These are the rules we use when trading iron condors and any similar options spreads. These are time-tested rules of thumb: they aren’t iron-clad commandments that can never be broken, but they are strategic pointers that have proven useful.
- Always enter a position at least 4-10 weeks prior to expiration. If you’re wrong, the negative gamma risk outweighs positive theta risk at less than 4 weeks out.
- Look for a probability of success around 50-70%. Trades with higher probabilities of success also require higher levels of risk, so we usually avoid them.
- Range-finding techniques: our proprietary approach for determining the range of the spreads we work with includes variables such as historical volatility, implied volatility, general market health conditions, and implied volatility skew.
- Exit by time function, not by price. If you are nervous about a trade, there’s no harm in exiting half the position now and the rest later. To avoid exiting prematurely from stressed positions, we manage directional risk by hedging dynamically as needed.
3. Choose Your Weapon
- We don’t trade iron condors on individual equities, as you may have read on our FAQ. The biggest reason for this is that any individual stock will be subject to sudden price movement from events both expected (earnings, industry reports) and unexpected (management changes, big competitor success, etc.). The danger with these events is that they can easily create binary situations for our trades – if earnings are coming out on a volatile stock, either a good or bad report could push the price outside the range of our trade, leaving us with a loser overnight. Using index products dramatically reduces this risk. The only analogous event risks to indexes are market-external events like economic reports, geopolitical events, etc., and of course these are also risk factors for individual stocks.
- So instead of looking to GOOG, AAPL, XOM, or GE for our underlying, we prefer the most liquid and actively traded indexes. Until recently, this meant things like SPX, RUT, and OEX. But the introduction and increasing use of ETF indexes has made those instruments increasingly attractive, not least because they often feature tighter bid/ask spreads and electronic execution. So now we usually look to SPY, IWM, DIA, QQQ, XLE, and similar underlying instruments. These weapons give us greater flexibility, reduce slippage, and faster execution.
5. Capital Allocation
- Over time, we typically enter multiple iron condors with same expiration month but non-identical strike ranges. This allows us to take advantage of changes in the market without being committed entirely to one range of potential movement or to one level of implied volatility.
- We also allocate capital to dynamic hedges, which reduce directional risk and allow us to keep positions open for longer. Hedge positions may use options or shares of the underlying assets.