What should you do when the underlying moves against an iron condor position you have open? (For example, if you’re a member, you may have noticed that one of our DIA trades for May expiration is looking threatened by the recent price action in the index.) Any time this situation arises, people will always write in to ask about how they can “adjust” or “fix” the trade if the market continues to be uncooperative. It’s an understandable impulse to want to take action when things don’t go your way, but it’s also important to guard against the danger of overtrading.
Our answer here is the same as the answer we always give: there is no magic solution for “fixing” trades that move against you. Sure, there are actions that you can take to reduce risk or minimize losses, but those actions come with their own inherent risks and downsides, and any added risks need to be recognized as such.
1. Allocation, allocation, allocation
Our official position is always that the best way to guard against the pain of a losing trade is to allocate conservatively. Asset allocation is extremely important. And as we’ve said elsewhere, there’s no rule that says it’s a disaster if the underlying touches our short strike – in fact, the probability of the underlying touching a short strike will always be higher than the probability of that short option expiring in the money. In other words, if you dump a position every time the underlying moves against you, after a year or so you’ll end up with a boatload of stop losses and just a handful of easy wins, for a definite net loss. However, if you play defense by managing your risk and your allocations intelligently (rather than by prematurely cutting off uncooperative trades at the knees), you’ll end up with more winners than you might otherwise expect.
In short: when probability is on your side, it only makes sense to let those probabilities work themselves out. Imposing artificial stop losses or entering expensive or risky hedges can actually worsen the overall performance of the strategy. Instead of putting on one or two huge positions and then having to worry about what happens to them, try putting on lots of relatively smaller trades across multiple underlyings, multiple strike prices, and multiple timeframes.
2. Manage Greeks, Not Trades
The other point that should be made here is that once you’re appropriately allocated, the task of managing your portfolio actually becomes much easier. This is kind of counter-intuitive – shouldn’t it be harder to manage 20 trades than it is to manage just 2? But the secret is that a balanced portfolio of positions can be managed on the basis of aggregate Greek values, rather than on the basis of what each individual trade does.
This means that the events that trigger actions on your part will not be one-dimensional events like the price action of an underlying; instead, you’ll be responding to changes in the overall Greek values of your portfolio. So if you know that you get uncomfortable when your total deltas get above some value n, at n + 1 (or n + 50, say if n > 500), you know it’s time to take off some existing positive deltas, or to enter some new positions with negative deltas. If you know that you like to keep your portfolio generating positive thetas, then you also know that any future hedges or adjustments you make should fit that general profile, which means buying calls and puts won’t be high on your priority list.
With those preliminaries out of the way, let’s examine a few ideas for how you can hedge an iron condor that isn’t acting the way you hoped it would. In part 2 of this article (subscribers only), we’ll offer some specific techniques, using a real-world position.