Note that you also receive a lower credit for the trade. Like the other trade, we sell 10 contracts so our margin effect is $10,000.

From June 17^th through July 1^st, the RUT makes a nearly vertical assent to 840.04 (it will reach 858.11 by the 7^th). On the 1^st the delta on your 870 call reaches 29. You decide to act and roll up your options. You buy back your nearly worthless put spread (650/640) and sell a new put spread which is 720/710 for a net credit. Note than in uptrending markets it is often difficult to roll up your put side for sufficient credit, thus we have to become more aggressive with deltas. They will be higher than 10.

We then buy back our call spread (870/880) and sell the 900/910 spread. Note that the net of your call transactions would create a debit that is greater than what you receive from rolling up your put transactions. This may require you to stay in the IC longer than planned, and it may be best to exit at break-even point or for a small loss. We are lucky as the market begins to fall and we exit the trade a week later at break even.

Other alternatives for managing a difficult trade include rolling the losing side of your IC to the next month or rolling and selling more contracts to generate a greater credit. Our focus will be on helping you maintain the principal you have long built up in your retirement accounts while also realizing healthy returns. So when the going gets tough we will be there to help guide members through difficult markets.