How to Trade Iron Condors (Part 2)
11/26/2015 7:00 am EST
An iron condor can be designed to accommodate your risk tolerance and account objectives, but those adjustments will always have a tradeoff. As with most option selling strategies, this means there is an exchange of a higher probability of a successful outcome and lower premiums or higher risk and larger premiums.
Most iron condor traders opt for a fairly wide spread between the two short strikes to increase the probability that the underlying ETF won't close at expiration beyond those prices. This obviously reduces the premium paid and should not be taken to extremes.
How far apart those short strikes "should" be is a difficult question to answer. As with trading any option or stock strategy, the answer probably depends on your personal risk tolerance. Getting to know what kind of risk you can tolerate within a trade like this requires some experimentation and paper trading.
We have spent a fair amount of time talking about the tradeoff between probability and premiums so that you will understand the importance of appropriate expectations. Managing risk is a function of position size as well as the choice of strike prices. Getting into a position that is too large for your peace of mind can be a disaster.
Position sizing for an iron condor is relatively simple because the maximum loss is known in advance. You can consistently size your iron condor trades by allocating a consistent percentage of the portfolio available for these strategies per trade. In the example we used in the first article, we knew that the max loss was $1.04 per share, or $104 per iron condor. If we assume that we are willing to risk 5% of a $5,000 portfolio, then we can use that maximum risk amount to calculate the appropriate position size as two spreads.
1. $5,000 (capital) X 5% (maximum acceptable loss) = $250 (available capital
2. $250 / $104 = 2 spreads
Being consistent in your position sizing is important and varies based on what strategy you are using and you personal preference. A bad trade can be emotionally trying, but you can minimize those issues by understanding the risk in the trade and staying with small position sizes.