Note to new readers: This is a regular update on the status of our XJO Iron Condor Model Portfolio. Please read the setup post first in order to understand the objectives and the rules for trading this model portfolio.
With the XJO index settlement price (also known as the Opening Price Index Calculation or OPIC) at 5343.5 upon options expiry on Mar 20, all the options in our March iron condor expired worthless. We got to keep the entire premium received which was $2040 after brokerage costs as shown below.
So far we have had 3 winning months and collected $5900 in gross premiums as shown in the table below. We will track our performance is a similar manner as 10percentpermonth.com, who do not include commissions as this will vary from broker to broker.
For our April trade, I put on our full position (20 contracts) on Mar 7 which is about 6 weeks to expiry, in order to collect sufficient premium to meet our target of 10 percent per month. I was able to collect premium of $2200 as shown below.
For April, $2200 is our maximum profit which we will get if XJO is trading between 5125 and 5675 when these options expire on 17 April 2014. The margin required for this trade is $17,800 ($20,000 – $2200). This is also our maximum loss which we will incur if XJO is trading below 5025 or above 5775 upon option expiry. Hence the potential return for this trade is around 12.4% ($2200 / $17,800) before commissions. XJO was trading at around 5450 when the trade was opened on Mar 7.
There are a few important lessons that we can learn from the March trade. The first lesson is the importance of sticking to your risk management plan. Our risk management plan as detailed in my first post is to do nothing but wait until expiry. The sharp rally in February to a high of 5462 caused our bear call to be ITM for a few weeks. At one point our March Iron Condor was showing large unrealised losses and it was hard to resist making some adjustment to the trade to avoid further losses. There are many schools of thought on managing Iron Condor trades. Our decision not to do any adjustments is based on our understanding of probabilities. By selling options at deltas of 0.1, our options have roughly a 10% chance of expiring ITM as shown in the option chain below:
However, this does not mean that there is a 10% chance that the index price will touch the strike price of that option. The probability of touching that strike price is much higher than the probability of expiring at that strike price as shown in the option chain below.
It also helps if you can visually see the risk profile of an Iron Condor trade. Below is the risk profile of an Iron Condor with one week to expiry. The white line shows the current profit/loss of the trade and the red line shows the profit/loss at expiry. As you can see, you would realise a loss of over $3500 if you decide to close the trade when the index price touches the strike price of the short option one week before expiry. However, this would become a $2300 gain a week later if the index is trading at the same price when the option expires.
Our understanding of probabilities and risk profiles, coupled with high trading commissions is what led to our decision not to do adjustments. Ideally, we would prefer to put in more trades with fewer contracts in each trade so that the maximum loss per trade is not so big. It is very hard psychologically to take a big loss. I personally could not bring myself to trade iron condors for about six months after hitting the maximum loss on my iron condor trade in October 2008.
Another lesson is the importance of “insurance” options in managing margin requirements. One reader wrote in to ask if I received margin calls when the market moved against our trade. As our sold options have a 90% chance of expiry OTM, another reader has also questioned the need to buy insurance options which are even further OTM. Not buying those options would increase our profitability significantly as OTM options are very expensive. This strategy (also known as a “short strangle”) can be very profitable as shown in the graph below of the same trade without the insurance options. The maximum profit is $4,700 instead of $2,300 for an iron condor.
However, the margin required by the broker will increase as sold options get further ITM. If we do not have sufficient cash in our account, we may get a margin call and be forced to close our trade at a large loss when the market is very volatile. By buying the insurance options our margins will not exceed the maximum loss (e.g. $17,700 in the above example) so we do not have to worry about margin calls as long as we have set aside that amount of cash in our account.
I will provide another update after the April trade expires on April 17. If there are any readers out there who are trading XJO iron condors, I would like to hear from you. Please share your experience by leaving a comment or sending me an email. Thank you to all who have done so already.
Disclaimer: This post is for educational purposes only and should not be treated as investment advice. This strategy would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek investment advice if required.