Trading Iron Condors IV. The Debit Spread Adjustment

This series of posts represents a collection of my thoughts that I plan to use for a course on trading iron condors.

Today I’ll tackle another risk management technique: buying a debit spread to reduce the risk of owning an iron condor position.

Premise

The underlying asset has moved too far in one direction and our position is uncomfortably long (as the market is declining) or short (as the market is rising).

    Note to beginners: If you are not yet aware, owning positions with negative gamma results in your option position gaining positive deltas during a decline and negative deltas when the market rallies. In other words, negative gamma results in monetary losses when the market moves too far. To compensate the trader who has negative gamma, these positions have positive theta and gain in value as time passes.

The debit spread as a risk-reducing adjustment

To pick up some positive deltas (when too short), the trader can buy a call spread.
To pick up some negative deltas (when too long), the trader can buy a put spread.

    Note #1. Yes, the trader can sell a put spread instead of buying a call spread. Yes, the trader can sell a call spread instead of buying a put spread. However, the position is often easier to comprehend when this type of adjustment is made by buying the debit spread.

    Note #2. When ‘buying’ a spread, we buy the more expensive (higher delta) option.

The Trade

Before making this trade, certain points must be understood:

  • The trade provides limited protection and is useful when you are not concerned with the big move.
  • Buy FEWER debit spreads. In other words, if short 10 call spreads, buy 2-3 debit spreads.
  • The spread bought should always (this is an opinion, not a scientifically proven fact) use strike prices that are less far out of the money than the position being adjusted.
  • Example:

    {{{gold}}}

    The trader is short the Dec INDX 1700/1710 call spread.
    To adjust, buy any of these spreads:

    1. Dec 1680/1690 (least costly ‘clean’ trade) [clean = no overlapping trades]
    2. Dec 1670/1680; 1660/1670; etc. Going too far away from the short position increases cost beyond an acceptable level.
    3. 1690/1700. This buys back some of your current short option. That is acceptable. Do not go out of your way to avoid making this trade. There is nothing wrong with it.
    4. 1700/1710. This is a position reducer because it buys back some of the current position. This is also an acceptable, often over-looked, trade adjustment.
    5. Do not use any options that is farther OTM than your current short.
  • Choose the most effective debit spread. Many times that turns out to be the spread sold earlier. That’s ok – the adjustment trade reduces position size instead of adding a new spread.

How risk is reduced

If the market continues to rise, the spread purchased as an adjustment increases in value. Because it is less far OTM than your original short call spread, this spread is never worth less that the original. In fact is it always worth more – except when both spreads are worthless or when both are worth their full value ($10 in this example).

When the market rises slowly, the debit spread adds some profit to the portfolio – and that offsets a portion of the loss resulting from the original spread. The nice part about this type of adjustment is that there is a small ‘bonus’ area in which extra profits are attainable. When we look at this risk graph, this feature is readily apparent.

Do not count on collecting those profits because they build as expiration approaches – and that is the most dangerous time to own the iron condor position.

When making any adjustment, the trader’s primary goal is to reduce risk. Yes, it’s nice when the adjustment results in extra profits (collected when we exit the position), but please make a trade that takes care of your risk situation first and be less concerned with earning extra money. The adjustment is required because the original trade is in trouble and your goal right now should be to manage this position to prevent a large loss.

Video example

Full screen video added Apr 9, 2012, 10:07AM

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