One of my friends specializes in play therapy for children whose lives have been tough. Without intending any minimization of the hard lives some children lead and their need for play therapy, I thought it might be time for some play therapy for us options traders, too. Let's play around with freeware Option Oracle's site and see what we can see with an iron condor.

Imagine that on Thursday, October 06, 2011, we elected to open a 10-contract SPX iron condor, with the sold strikes at 955 and 1295, and the long options 10 points further out of the money. Using the price Options Oracle provided for this iron condor, we theoretically would have taken in $1,760 in credit after commissions, leaving us with a maximum loss of $8,240.

Many options traders will be familiar with the typical expiration graph for an iron condor.

Typical Expiration Graph:

Looking at this graph, newbie iron condor traders might be thinking that they've got lots of room for prices to move before that trade gets into trouble. Is that true? How does the newbie trader know what would have to happen for that trade to get into trouble over the next few days, for example? Would it have to go all the way toward the upside or downside expiration breakevens or would some closer level cause problems?

All the charts I'll use here were generated that Thursday, seeing what the traders would have seen that day, making decisions based on only the information those traders had at hand. Many of you will remember that this particular Thursday was the day before the nonfarm payrolls number was due to come out pre-market the next day. Is expiration really what worries us iron condor traders with such an event looming? The SPX had screamed lower earlier in that week and then had flamed up for three straight days. Aren't we worried about what's going to happen the next day?

Profit-Loss Line for the Next Day:

The profit-loss line is a hill-shaped line that has steep sides and a rather narrow top. Losses accumulate rather steeply, don't they, once price moves over the top of that hill and starts down either side? The red dot is placed at the midweek low. We know what actually happened in hindsight, but we're looking at what the iron condor trader was seeing that Thursday. What if the SPX dives back over the next day or so to the previous low of that week, breaks through and keeps dropping, that iron condor trader might be asking? What we know about such movements is that implied volatility tends to rise. Such a rise in volatility hurts vega-negative iron condors.

Profit-Loss Line for the Next Day with Increased IV:

You can see that the rounded top of the "today" chart has slipped lower, the effect of the raised IV's. In the first "today" chart, there was the possibility of breakeven or even a teensy profit, but this one shows no such possibility, at least theoretically. This has the effect of making losses bigger at each nearby price point.

I like to keep a tight rein on my unrealized losses. Unlike some iron condor traders, I do pay attention to unrealized losses during the trade and don't just concentrate on the expiration graph. Other traders handle this issue differently, but I personally don't want to lose more than about eleven percent of my margin or buying-power effect on an iron condor. Maybe I keep too tight a rein on the unrealized losses during a trade, but that's what makes me feel comfortable enough to trade iron condors. Do understand that the tighter a rein that is kept on unrealized losses, the more frequently the trader will be taking losses. I prefer more frequent but smaller and more manageable losses. Others might have different views and practices.

I will close out an iron condor for a loss if the unrealized losses are at eleven percent and I see no way to flatten out the profit/loss curve enough so that they won't increase. Here's my take on this: most times the iron condor's expiration breakevens are wide enough that there's going to be a reversal again by expiration that will allow you to close out the trade for a profit or for a loss smaller than some of the unrealized losses that accumulate during the trade, at least in theory. However, some situation sometime is going to cause you to have to close out an iron condor trade before expiration: when your technical analysis shows you that it's likely that the prices will likely be outside the iron condor at expiration, when a personal or job situation means you cannot monitor an iron condor that's already in trouble, or some other situation you didn't forsee when you entered the trade and then watched unrealized losses accumulate. If you've let those unrealized losses grow too great, thinking the trade will be fine by expiration, you might then be facing a loss multiple times larger than any profit you might typically take in for an iron condor. Such losses can wipe out months of accumulated profit. If the iron condor trader has invested too large a proportion of the trading account funds in an iron condor, that loss can decimate the account.

I tend to start adjusting, flattening out that curve so that the losses don't accumulate so quickly, when I'm about halfway to that eleven percent loss. Because of sizing requirements, I can't show all the information this chart actually shows, but it provides a theoretical profit or loss for each spot that red dot is positioned. Studying that, I was able to conclude that a drop back to that week's low would result in a theoretical unrealized loss that would be halfway to that 11 percent loss that I personally allow in my own trades.

