If you haven’t yet had the pleasure of reading the first part of our October Iron Condor analysis, you can do so here.
One of the aspects of selling longer-term Condors re-iterated to me this month was how the pain of holding a losing position is prolonged. This often increases the emotional component of this type of strategy as compared to, say, a day trade. For example, if you enter a day trade and get stopped out ten minutes later, there isn’t a ton of time to internalize and emotionalize the loss. But with a two-month Condor, you have oodles of time to question your system, lose your confidence, and otherwise fret over the trade.
It can be like Groundhog’s day where each day you wake up hoping the RUT will finally cooperate, only to see small-caps scream higher … again.
Moreover, because of the negative gamma associated with Condors, your exposure increases the further the position moves against you. The pain isn’t just prolonged; it’s intensified.
So what’s the solution?
First, make sure you recognize the nature of the beast. Like any trading system, Iron Condors are lovely when they work, but require conviction and sound risk protocols when they don’t.
Second, you have to position size appropriately. Your pain is directly linked to the size of your loss relative to your overall portfolio. For example, if in the day trade mentioned above my loss was $100 and on the Iron Condor my loss was $100, then even though incurring the loss on Iron Condor was a long, drawn-out process, the level of pain shouldn’t have been all that different from the day trade.
Smaller positions always equal smaller pain.
When Correlations Crumble
As the RUT was rising this past month, the delta of my Oct Iron Condor began to dominate the overall portfolio. Since the bear call was moving closer to the money, the position was turning more and more delta negative.
To offset that I entered bullish trades. The most direct and fool-proof way to hedge is to add bull plays on RUT. An alternative method is to add bull plays in other stocks which you expect to rise as the RUT keeps rising. The challenge with the latter approach is what if the RUT rises and the stock you entered a bullish play on just so happens to go down?
To be clear, the direct approach involves adding bull puts, bull calls or long calls on RUT to hedge the RUT Iron Condor. The indirect method involves adding bull trades on really any other stock you think will rise alongside small-caps.
There’s nothing more insulting than having the RUT rise while the stock you entered bull plays on goes down. It’s a double-whammy of insult. And it happened to me on FB and TSLA. Because sector rotation is what helped drive the RUT up so much last week, small-caps rallied while tech stocks, especially Facebook and Tesla, fell.
In hindsight, I should have focused more on the direct route and added long delta trades to the RUT.
Bull Calls vs. Bull Puts
In the Cash Flow Condors video series, we focus primarily on adding bull put spreads as the go-to hedge. The rationale is two-fold. First, they boast a high probability of profit which provides a large margin of error just like the original Iron Condor. Second, it adds positive theta to the portfolio.
But there is a drawback to bull puts. Their effectiveness as a hedge diminishes as the RUT rises. This flaw was on full display over the duration of the Oct Condor. Think about it this way. The original bear call spread we sold (Oct $1470/$1480) had $9.45 of theoretical risk. And due to the negative gamma of the position, the rate at which we rack up losses increased the further the RUT rose.
If I throw on an extra bull put for 80 cents, then my potential gain is limited to, well, 80 cents. Furthermore, the rate at which I earn that 80 cents slows the further the RUT rises.
So let’s get this straight – our rate of loss on the parent position accelerates while the rate of gain on the hedge decelerates. That’s not the best combination.
To fix the flaw, we have three choices. The first is to keep adding bull puts. You’ll notice in the hedging example above we added three separate bull put spreads over the duration of the trade. Since the effectiveness of the original hedge diminished, we had to add more bull puts to compensate.
The second choice is to use a more aggressive bullish strategy to hedge. This is where the bull call spread comes in. It’s a lower probability alternative than the bull put but it offers far more profit potential if the RUT really ramps. As a result, it does a better job at cutting down your upside risk.
In structuring the trade, you’ll want to use OTM call options that are lower than your bear call strikes. The cost should run anywhere from $5 to around $3 and if it’s a $10-wide spread should offer anywhere from $5 to $7 of profit potential. Compared to the 50 cents or $1 of profit that is typically available in the bull put we’re selling, this is obviously a much bigger gain to bank on.
For example, let’s say the RUT is at $1450 and your bear call is at $1510/$1520. I suggest adding a bull call as close as $1460/$1470 but no further away than $1490/$1500. That way if the RUT does end up running all the way to your short bear call strike ($1510) then it will have moved through your bull call spread generating handsome rewards in the process.
The third choice is to sell closer-to-the-money bull puts. Instead of entering a 15 delta put spread for a mere 50 cents to $1, move to something more like a 30 delta and shoot for something more like $2 to $3 credit.
Internalize these lessons and you’ll be much better equipped to handle the next Heartbreaker that inflicts your portfolio.
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