Condor Options

We talk a lot about why adjusting iron condors is rarely, if ever, a good idea, and adjustment decidedly is not a part of the Condor Options strategy. So you’re probably wondering, why all these Calendar Options posts about adjustments? The answer is simple—calendar spreads are not like iron condors.

A quick review: As we explained in Part I of this series, our decision to adjust calendar spreads is based on the same criteria as our decision not to adjust iron condors—probability. When we open an iron condor, we typically have nearly a 70% chance of expiring out of the money. And as long as we’re out of the money, we can keep most of our initial credit when we close the trade. Our winning trades have an average return of 23%, and a few have returned more than 30%.

A typical calendar spread, on the other hand, has only a 30% to 50% probability of being profitable when the short option expires. If we’re lucky enough to be near the money when expiration week rolls around, we could have a 50% or 60% return; but if the stock is as little as half a standard deviation away from our strike, every dollar it continues to move against us can slice 10 percentage points off that return. If we expect to get high monthly returns from calendar spreads, month after month, we have to do something to tip the odds in our favor. One thing we can do is open a trade as a double-calendar, but even a double-calendar has only a 50% to 60% probability of profit if left as-is.

That’s where adjustments come in. Calendar spreads provide ways to adjust our trades that extend our range of profitability if the underlying moves too far in one direction or the other.

In Part II, we discussed how to tell when an adjustment is necessary, but what’s every bit as important as having good reason to adjust a calendar spread is doing it in a way that reduces risk and doesn’t result in a new position that requires constant attention. And because we usually don’t want a strong directional bias, we also prefer adjustments that reduce our position delta.

Striking a Balance

While it takes experience, good technical-analysis skills and a certain finesse to apply our adjustment strategy well, the basic concept is simple. In general, our adjustments entail moving a portion (usually half) of our position at one strike to a higher or lower strike. Let’s take a look at the adjustment we made yesterday to our open EEM position:

Before the adjustment, we were in a July/Sept put calendar at the 140 strike (see figure at left). EEM gapped down $3 to open below $133 and was approaching the break-even price modeled when we opened the trade ($131.80). Even though we were still a dollar away, a shift in implied volatility had taken away some of our net premium; the simulator was now showing a break-even of $133.50, and we had a 10% loss on paper. We knew that a lot of traders were looking for a big selling climax before they would even think of turning bullish, so there was a distinct possibility that things might get worse—very quickly—before they got better. It was time to make a little more room for negative price action.

The answer, in this case, was to slide our lower break-even down by moving half of our contracts from the 140 strike to 130. This changed our position into a double-calendar with break-evens at $128.30 and $142.60 (see figure at right). We gained another $5 of room for EEM to fall before getting outside our profit zone.

One might ask (and, in fact, readers have), Why not just close out the losing trade and open a full position at 130? There are instances where that might be appropriate; but as we had pointed out in yesterday morning’s subscribers-only market commentary, if we did get a climactic sell-off marking a short-term bottom, a dramatic rally would’ve been more than likely to follow. That could have put EEM back at $138 or $140 in no time, and the 130 single-calendar’s upper break-even was less than $136.

We can handle it if our underlying moves around some, and we can even handle a fairly strong trend—but day-to-day whipsaws can quickly eat away any chance for us to profit. When we make an adjustment, we want to do it with the big picture in mind, so as to avoid getting bounced around. Moreover, the need for adjustment usually indicates that the underlying is becoming more volatile, and when that’s happening, we want to widen our profit range in addition to moving it up or down.

Allocation, Allocation, Allocation

So why not open another full position at 130 and keep all of the contracts at 140? The answer is allocation. If we doubled down every time a trade needed help, our portfolio would get wildly out of balance. Also, even though it’s important to keep some cash on hand for adjustments, we want to minimize the amount that sits idle in our (typically low-interest) brokerage accounts. By selling half of our original position, we were able to make yesterday’s EEM adjustment with less than a 7% increase in the total dollars committed to the trade.

One big drawback to rolling in this fashion, though, is that it can be tricky to execute the trade. We’ll talk more about this in a future post, but the key point is that executing Calendar Options adjustment trades often requires more attention and flexibility than some readers might be used to.