What if it was my view that Thursday afternoon that the rally was already extended and there could be a sell-the-news drop on Friday? Could I do something ahead of time?

In truth, I almost always do something ahead of time on the put side. I tend to spend about 10-12 percent of the credit I take in on the trade, $1,760 in this case, to buy an extra OTM put. On a 10-lot size on the SPX for the iron condor, this would mean that the extra put would be outside the iron condor, below the long in the put credit spread. If this had been an actual trade, I would have spent 10-12 percent, or $176 to $211.20, to buy that extra put. The mid-price or mark of the NOV 790 put was 1.75, so I just chose that one for the sake of our graphs.

Let's look at that profit-loss line for the next day with increased IV for the new combined position with that insurance put.

New Profit-Loss Line for the Next Day with Increased IV:

Because of the sizing requirements on the two charts, it's hard to see the theoretical differences in loss at the small red dots, but on the first, uninsured iron condor, the theoretical loss would have been about $1,035 and maybe more if the volatility had kicked up even higher than I set it, while at the second, insured iron condor, the loss would have been about $838.00. Over this price range, the benefit would have been just a little more than the price of the put, but the difference would become much more pronounced if the SPX dropped further or if the implied volatilities climbed higher. In the case of a Black Swan event, the extra insurance put would save much money and perhaps even produce a profit, depending on how far and fast the SPX dropped.

I don't worry about a Black Swan event, so perhaps it seems ludicrous that I'm even talking about what an insurance put would do in that case. However, over the last years, with all the doom-and-gloom talk, it's the addition of that insurance put to my trades that makes it possible for me not to worry!

You can see that the shape of the two charts is much different. Would this have worked if I'd waited until the markets collapsed to add an extra put? Of course, it would have helped some but not like this. This put was bought before the volatilities theoretically sprang higher, making options more expensive.

Some traders place debit spreads in front of their going wrong credit spreads. What if I'd chosen to buy a debit spread to hedge this imagined trade--buying a long put and selling a further out one--instead of just buying a long put?

That changes the shape of the expiration curve, putting a little ear shape kicking up on the far left-hand side of the graph. However, when this trade was first placed, the day before the non-farm payrolls, expiration wouldn't have been a trader's biggest worry. What would this tactic do to the "today" line on Friday, October 7, if the SPX had dropped and implied volatilities had risen to the same levels tested in the other graphs?

Last Profit-Loss Line for the Next Day with Increased IV:

This one worked best of all over this short distance, with a theoretical loss at the red dot of about $673.00. So is it best to buy a debit spread for insurance?

That depends on what you fear. The new maximum loss on the put side is now $6479.00, due to the effect of the debit spread's protection, so risk has been lowered, if all you fear is a normal downturn. What if you fear that you'll wake up one day and the events going on with Dexia this month have spread to other institutions? What if fear runs rampant and markets crash, with the fabled Black Swan event occurring? Go back and study the shape of the chart with the single long OTM put and compare it to this one with the debit spread. Notice how the single long put chart flips upward after a certain point? If you're protecting yourself from a more-than-average downturn, that single put might be a better choice.

Of course, debit spreads can be wider or narrower than this one. They can be ITM, ATM or OTM. Single puts can be closer or further, more expensive or less. Your worry about what will happen with the markets can be well founded or unfounded. There's no right or wrong to choosing any of these methods. Knowing what actually happened after the non-farm payrolls number as we do, some could even argue that buying that insurance was a waste of good money that could be used for other things. However, last night, I contributed to a fundraiser for a community member who lost both his house and his business in the wildfires that hit our town last month. He hadn't bought insurance on his business equipment. He'd just set up his new business space and had spent money doing so and hadn't gotten around to buying that insurance. Ask him what he thinks about insurance now, and how soon it should be bought.

This was not a discussion of what you should be doing in your own iron condors. Instead it's a demonstration of how you can use non-trading time and even a somewhat clunky freeware program to test the way you want to see up your trades.

Would these same tactics work the same way offering protection for an upside move? Other considerations might change the way such protection works on upside moves. We'll look at those next week.