Part Two: Philosophy of the Iron Condor
Incase you missed Part One: http://optiongenius.com/blog/iron-condor-option-trading-mini-course/
Stocks move up and they move down. Very rarely do they move in only one direction for an extended period of time. Since most of the time, stocks trade in a range, why don’t we make money from the range, instead of trying to determine if they are going up or down?
That in essence is the philosophy of the iron condor spread. No need to determine which way the market will move, because within a 30-50 day time period chances are that the market will stay in a range. Over time, it may move in one direction. But in a short period of time it probably won’t.
So let’s sell options that are far out of the money, which have very little probability of hurting us, and make money by selling time. As days go by, the options lose value, the markets go up and down, and we profit.
Iron condor spread trading is non-directional trading. An iron condor trader does not need to know which way the market is going. It helps if he does know, but my opinion is that no one can accurately predict over and over which way the market is going or where it will go to.
So when people ask me what I think of the market, I tell them “I don’t know”. And as an iron condor spread trader I don’t really need to know. As long as it gets to wherever it is going slowly, my iron condor spread trades will make money.
Two Types of Condor Traders
There are two major schools of thought when it comes to the Iron Condor spread trades. The first school says that the condor spread trade is a strategy that works on its own. In other words, no adjustments are needed. If you let it do its thing, over time the trade will make money.
The other school of thought says that you should adjust your condor spread trades when they get into trouble.
I fall into the second school. I don’t like losing money and taking a max loss on a condor trade by not adjusting it can be a depressing event.
By adjusting a condor, I mean to make changes to the original position to impact the trade. There are many different adjustments possible, and I will cover them later in this mini-course. By adjusting the trade, you give yourself an even better chance to make money. But every time you do an adjustment, you reduce the maximum yield you can make on the trade.
What Probability Do You Want?
Once an iron condor trader has decided if he will adjust or not, he must decide what probability of profit he wants to aim for. Does he want 60%, 70%, 80% or more? Based on this number he will pick his strikes (options to sell). The further away from the money, the greater the chance that the iron condor spread will make money, but the lower the yield and the greater the max loss.
I like to be in the 80% probability range.
Another way to influence the probability is the amount of time to be in the trade. A trader can be far from the money, with a high probability of profit, and a higher than normal yield, but only if he stays in the trade longer.
For example, an iron condor that is entered 50 days to expiration has more yield and option premium than one entered 25 days to expiration. But those extra 25 days add risk that something could happen in the market to hurt the position during that time.
How to Determine Strikes
When it comes to strikes, again we have two schools of thought.
One group of traders uses technical analysis to determine which strikes to sell. They look at the charts, find the support and resistance levels and whatever other technical indicators they use and sell strikes that they feel give them the best chance of making money.
Iron condor spread trades
The other group, of which I belong, use statistics and math to determine which strikes to sell. By using statistics you can set your strikes to have a high degree of confidence that your strikes will be safe. For example, you can set your strikes one standard deviation away from the money, or two standard deviations away. These deviations are calculated, using option prices, the volatility of the underlying, the time left to expiration, and several other factors.
Option trading strategies
Whichever of these two methods you use, keep in mind that there is no guarantee that the market will not violate your short options. So even with a high probability of profit, you can still lose money.