What should you do when the underlying moves against an iron condor position you have open? (For example, if you’re a member, you may have noticed that one of our DIA trades for May expiration is looking threatened by the recent price action in the index.) Any time this situation arises, people will always write in to ask about how they can “adjust” or “fix” the trade if the market continues to be uncooperative. It’s an understandable impulse to want to take action when things don’t go your way, but it’s also important to guard against the danger of overtrading.

Our answer here is the same as the answer we always give: there is no magic solution for “fixing” trades that move against you. Sure, there are actions that you can take to reduce risk or minimize losses, but those actions come with their own inherent risks and downsides, and any added risks need to be recognized as such.

1. Allocation, allocation, allocation

Our official position is always that the best way to guard against the pain of a losing trade is to allocate conservatively. Asset allocation is extremely important. And as we’ve said elsewhere, there’s no rule that says it’s a disaster if the underlying touches our short strike - in fact, the probability of the underlying touching a short strike will always be higher than the probability of that short option expiring in the money. In other words, if you dump a position every time the underlying moves against you, after a year or so you’ll end up with a boatload of stop losses and just a handful of easy wins, for a definite net loss. However, if you play defense by managing your risk and your allocations intelligently (rather than by prematurely cutting off uncooperative trades at the knees), you’ll end up with more winners than you might otherwise expect.

In short: when probability is on your side, it only makes sense to let those probabilities work themselves out. Imposing artificial stop losses or entering expensive or risky hedges can actually worsen the overall performance of the strategy. Instead of putting on one or two huge positions and then having to worry about what happens to them, try putting on lots of relatively smaller trades across multiple underlyings, multiple strike prices, and multiple timeframes.

2. Manage Greeks, Not Trades

The other point that should be made here is that once you’re appropriately allocated, the task of managing your portfolio actually becomes much easier. This is kind of counter-intuitive - shouldn’t it be harder to manage 20 trades than it is to manage just 2? But the secret is that a balanced portfolio of positions can be managed on the basis of aggregate Greek values, rather than on the basis of what each individual trade does.

This means that the events that trigger actions on your part will not be one-dimensional events like the price action of an underlying; instead, you’ll be responding to changes in the overall Greek values of your portfolio. So if you know that you get uncomfortable when your total deltas get above some value n, at n + 1 (or n + 50, say if n > 500), you know it’s time to take off some existing positive deltas, or to enter some new positions with negative deltas. If you know that you like to keep your portfolio generating positive thetas, then you also know that any future hedges or adjustments you make should fit that general profile, which means buying calls and puts won’t be high on your priority list.

With those preliminaries out of the way, let’s examine a few ideas for how you can hedge an iron condor that isn’t acting the way you hoped it would. In part 2 of this article (subscribers only), we’ll offer some specific techniques, using a real-world position.

A fun game on a slow Friday afternoon: take the front page headline on Yahoo Finance, and perform some desirable action if the headline makes a dubious assumption about causation.  Move to the next headline, and repeat.  We were going to suggest this as a drinking game, but we don’t want everyone drunk before the market’s even closed.

Felix Salmon makes this point well.  Financial journalists, for whatever reason, constantly report on correlated events (”Today, p occurred after news that q”) with sufficient ambiguity as to leave the reader with the impression that q caused p.  As every freshman philosophy student learns (or used to learn, anyway), correlation does not imply causation.  Enough pontification, let’s play…

“Oil prices rose sharply Friday on news that a ship under contract to the U.S. Defense Department fired warning shots at two Iranian boats.”  Really?  Did the Associated Press talk to traders at the NYMEX who were all, “OMG warning shots, buy buy buy!!!”  No.  Isn’t it just as likely that after yesterday’s heavy selling in the energy sector, some mean reversion was due?  Isn’t it also just as likely that oil rose in price for no discrete or knowable reason whatsoever?  The point here is that unless you’ve got a defensible causal chain to report on, it’s sloppy to be casting prepositions all over the place that leave readers with the impression that causality has occurred.

The story goes on to undermine its own headline with an account of how non-unique these saber-rattling sorts of events are.  It follows up with the concession that, “On Friday, oil prices were already up before the report on news of a pipeline attack in Nigeria and a looming refinery strike in Scotland,” and then continues anyway with commentary on one of the perennial bugbears of oil reporting, namely shenanigans in Nigeria.

Sadly, the story does not achieve oil cheerleading nirvana inasmuch as it fails to include a quote from T. Boone Pickens.

