An iron condor is really not a strategy very suited to adjustment. Usually, adjustment can only mitigate a loss, not eliminate it. It is inherent in the strategy that we face a non-zero probability of the market price of the underlying going outside our short strikes. What should we do when this happens? In this article I consider three responses that are in common use and give you my assessment of each.
Strategy 1: Do nothing.
Let the market price approach and even go outside the condor’s short strikes. If it is there at expiration, you lose at most, the difference between the strikes minus the premium you took in. Proponents of this view make two claims in its defense:
a)The long option is chosen to limit your losses, so the protection is already built in;
b)Even if the price of the underlying does go outside the short strikes prior to expiration, it can come back and the position still expire worthless. One of the most interesting pieces of research on options trading examined returns to many iron condors under two adjustment systems. First, doing nothing, the one we are discussing now. Second, selling the spread when its short strike was hit. For example, if the price of the underlying went down, when it hits the short put buy that put back and also sell the other put on that side of the condor. This research had an interesting conclusion: The former strategy outperformed the latter. This counterintuitive result is because of two things. First, sometimes the price of the underlying came back, as described above. Second, buying back the spread at that price of the underlying resulted in a lousy price.
Strategy 2: Roll out the credit spread at the short strike that is hit.
Buy back the condor when the underlying hits, or approaches, the short strike. Precise rules about how close the underlying should get to the short strike vary. Then, buy another credit spread on the same option series at a strike further out. The choice of new strike depends how far you expect the underlying to move prior to expiration, its implied volatility and liquidity in the option. I will deal with this subject in a later article. This does stop losses and create a credit but usually results in some loss on the trade.
Strategy 3: Buy insurance.
Purchase long options around the strike that is threatened. These increase in value as the iron condor position loses value. The amount that they gain depends on the number of options bought and the closeness of the strike price to the price of the underlying. Use your option analysis software to determine the exact payoff. Since these ‘insurance’ options have a premium this subtracts from the premium taken in when we sold the iron condor. Although this insurance can, in principle, result in a position more profitable than the original condor it is more likely to only mitigate losses like the earlier adjustment strategies.
In practice strategy 2 is what I usually do. I then spend some time searching for the best spread to roll to. How well this works has a major effect on how much lost value I recover. If a good roll is not available I often wait a day or two.
I find that to pursue strategy 3 I have to buy the long option when the underlying is far away from the short strike. This gets the option at a low price. However, the underlying doesn’t move low enough to make the strategy pay off. However, if technical analysis gives me a clear view as to where the price is going then I can buy a long option with more confidence.
The difficult task of adjusting condors illustrates the importance of choosing the short strikes carefully at the time the position is put on. In a future article we will address this question and show how technical analysis can help.
