The Dangerous Iron Condor

Kerry W. Given, Ph.D. (Dr. Duke)

Disclosures and Disclaimers

Buying and selling stocks and options involves risks and may not be suitable for all investors. Prior to buying or selling an option, the investor must receive a copy of the booklet, Characteristics and Risks of Standardized Options, from your broker or from The Options Clearing Corporation, 1 North Wacker Drive, Suite 500, Chicago, IL 60606. The information in this presentation is presented for educational purposes only. It should not be construed as a recommendation or solicitation to buy or sell options. Many examples of options trades are presented in this presentation as illustrations of the principles being taught in this course. These examples are not recommendations or solicitations to buy or sell any stock or option. To simplify the calculations, commission costs have not been included in the examples in this presentation. Commission costs will affect the outcome of any stock or options trade and must be considered prior to entering the transaction. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed in this presentation. The past performance of any trading system or methodology is not necessarily indicative of future results.

Introduction
Stock and index options can be used in two broad strategies: To profit from my directional prediction for a stock or index (directional strategies). To profit from sideways channeling of a stock or index (nondirectional strategies). Vertical option spreads are formed when I buy one option and then move up or down one strike and sell that option. Vertical spreads are the building blocks for creating multilegged spreads such as condor and iron condor spreads. The condor and iron condor spreads are classic nondirectional strategies. These strategies are commonly used for monthly income generation.

Using Vertical Spreads Directionally

AAPL at $202 on 11/12/09 Recent high approximately $208; areas of support near $186 Our prediction: AAPL trades below $210 until early December

Creating the Bearish Vertical Spread

Sell the AAPL Dec $210/$220 call spread for $2.36 Buy the Dec $220 call at $1.94 Sell the Dec $210 call for $4.30 A bear call spread for a credit of $236/contract This has created a vertical spread with a net credit of $236 and a profit potential of $236 (31%) if AAPL closes anywhere below $210 Dec. 18.

Using Vertical Spreads Directionally

AAPL at $202 on 11/12/09 Recent high near $208; areas of support around $186 Our prediction: AAPL trades above $185 until early December

Creating the Bullish Vertical Spread

Buy the AAPL Dec $175/$185 call spread for $8.95 Buy the Dec $175 call at $28.30 Sell the Dec $185 call for $19.35 A bull call spread for a debit of $895/contract This has created a vertical spread with a net debit of $895 and a profit potential of $105 (12%) if AAPL closes anywhere above $185 Dec. 18.

Using Vertical Spreads Nondirectionally

AAPL at $202 on 11/12/09 Recent high approximately $208; areas of support near $186 Our prediction: AAPL trades above $185 and below $210 until early December

Creating the Condor Spread

Sell the AAPL Dec $210/$220 call spread for $2.36 with a profit potential of $236 (31%) if AAPL closes anywhere below $210 Dec. 18.

Buy the AAPL Dec $175/$185 call spread for $8.95 with a profit potential of $105 (12%) if AAPL closes anywhere above $185 Dec. 18.

Now we have a condor spread that returns $341 if AAPL closes above $185 and below $210 Dec. 18. The total capital at risk is the net debit of $659. Therefore the potential return is 52%.

Several Varieties of the Condor

Many variations on the condor spread are possible, each with its own characteristics, advantages, and disadvantages. The condor spread (debit) vs. the iron condor spread (credit) Look for channeling stocks as candidates. Trade the broad indexes every month. Strike price placementnear or far? Time to expiration? Are spreads established simultaneously or by legging into the position?

Risk Management
The risk-reward ratio for condor spreads is highly unfavorable; therefore, risk management is crucial. Risk management comes in two parts: 1)Protect the downside with a contingency stop-loss order. 2)Develop an adjustment system with specific triggers and adjustments. Immediately after establishing the iron condor position, enter a contingency order to close your downside put spreads in the event of a sudden downward move. Adjustments come in a variety of different flavors.

Variety of Adjustments
1. The 200 Percent Rule: When the debit to close is greater than or equal to 200 percent of the original credit, close all of the spreads on that side. 2. Closing Spreads: When your trigger point is reached, close 30 percent to 40 percent of the spreads on that side. 3. The Buy Back: When your trigger point is reached, buy back some of the short options (buy 1 option for every 10 spreads). 4. The Long Hedge: When your trigger point is reached, buy long options at the short strike in the next month (buy 1 option for every 10 spreads). 5. Rolling Spreads: When you close all of the spreads on a side, you may choose to roll up or down to continue the trade.

My Approach
I trade the iron condor every month for income: The Insurance Model. I initiate the position around 45-55 days to expiration; the precise day is not critical. I calculate one standard deviation () and position the short strikes greater than 1 OTM. I establish both call and put positions the same day. On the Friday before expiration, I close the spreads if they are less than 2 OTM; if they are greater than 2 OTM, I allow them to expire worthless. My adjustment trigger: When of short strike is greater than or equal to 18, I adjust the trade. When delta 30, I close that side. I adjust by buying long options at the short strike price in the next expiration month (1 for every 10 spreads).

How Has It Worked Out?

Option Month
June July August September October November December January January February

Days to Expiration
48 34 55 37 56 56 51 51 31 44

Max Gain
$3,900 $6,600 $4,000 $4,360 $2,400 $3,460 $3,800 $4,340 $4,650 $3,740

Max Loss
$16,100 $13,400 $16,000 $25,640 $12,600 $16,540 $16,200 $15,660 $5,350 $16,260

Adjusted?
One Roll No Six! One Five! One Roll Five! Three Three

Days in Trade
48 12 55 35 56 56 51 50 30

Gain/Loss
$4,600 (+29%) $1,400 (+10%) -$810 (-5%) $1,630 (+6.4%) $715 (+5.7%) $2,060 (+13%) $2,450 (+15%) $2,240 (+14%) $370 (+7%)

Conclusions
Iron condor spreads can be configured as conservative income-generation trades. All condors spreads have high risk-reward ratios, i.e., we can lose $7 to $9 for every dollar of potential profit. Therefore, risk management is crucial. Risk management consists of: Always have a plan and unemotionally follow the plan. Always have a protective contingency stop-loss order set on the downside. Adjust when necessary. Adjusting too early reduces profits, but adjusting too late results in large losses.

Questions?

Email: Dr.Duke@ParkwoodCapitalLLC.com www.ParkwoodCapitalLLC.com