Part Three: The Risk of the Iron Condor Spread and How to Mitigate it.
So far we have talked about how the iron condor has great probability of success and can generate a decent return month after month.
In this section we are going to talk about what happens when things go wrong.
Most traders say that iron condor options trading is a conservative strategy. Others say it is very risky because you can lose a lot more than you can make.
It all depends on how you set up the condor spread. You can choose strikes that are way out of the money and that give you a 95% probability of success or you can choose strikes that are close to the money and give you a 40% chance of success. The closer your short strikes are to the money, the more your iron condor becomes a butterfly. A butterfly is also two credit spreads like a condor but close to the money.
As an example, let’s look at a condor spread that has an 80% probability of success. In our example we get a credit of $1.00 and the max we can lose is $9.0. So we can make $100 per spread or lose $900. As you can see you don’t have to lose too many times to lose all your money. Even if you win 9 times and lose once, you will be negative. And since the odds are saying you will win 8 times and 2 two times for every ten trades this is a losing proposition.
But no one said you have to lose the whole amount.
By using money management you can limit your losses in the months your condor spread is not going to make money. And yes, there are several months like that where no matter your adjustments, you are still going to lose unless you are willing to throw an endless supply and money at it and are willing to roll into other months.
Instead of letting our condor spreads go all the way to the max loss; let’s say we decide to limit our loss to 20%. For simplicity sake we will limit our loss in the example to $2. Once we enter the trade, we get $1. But if we are ever down $2 or $200 per spread then we exit the trade.
What about Stop Loss Orders?
You can use them. Place orders to buy back your spreads at whatever you decide as an acceptable max loss. That should help you sleep at night.
What about another 9/11 event?
The iron condor does well when the markets are flat. Or if they go in one direction then it works if the move is a slow on. A major event like a 9/11 event that makes the market move huge in one day can kill an iron condor trader.
Normally, these types of moves happen to the downside. If there is a nuclear explosion, or war, or earthquake, or anything similar, the markets will drop. As is the common phrase “Bulls go up the stairs. Bears go out the window.”
An iron condor trader can protect herself from such an event by buying Put insurance. You simply take some of the credit you get and buy enough put protection to protect yourself in case the word ends. With this insurance, if the markets go down enough you can still make money even if you lose the max on the condor spread.
Let’s recap our lesson on iron condor risk.
To mitigate the risk of getting to the max loss, you simply decide on an exit point. “When I am down ____ % or $_____ I will exit the trade and live to trade another day.”
And to protect yourself from the end of the world, simply buy some Put(s) as insurance. How many puts and which puts is a matter of personal preference and depends on your trade size.