Some quick thoughts tonight:

1. The VIX dipped below 20 intraday for the second time this year.  The 1-month VIX continues to head lower relative to the 3-month VXV, and the more stretched this ratio gets, the more bearish that reading is for stocks.  The funny thing about volatility readings is that they’ll tend to drift lower, and then spike up suddenly.  We’re due for a jump in the VIX - maybe not now, but soon.

2. Lots of resistance overhead in the indexes - the SPX nearly gave itself a concussion today at 1397, and we expect more tension around this 1400 level until it is either decisively broken or is retreated from.  In the passive voice.

3. Leadership may be changing here.  The energy sector (XLE), down 2.62% today, may have finally stopped its unbelievable tear.  Pair this with fantastic gains in the financials (XLF, up 3.6%), real estate (IYR, up 2.3%), and transports (IYT, up 2.11%), and along with the already-strong tech, you’ve got the possibility of some broader leadership forming for a bullish move.

If these points seem in tension, that’s just because nobody has any idea where this market is going.  We wouldn’t mind if it just stayed put for awhile.

So the big question now is whether the markets are consolidating and setting up for another move higher, or are preparing to roll over from the lack of broad-based leadership. As energy and commodities power higher, the financials continue to act as a major drag - consider the chart at right comparing the S&P500 ETF (white line) with the Dow Jones Industrials ETF (blue line). The Dow has clearly outperformed recently, and without some relief in the financial sector, it’s hard to see how the S&P500 will be able to push through any resistance at the 1400 level.

We may be getting some weak sell signals from a couple indicators, but nothing very persuasive, and if anything, a slow churn upward seems likely from here. Volume continues to be lackluster. Sorry this is so noncommittal - we’d like to espouse some grand market prediction, honest, but there’s just not much reason to be an enthusiast in either direction right now: the long term trend is bearish, but it also seems likely that this bear market rally isn’t finished yet. Indecision is often a great reason to sell premium.

Volatility continues to underwhelm, although it’s worth noting that the implied volatility in the major indexes is now crossing above the historical volatility levels for the first time since mid-March.

Reversal Readings

IWM - Russell 2000 - 8.88
XLE - Energy - 99.42 - nibbling on more negative deltas here
XLV - Health Care - 8.72
IYR - Real Estate - 9.70
DBC - Commodities - 97.51
EWW - Mexico - 96.27

Regarding Monday’s Bonus Trade, reader Carl M. writes:

A May 50/55/60 call butterfly on GRMN at $0.60 or less leaves a very good potential profit range from 50.60 - 59.40. Any thoughts on that approach?

We intended this to be a purely directional trade, with room to run on the upside - but recognizing that there’s a good chance any rally the stock might see could be limited, the butterfly strategy has a lot going for it:

• Maximum potential profit - on a percentage basis, more than 400% if the stock price is in the vicinity of $55 near expiration - handily beats the two spreads suggested in our original post;
• It would be reasonable to expect at least a 100% return if the stock price is in the $50.60 to $59.40 range at expiration;
• Because of the low cost, the risk in case of an unexpected plunge in the stock price is very low - as long as you don’t bite off a bigger position than your risk tolerance warrants;
• Theta becomes positive when the stock is above $48 or $49, which is a significantly lower threshold than for the May 50/55 spread (a good thing), but slightly higher than for the May 55/June 50 diagonal.

All in all, this looks like it could be a good strategy…but you have to watch out for the upside risk. If GRMN is at or above $55 on April 29, a positive earnings surprise on the 30th, although unlikely, could push the stock up to $60+ and wipe out your gains, at least temporarily. So it might be a good idea to lock in profit (or at least a portion of it) on the 29th if the stock closes above $53 or $54.

Alternatively, you could add another May 60 call to the position. This would raise your break-even point at expiration to $51 or $52 and diminish your maximum theoretical profit; but you could still have a 100% profit if the stock is above about $50.40 the day before earnings, and you’d be biased to the up side if you want to bet that the news will be good (but your risk in case of a big gap down on bad news would be about 30% greater).

Of course, after today’s sell-off, which hit tech stocks especially hard, this discussion may be academic anyway. GRMN broke trend-line support in the first half-hour of trading and fell through our $43.75 stop-loss threshold shortly after noon. But the bump in volatility premium that accompanied the drop kept us in the trade, and although the official close was $43.73, we saw a buyer come in at the bell and push the price over $43.80. The last after-hours trade tonight was at $43.90.

So you might look at the pull-back as a golden opportunity to get in at a discount, or a warning to cut your losses and move on - depending on what happens tomorrow. (Not that it really matters, since we don’t suggest you bet any serious money on these bonus trades of ours. No way, no how. Nevertheless, we’ll be watching GRMN closely at tomorrow’s open.)