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February 4, 2011 - by Christopher Smith

Iron Condors and Risk Management

Discover why probability-of-success is not particularly important and learn to instead focus on risk if you wish to be a successful iron condor trader.

Options traders often debate the idea of trading a monthly iron condor strategy on major indexes such as the S&P 500 or the Russell 2000, with a high probability of experiencing a successful trade. Proponents of the strategy will rely upon standard deviations, probability-of-touching calculations and other advanced math to support the idea that the iron condor can pull in healthy returns month-after-month.

The other side of debate includes the "Black Swan" crowd and the efficient market folks who will point out that those advanced mathematical calculations assume normal distributions which the market has repeated demonstrated cannot be reliably applied during times of crisis. They argue that assuming the options pricing formula is correct, then there is no inherent advantage to selling those out-of-the-money options than there is to buying them.

What we need to know is which side of this debate is the winning side, and the answer is that they are both right but that they are missing something very important. They are both right because iron condors are typically constructed so as to provide a high probability of success to the option trader but this does not guarantee success because the market is capable of making very quick moves in excess of three standard deviations. When one of those moves occurs, the iron condor trader is vulnerable and will most likely experience a significant loss of capital absent some intervening factor preventing the loss.

To understand this better it is important to look at the risk-to-reward profile of an iron condor spread. The typical spread offers a relatively modest return while exposing the trader to rather significant capital risk. For example, assume that a high probability ten-point spread on the S&P 500 cash index (SPX) brings in a $2.00 credit. This represents a potential yield of 25% which seems quite generous, but the other side of that equation is a potential loss four times that size.

This lopsided risk-to-reward profile of the iron condor means that we need to win on the large majority of trades if we hope to offset the occasional loss and still keep some money in our pockets. It is also a sobering reality for those lost in the fantasy of making 10% every month, because just one losing month can wipe out several months of winning trades.

To overcome this favorable risk-to-reward profile some traders begin looking for gimmicks, which they mistake for a "trading edge." Make no mistake, there are traders who do have an "edge" in the market which is simply some aspect of their trading that pushes the probabilities to their favor much like a casino always has an "edge" against those who try their luck against the house.

Much like those gamblers who blow on their dice, many traders rely upon various gimmicks to ease their anxieties and convince themselves that they can overcome what can only be described as rotten odds in the form of the risk-to-reward of our iron condor. The gimmicks include all sort of analytics, but they each miss the critical chore of managing risk.

An iron condor trader must really take on the role of risk manager. Instead of focusing on that 5% or 10% potential monthly return, the focus must be upon the crippling 100% loss. Those monthly profits are nice to see, but that unmitigated loss will end your trading. Recognizing that it is the losing side of the trade that requires our greatest attention is the first step to becoming successful as an iron condor trader.

There are no magical analytical tools. You will still be buying and selling the same options that everyone else in the market is buying and selling and you will still be taking on the same risks and potential rewards when you do so. Selling a spread further away from the money will give you a higher probability of success, but it will also entail an increased level of risk. So, whether you look at "probability of touching," "probability of expiring," one, two, or three standard deviations, etc., the risk-to-reward equation will still be at play.

Technical analysis has the potential to afford some level of edge, but it is not infallible and has the tendency to amplify the risk-to-reward problem. Some traders feel that by selling one side of the iron condor and then the next they can achieve a larger credit and thereby shift the risk-to-reward more in their favor. What they do not always recognize is that this approach of "legging in" carries additional risks. Once one side of the iron condor is sold the trader needs the market to move away from the short-strike of that spread so that they can sell the opposite wing of the iron condor. If the market fails to make the move or, even worse, reverses against the spread, they are then facing potentially even greater losses than had they sold the entire iron condor.

These various studies all have their place and they are valuable, but there are limits to what they can achieve for us. Where they fall short is in limiting our risk of loss on the trade and that is what will make the difference between long-term success or failure.

Once you realize that your attention needs to be focused upon loss avoidance and mitigation, then you can being taking steps to prevent the crippling blow. Make note that we are not focused upon increasing our probability of success. We are focused upon limiting losses in the event of an adverse market move.

Christopher Smith founded and has been an active iron condor trader for several years. He hosts weekly "trade along" sessions in the Trading Room where you can follow along as he opens and manages iron condors and other monthly income positions.

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