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Saturday, June 16, 2012

In Search of the Iron Condor - PART ONE



In the options world, Iron Condors are as common as "hawks" in the pit of the NY Stock Exchange.



But to beginners, the very words conjure some hugely complex trade with an ominous name--one that should be pushed aside for years until one is professional, or nearly so. Pshaw!

Iron Condors are simply two basic credit spread trades (the Bear Call and the Bull Put) put on at the same time. That's it. No funny business. No secret handshakes or decoding rings needed. Unintelligent traders put on these trades all the time, but the way to make money is to do it the smart way. And that, as all things in options, takes some knowledge and some study. If you don't have the will to learn, this is not the trade for you. BUT IT'S NOT DIFFICULT.

BUT HOW DOES ONE GO ABOUT FINDING SUCH A TRADE?

I had the good fortune to be invited to a week of free online classes presented by a very savvy group called ProEdgeTraders.com. Our speaker was John Kelly who discussed...what else? Credit spreads and Iron Condors. It was a really good class and while I thought I knew credit spreads, I realized how much more there is to learn. (endless). I wrote down as much as I could, and I'm hoping this will be helpful.

John Kelly is a former airline pilot and believes strongly in "checklists" and I love checklists myself, so this was right up my alley. And I discovered that he has an entirely "different" way of trading credit spreads and iron condors than the ways I've learned on Options Animal. It's heartening to know that there are so many different ways to do the same trade, but also a bit daunting.

1. Earnings

Before you even think about doing the trade, check for Earnings.If you are within 20 days of Earnings, find a new stock.

2. Volatility

a. You want the Implied Volatility (IV) percentage to be higher than the Historic Volatility (HV)

b. The lower the Realized Volatility, the better. WHAT is Realized Volatility?

Average True Range Technical Indicator (ATR) is an indicator that shows volatility of the market, and can be added beneath your charts. If you set the ATR for 10 days (I think the default is 14 days) and then divide the current ATR by the stock price, you get the Realized Volatility.

Example: ATR is $14.58 and the Stock Price is $51.00, ($14.58/$51.00)= 29.20% RV (Realized Volatility).


I assume that as you compute more and more of these, you will begin to get an idea of what constitutes the "high" or the "low" of realized volatility.

3. The VIX index

VIX is the symbol for the Chicago Board Options Exchange's volatility index. It is a measure of the level of implied volatility, not historical or statistical volatility, of a wide range of options, based on the S&P 500. When the VIX is at 20 and below, the market sentiment is complacent; no fear. When the VIX is above 20, you can tell fear sets in, selloffs begin and premium gets expensive. (usually when Bernake speaks!)
So for this Checklist, you want the VIX = 20 and below for Bull Puts, and above 20 for Bear Calls.

Here's a sample $VIX chart:



4. Find Support and Resistance

There are different support and resistance lines on a chart. You want your credit spreads to fall OUTSIDE OF SUPPORT AND RESISTANCE.

a. Pivot Points

If you use Pivot Points (an indicator on many chart programs) on the chart, you'd see R1 and R2, and S1 and S2. These are based on standard deviations, and usable for our purposes. But that's just for starts.

b. Linear Regression Channels

John Kelly uses Linear Regression Channels (both 50 day and 100 day) which provide more support and resistance lines. (These indicators are available on ThinkOrSwim platform, but not on all platforms. StockChart.com has them in the "drawing" mode, but you have to place them yourself)
I didn't know what Linear Regression Channels were, so I asked. They are the "bell curve" turned on its side, and how the stock trades in regard to 2 & 3 standard deviations. I had to have my friend Linda explain standard deviations to me. "The Standard Deviation is a measure of how spread out numbers are." (huh?) But she helped me. Think of a "mean" middle line, the "average" and then equal-width lines on either side, like channels which deviate from the mean in equal distances. That is a linear regression channel. It's a mathematical equation but all you need to know is that you want your short options OUT OF THE 2 Standard-Deviation lines.


The point is that you want your credit spreads to be placed OUTSIDE of the regression channels - OUTSIDE of Support and Resistance.

c. Moving Average Lines

And of course the 200 day, 100 day and 50 day Exponential Moving Average lines also provide an idea of support and resistance.

d. Draw a Channel!

You can draw your own lines top and bottom on your chart, making a channel touching the highest candle above and the lowest candle below for the time period that you are trading.

e. Even your 52-week high and low show resistance/support. So get familiar with them all.

Depending on how long you are going to be in the trade, you would pick your support and resistance accordingly. (obviously if you're in a weekly trade, you'd be looking to see how much your stock moves (the range) in a typical week. If you're doing a 90 day trade, you'd be looking at the movement for 90 days, and use Support and Resistance based on that time frame.

This requires you to study the chart, and be careful of where you place your shorts. You do not want your short call or short put to EVER go in the money on these Iron Condors. The point of this trade is to keep the credit you get, and let the trades expire worthless (or reverse them before expiration for 90%+ of your credit received).

f. ATR Multiplier

ATR is an indicator which can be added beneath your chart. It stands for Average True Range. This is perhaps a less scientific approach to support/resistance, but can be a confirmation of Strike price choices. The same ATR indicator mentioned above can be multiplied by 2.5, 3, or 4 (the higher the better) and compared to the Support line and Resistance line you've decided on.

For example: A stock is trading at $561.28. You may have chosen a bull put of 495/490, and a bear call of 615/620. How can we verify if those strike prices are in a "safe ranges"?

Well, multiply the ATR of $16.82 times 3 = $50.46.

Subtract $50.46 from the stock price ($561.22-$50.46=$510.53) Our $495 short put in way below this support line.

Add $50.46 to the stock price (561.28 + $50.46=$611.45. Our $615 short call is ABOVE this resistance line.

So this confirms our support/resistance "safety" zones. You can never be too sure. Never have enough redundancy when you are risking money.

So if we look at the chart...


6. Probability & Premium

Final requirements are probability and premium. This was a tough one for me to get. John Kelly uses .05 to.10 Delta to pick his strike prices for both the Bear Call and the Bull Put!

This Delta translates also to a 5% or 10% probability of going into the money, which means it's also 95% and 90% probability (of success)!



This gave me pause as there's not much premium at those delta levels. But John does not look for high premium. He looks for (on a monthly trade) 3% minimum return after commissions and fees, or 1% (on a weekly trade).

As an example: on a $5 spread (between strike prices), for every $.05 nickel of premium, that is a 1% return. on a $10 spread, you're looking for $.10 dime of premium.

You need to sit down and do the math. (or let your trade calculator do it for you).

There are trade calculators on your broker's platform which compute probability on your trade. My own trading plan counts on an 80% to 85% probability of success. John's is higher. But I have a smaller fund, therefore I can't do as many contracts because of the margin freeze.

If you use the Delta as a measurement of probability (.05 Delta is 5% probability of going in the money (or 95% chance of being safe), you don't really need a calculator, but the software on most platforms has other bells and whistles that make it very helpful in trading. I would encourage you to learn how to use the software available to you on whatever platform you choose: OptionsXpress, Trade Monster, Think Or Swin, to name only a few of the top ones.

A snapshot of OptionsXpress's calculator:


A snapshot of TradeMonster's calculator:


This is getting pretty lengthy, so I think a second chapter is needed here: See the next post for Timing and Maintaining this Trade!

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