The Art of Making Decisions when Trading

One of my basic tenets in teaching people how to trade options is that rules and guidelines should not be written in stone and that there are valid reasons for accepting or rejecting some of the ideas that I discuss.

When I offer a rationale or explanation or a suggest course of action, it is because I have found that this specific suggestion has worked best for me and my trading. I encourage all readers to adopt a different way of thinking when appropriate. The following message from a reader offers sound reasons for taking specif actions regarding the management of an iron condor position. My response explains why this specific reasoning is flawed (in my opinion).

The question

Hi Mark,

I have some questions on Chapter 3 (Rookies Guide to Options) Thought #3: The Iron Condor is one position.

You mentioned that the Iron Condor is one, and only one, position. The problem of thinking it as two credit spreads is that it often results in poor risk-management.

Using a similar example I (modified a little bit from the one in the book) traded one Iron Condor at $2.30 with 5 weeks to expiration:

Sold one call spread at $1.20

Sold one put spread at $1.10

Say, a few days later, the underlying index move higher, the Iron Condor position is at $2.50 (paper loss of $0.20):

call spread at $2.00 (paper loss of $0.80)

put spread at $0.50 (paper profit of $0.60)

I will lock in (i.e. buy to close) the put spread at $0.60 for the following reasons and conditions:

1. it is only a few days, the profit is more than 50% of the maximum possible profit

2. there are still 4 more weeks to expiration to gain the remaining less than 50% maximum possible profit. in fact, the remaining profit is less as I will always exit before expiration, typically at 80% of the maximum possible profit. so, there is only less than 30% of the maximum possible profit that I am risking for another 4 more weeks.

3. the hedging effect of put spread against the call spread is no longer as effective because the put spread is only at $0.50. as the underlying move higher, the call spread will gain value much faster than the put spread will loss value.

Is the above reasoning under those conditions ok? Will appreciate your view and sharing. Thank you.

My reply

Bottom line: The reasoning is OK. The principles that you follow for this example are sound.

However, the problem is that you are not seeing the bigger picture.

1. There is no paper loss on the call spread. Nor is there a paper profit on the put spread. There is only a 20-cent paper loss on the whole iron condor.

2. When trading any iron condor, the significant number is $2.30 the entire premium collected. The price of the call and puts spreads are not relevant. In fact, these numbers should be ignored. It is not easy to convince traders of the validity of this statement, so lets examine an example:

Assume that you enter a limit order to trade the iron condor at a cash credit of $2.30 or better. Next suppose that you cannot watch the markets for the next several hours. When you return home you note that your order was filled at $2.35 five cents better than your limit (yes, this is possible). You also notice the following:

• The market has declined by 1.5%.
• Implied volatility has increased.

• The iron condor is currently priced at $2.80.
• Your order was filled: Call spread; $0.45; Put spread; Total credit is $2.35.

Obviously you are not happy with this situation because your iron condor is far from neutral and probably requires an adjustment. But that is beyond this todays discussion so lets assume that you are not making any adjustments at the present time.

That leaves some questions

• Do you manage this iron condor as one with a net credit of $2.35? [I hope so]
• Do you prefer use to the trade-execution prices?

If you choose the $2.35 iron condor, it is easy to understand that this is an out-of-balance position and may require an adjustment.

If you choose the 45-cent call spread and $1.90 put spread then the market has not moved too far from your original trade prices, making it far less likely that any adjustment may be necessary.

In other words, it does not matter whether you collected $2.00, $1.50, $1.20, $1.00, or $0.80 for the put spread. All that matters is that you have an iron condor with a net credit of $2.35.

3. You should consider covering either the call spread, or the put spread, when the prices reaches a low level. You are correct in concluding that there is little hedge remaining when the price of one of the spreads is low. You are correct is deciding that it is not a good strategy to wait for a long time to collect the small remaining premium.

If you decide that $0.60 is the proper price at which to cover one of the short positions, then by all means, cover at that point. (I tend to wait for a lower price).

If you want to pay more to cover the low-priced portion of the iron condor when you get a chance to do so quickly. there is nothing wrong with that. However, do not assume that covering quickly is necessarily a good strategy because that leaves you with (in your example) a short call spread and you no longer own an iron condor. If YOU are willing to do that by paying 60 cents, then so be it. It is always a sound decision to exit one part of the iron condor when you deem it to be a good risk-management decision. But, do not make this trade simply because it happened so quickly or that you expect the market to reverse direction. If you are suddenly bearish, there are much better plays for you to consider other than buying back the specific put spread that you sold earlier.

4. The differences in your alternatives are subtle and neither is right nor wrong.

The main lesson here is developing the correct mindset because your way of thinking about each specific problem should be based on your collective experience as a trader.

Your actions above are reasonable. However, it is more effective for the market-neutral trader to own an iron condor than to be short a call or put spread.

You are doing the right thing by exiting one portion of the condor at some low price, and that price may differ from trade to trade. But deciding to cover when it reaches a specific percentage of the premium collected is not appropriate for managing iron condors.

Volatility Indexes: VIX and RUT

Interesting story in todays Wall Street Journal online .

Most people are familiar with the VIX, the CBOE Volatility Index. It uses options prices to measure the expected volatility of the S&P 500 index. A lesser known index is the RVX, the CBOE Russell 2000 Volatility Index. This uses the exact same formula as the VIX, but applies it to the Russell 2000′s stocks.