How to use Defensive Strategies to Defend an Iron Condor Trade
A Credit Spread or an Iron Condor trade seems like such a “no-brainer” method of collecting income, that it’s very common to see students get carried away in their enthusiasm….until the price starts to move towards one of their short strikes, and the” pain” that they feel is very real, especially since it’s now undoubtedly too late to effectively risk-manage their trade. This is why the most frequently-heard comment that I get from prospective students is: “I tried that trading style once….I won 6 months in a row, but gave it all back on the 7th month when I lost that trade.”
And it’s not surprising; too many students just want to know how to ENTER a trade, and too many educational firms are happy to provide that information alone. What I’ve learned through the years, however, is that it’s not what you collect at the beginning of the trade that matters….it’s what you KEEP at the end of the cycle that counts!
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We all know that selling options premium is a great way to collect income, but how do we KEEP more of it? Well, if we can take a lesson from sports teams that continually rise to the championship level, the answer is DEFENSE. We need to learn to defend our options trades, which means doing so proactively, and not after the trade is “buried.” To paraphrase Dan Sheridan, “we need to defend during times of peace, and not war.”
To accomplish this “defense”, I’ve broken my defensive schemes into four different levels:
Static Risk Management – In the world of Stocks, this would also be known as a “stop loss.” Before I place any option trade, I pre-define the point at which I will no longer let the price attack this position. This is my most basic form of defense, and is essentially my “last line of defense”, or “brute force risk management.”
Dynamic Risk Management – Warning, here comes the Option Greeks! Most of my positions are “short gamma” which means that they don’t want to see the price anywhere near the short strike price near expiration. If that’s the case, then the thinking behind this form of defense is to add some positions that complement the credit spreads…..ones that GAIN value as the price approaches the short strikes of your credit spreads. These are going to be “long gamma” trades, or generally debit spreads of differing composition depending on what risk factors (price or volatility) that I’m guarding against.
Active Delta Management – Sometimes, holding a credit spread position during a trend in the Market gives you the feeling on standing on a railroad track, watching as a distant freight train slowly and inexorably bears down on you. During the time between when you first spot the train coming in your direction….and when it’s almost on top of you….isn’t there SOMETHING that you could have done during that whole time to help mitigate that risk of being run over?! Well, there is, and this is where we need to actively manage our Position Deltas and make sure that they don’t grow too large in one direction or another, signifying that the risk of the next point move in price is growing toolarge. There are many different ways to accomplish “neutralizing” your deltas, either by adding stock/futures/long options, but the key point here is to understand what your “threshold” is at which point you will take action, well BEFORE it becomes a problem.
Active Risk Management – This is really another term for “common sense.” If we’re sitting on a nice profit, but it’s late in the options cycle and a quick 10 point move in the underlying will erase everything that we’ve worked for over the past 5 weeks, wouldn’t it make more sense to take what the Market is giving you and not try to squeeze that last nickel out of the trade? I’ve found what really helps here is to have some form of P/L Analyzer, so that you can graphically see how changes in price, time, and volatility will affect your future risk….and when it’s time to get out while the Market is extending you an olive branch. I will also doff my cap to the strength of a trend if we’re in the midst of one, and start removing positions for break-even or better if I think that the odds favor them being in “trouble” before the cycle is up. Remember, that credit that you collect is not yours until your obligations are eliminated. I don’t mind using some of the collected credits to spend on defense.
If you note, with these four styles of defense, none require you to have a genius level IQ nor correctly forecast the Market; the emphasis is on PROACTIVITY. You will find it difficult, if not impossible to manage a live cash trade “on the fly” with a lively market.
You must plan out your actions and “script them” the night before so that you’ll know exactly what you’ll do the next trading day.
If you’re an options trader that desires to keep more of your initial credits, smooth out the variability of your monthly results, and spend fewer sleepless nights….then invest a little bit of time to sharpen your defensive saw.
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