Adjusting the trade – Staying Out Of Harm’s Way

The key to successful investment and or trading is risk management, Managing your risk entails that you have a plan in place, in case the trade goes wrong and more importantly that you execute on the plan.

An Iron Condor has two credit spreads the Bear Call Credit Spread and the Bull Put Credit spread. The credit spreads are established with a short strike on both the Call and the Put with a simultaneous long on both the Call and the Put. For our current July 2011 trade cycle we have established the following trade –

 

 

 

 

The goal of the above trade is to manage it till expiration with the goal of keeping the total premiums of $1.20 per contract which translates to a gross amount of (15×100) x $1.20 = $1,800. Remember each contract controls one hundred shares and is the reason why we are multiplying the 15 contracts we hold in this position by 100. Our short strikes are the 855 strike price on the Call spread and the 700 strike price on the Put spread.

Our risk in this trade is the difference in the strike prices which in this case is equidistant and is 10 points for both the Put an the Call credit spread (we only use the difference on one side of the spread) multiplied by the total number of contracts less the gross premiums received. In this case the calculation is as following –

 

(865-855) x (15 X 100) – ($1.20) x (15X100) = $13,200

 

The reason for using just one leg of the spread is because in an Iron Condor you can only lose on only one side of the spread technically.

Once the trade is established we now begin the process of managing our risk and to make sure that our short strike prices stated above are not breached. We normally put up the trades at a delta of between .8 to .12 and also two standard deviations from our short strikes. The goal is to monitor our deltas and make sure that we buy protection in case our deltas begin to get too large and the market trends in a particular direction. The key is to buy insurance 10 points below the short strike price on the Call side, which in this instance is the 845 strike price and 10 points above the Put short strike price in this case it is the 710 strike price.

 

Let’s say our short Put strike price of 700 which is currently at a delta of .11 goes to .20, our first step is to buy insurance which in this case is the Purchase of about 2 contracts at the 710 strike price. The rule of thumb is to purchase 1 contract for every 10 contracts you hold at the short strike price.

If the trend continues to the downside and the short delta goes to between .25 to .30, the next step is to roll the entire position down (for the call side you will roll it up) and at the same time increase the number of contracts by 1.5 times. Simultaneously you will sell the two contracts you bought at the 710 strike price, which will have made you enough money to mitigate your loss and to enable you pay for the roll, reduce the potential profit of the original trade but still be profitable with the new established position, which will be to the next .12 or .08 delta. Additionally you will roll down  from the 865/855 which by now will have made the most profit for you  to say the 835/825 to pick up additional premiums and also increase the contract size by 1.5x to about 20 contracts the same as the new position on the put side.

 

Let’s say we roll down from the 700/690 to the 690/680 strike, our trade to establish the new position will be as following –

 

+15 RUT JUL11 700P

-35 RUT JUL11  690P

+20 RUT JUL11 680P

 

New position on the Put spread will be as following –

-20 RUT JUL11 690P

+20 RUT JUL11 680P

 

Roll down the call side –

 

-15 RUT JUL11 865P

+15 RUT JU11 855P

 

-20 RUT JUL11 825C

+20 RUT JUL11 835C

 

The new position for the entire position after the roll on both credit spreads will be as following –

 

The whole idea is to manage the risk such that  your short strike prices are never breached either on the put side or the call side and to stay out of harm’s way.