Opening a new position is fun because it represents an opportunity to earn money. The not-so-obvious corollary is that there is also the possibility of losing money. When a trader recognizes that the priority is to avoid the large losses, he is on the road to success. Holding positions to ‘see what happens’ is not viable for long-term success.
Today let’s look at one suggested idea for managing risk when owning iron condor positions.
The risk of owning an iron condor is that it will cost too much to exit the trade at a later date. That occurs when the underlying asset moves near, and then through, the strike price of one of the short options. One risk management technique is discussed below.
I recently viewed a webinar by an options educator who offered a reasonable method for adjusting or repairing an iron condor position when risk has increased to a point where the trader is uncomfortable holding the position.
The suggested ‘repair’ for an at-risk call or put spread is to append a butterfly spread. First let’s look at an example, and then I’ll explain why this idea is too limiting and that a bit of ingenuity offers more flexibility and more choices for the trader.
Premise: You own an INDX iron condor, where INDX is a fictional, broad-based index.
Long 10 INDX Oct 730 put
Short 10 INDX Oct 750 put
Short 10 INDX Oct 930 call
Long 10 INDX Oct 950 call
Next, INDX rallies to a price that makes you uncomfortable and it is time to adjust. Two possibilities:
- The loss is approaching the maximum acceptable loss (according to your trade plan).
- INDX is too near the strike of your short option and you are concerned about additional losses. Each trader has an individual comfort zone and ‘too near’ could occur at 900, 910, 920 etc.
The adjustment trade: Buy the INDX Oct 930/950/970 call butterfly spread. The basic idea is that you cover the short call spread (930/950) and simultaneously sell another call spread.
The put position is unchanged and the new call position is:
Short 10 INDX Oct 950 call
Long 10 INDX Oct 970 call
You now own a new iron condor and must manage risk for this (not the original) position. Because it cost cash to buy the butterfly spread, your overall profit potential has been reduced. There is nothing to be done about that right now. It is far more important to manage risk to prevent a large loss.
It is quite possible that the trader will be uncomfortable being short the new call spread. However if using the ‘butterfly adjustment’ is all you know, then you will be ill-prepared to handle the situation. A bit of flexibility is required. Instead of ‘appending a butterfly,’ I suggest appending a condor. That offers alternatives when managing the position.
Buy a call condor instead of a butterfly. For readers who are not familiar with the difference between a butterfly and condor:
In the butterfly spread, we buy one call or put spread and sell another. Restriction: The two spreads have one strike price in common. The butterfly consists of three different options and they are all puts or all calls.
In the condor spread, we also buy one call or put spread and sell another (both call spreads or both put spreads). This time the only restriction on the strike prices of the two spreads is that there is no overlap. They may be very near each other or very far apart.
Instead of buying (to close) the 930/950 spread and selling to open the 950/970 spread:
Buy one of the following (or other) condors:
- 930/950; 960/980
- 930/950; 970/990
- 930/950; 975/995 etc.
In each trade, the 930/950 call spread is closed and the trader sells a new spread (in this example it is 20-points wide). This trade is not limited by the ‘butterfly’ designation, allowing the trader to construct a position he wants to own.
NOTE: It is always acceptable to exit the trade (instead of adjusting), accept the loss, and move on. Some trades cannot be salvaged.
There is nothing inherently wrong with the butterfly adjustment. However, it is limiting. The idea of making‘condor adjustment’with real choices could be an eye-opening lesson for the novice.
There are other viable strategies for adjusting an iron condor (or similar) position. The lesson here is that the thinking trader can afford to be flexible when following someone’s recommended rules.