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Saturday, January 22, 2011

Tip to close an Iron Condor (Part 1)

The purpose of this article is to explain an automatic an easy way to close an Iron Condor. It is true that the Iron Condor is a passive strategy which doesn't generally need constant surveillance. You set up your trade and you try to achieve a good profitability range where you are safe. Often times this range is good enough so as not to be overly worried about your play, making you effectively detached from the markets for a while....

Now, you need to, at a certain point, close your position in order to lock in your profit. Now remember the Iron Condor is a credit trade as it is formed by two vertical credit spreads. This means that you get some credit when you open the position. At a certain point you need to get out (close it) and you do it by paying a debit at that moment. The goal is to pay a smaller debit than the credit initially received when the trade was first open, and of course the less you pay the better to lock in a bigger slice of that juicy initial credit received. Sometimes it might be a little confusing for some, that in this kind of trades we get paid first, and we pay last when closing the position. This works unlike the usual approach of investing in something and then selling it in order to close the business.

At the critical moment of closing the trade it is not so passive anymore, since traders usually check how is the profit doing, where is the underlying price, is it threatening my range? Are odds in my favor to win now that expiration is close/far? So, this somehow forces traders to be a little glued to the market at that point.

By using a Good Till Cancel Order, instructing to close the Iron Condor at a specific limit price you can save some, or maybe most of this surveillance time. As usual let's go with the numbers. Say company XYZ is trading at $100 and based on some analysis you think it wont get outside the 80 - 120 range in the next thirty days. So basically you look at selling the 80 PUT and the 120 CALL. Let's use some hypothetical prices and assume both these contracts are worth 2.00. We also need to buy the 75 PUT and the 125 CALL in order to protect ourselves from a naked sale and in order to keep things and numbers simple let's assume the price of both contracts is 1.00

You open your Iron Condor:

BUY

1 XYZ 75 FEBRUARY PUT

@1.00 (-$100)

SELL

1 XYZ 80 FEBRUARY PUT

@2.00 (+$200)

SELL

1 XYZ 120 FEBRUARY CALL

@2.00 (+$200)

BUY

1 XYZ 125 FEBRUARY CALL

@1.00 (-$100)

So, you are getting a credit of $200 for this Iron Condor meaning you would like to pay less than $200 when time comes to close the position. By the way the risk on this trade is 300$. How to calculate it? Well, it is very simple, in this case the distance between each of the verticals is 5 dollars, you multiply that by 100, you get 500. And then you subtract your credit of 200 from those 500.

Now this is the time when you enter your limit order the way I said: Good Till Cancelled, but first you need to decide your price. Personally, I am happy with a 20% return on margin on each Iron Condor trade. Since my risk is $300: 20% of 300 equals $60. This means if I leave this position with a $60 dollar profit I am happy. In other words, if I can pay $60 dollars less than the initial credit I received when opening the position, I am making a 20% return on margin (margin is $300 for this particular play).

Given that I initially received a credit of 200$, I would like to close the position by paying a debit of $140 or less. So, I'd go ahead an enter a limit order "Good Till Cancelled" for the whole Iron Condor for 1.40 and just leave it there till it gets filled. By making it Good Till Cancelled we make it possible for our order not to expire at market close each day thus eliminating the need to re-enter the same limit order everyday.

With this simple technique your order may eventually get filled without need of being attached to the market charts. Another advantage to this way of playing is that for example there might be a very little moment, say 30 minutes during which closing your Iron Condor position cost the desired debit of 1.40, but you couldn't do it simply because at that very moment you were not in your pc following the market. Then price of closing the position kept fluctuating during the day and never got close or bellow 1.40 anymore. Well, by having your closing order entered before hand, your chances of getting filled are much better so in the long run your plans will yield better results.

I hope this helps some guys/gals out there. I will speak about another lazy an effective way to Close an Iron Condor in a future post.

Until then, bye - bye.

Related Articles:
Tip to Close an Iron Condor (Part 2)


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2 comments:

  1. For the transaction shown, i think there is a mistake between
    BUY
    1 XYZ 120 FEBRUARY CALL
    @2.00 (+$200)

    SELL
    1 XYZ 125 FEBRUARY CALL
    @1.00 (-$100)

    ReplyDelete
  2. Fixed!

    Thank you very much for your help maplenight. Really appreciate it.

    ReplyDelete