From September 19 through early October, the SPX had tumbled. The VIX had climbed, showing that premiums were likely elevated. However, by the morning of Monday, October 6, the VIX had hit the 16-18 level that often marked short-term tops for the VIX and short-term bottoms for the SPX. With the thought that the SPX might be about to bounce, was it time to take advantage of those good premiums and sell an iron condor?

SPX through October 6:

Theoretically, a typical so-called high-probability iron condor might be set up, bringing in $472.50 in premium for three contracts. That would amount to a maximum potential profit of $442.50 after two-way commissions of $1.25/contract.

Typical High-Probability Iron Condor, with a Theoretical Entry at about 10:55 am ET on October 6:

We now know the SPX had not quite bottomed. How would that typical iron condor have fared on October 15?

Theoretical Performance of the Same Iron Condor on October 15:

The theoretical loss shown here, if the trade hadn't been adjusted along the way, was $278. That's only 11 percent of the maximum margin in the trade, but it's 62.8 percent of the maximum profit that can be achieved with this iron condor. That can be seen as a significant loss to have endured, depending on the trader's plan. Since the iron condor theoretically is profitable more months than it endures a loss, some traders might set their max stop loss about equal to the premium taken in for a typical trade. Whatever stop loss an iron condor trader determines is right, the theoretical unrealized loss on this day was mounting significantly.

The trader's timing had been off if the trader had presumed that the SPX was steadying. What about a different trader who had entered her iron condor on October 15, thinking that the SPX had at least temporarily bottomed then? She would have been right, but did her correct assumption make the trade more profitable or easier to manage? First, let's look at the daily chart on October 15 and then the original setup if a trader had initiated an iron condor trade on October 15.

SPX through October 15:

Iron Condor Theoretically Entered about 10:55 AM ET on October 15:

This iron condor was set up at the same time of day as the first iron condor examined, using similar setup guidelines. The absolute values of the deltas of the sold strikes were below 10 and the hedging longs were ten points away. Because of the severely heightened implied volatilities, more premium was available for this trade, $540 after two-way commissions of $1.25/contract.

The SPX had indeed found a temporary bottom, at least, but how did that trade look just six days later?

Second Iron Condor, Theoretical Value at the Close on Tuesday, October 21:

How did it look? Not so hot. The theoretical loss is 28 percent of the maximum margin, but it's 1.28 percent of the maximum profit available in the trade. This article was roughed out more than a week before publication, but we all know that the position's profit-and-loss wasn't going to improve.

This graph illustrates the true concern of iron condor traders: losses can be much higher than the profit that is available. The iron condor as constructed here is a high-probability trade, a trade in which there's a high probability over time and many such trades that the underlying's price will end up in the profit zone at expiration most of the time. However, losses must be strictly controlled when the trade goes wrong since losses can be much higher than the possible gains.

What's the lesson here? Several. Speaking as someone who put on a 60-contract SPX iron condor the day before the Flash Crash, I speak with the authority of real experience: sometimes your timing is just bad. You've watched carefully for the signs that have worked in the past. You've waited for the price and implied volatilities to come to you. You've waited for the right number of days before expiration. You've done all the things that have worked for you in the past. And they just don't work this time. You were wrong or some master market manipulator was waiting for you to enter your trade so that the trap door could be opened and you would fall through. Take your pick of theories.

What if you find yourself caught in that kind of situation and the trade is going wrong? At the least, restructure your trades so that you reduce risk, especially if you're an inexperienced trader or an experienced trader who is unable to watch trades closely. Take off some or all of your position. Choose adjustments that reduce the amount of risk in the trade rather than add to it. If your planned maximum loss is hit, you have fewer choices available to you. As recently discussed, my choice under that situation is almost always to get out. With Friday's gap higher on most equities and indices, I noticed Dot Hazlin was wisely suggesting that Couch Potato traders take their lumps and close down an iron condor on that portfolio. It happens.

If you're caught in market action you didn't predict, then you're saddled with a trade that you would never have entered under those conditions. It may be best to take your lumps and stand on the sidelines rather than to keep jumping back into the melee with adjustments.

If your decision is to stay in, look at the list of possible adjustments you've practiced in the past. Evaluate which might or might not work. Decide if you're going to adjust if market action proves different than you expected. Early adjustments often result in less costly adjustments, but you may make unnecessary adjustments that wouldn't have been needed, after all. Decide if you're instead going to give price swings or timing of adjustments a little extra leeway. Sometimes that's the better tactic: sometimes that results in adjustments that are so expensive that they swamp the trade or in losses that grow so quickly that you must exit. Each tactic has pros and cons. Decide what you're going to do before your trade is in trouble and follow your plan.

As mentioned, consider choosing adjustments that lower the risk you have in your trade rather than increase it. For example, on October 21, I needed to raise the deltas in my butterfly trade. Choices for doing that included buying deltas, perhaps by buying a call debit spread, or selling negative deltas. (Remember that whole double negative thing from high school mathematics?) Buying a call debit spread would cost money and so increase what I had at risk. Selling one of my lower butterflies with their negative deltas brought in money and reduced the margin or risk in the trade.

You must have a trading plan that encompasses cutting your losses. Specifically when you're dealing with iron condors, that plan should set maximum acceptable losses that are equal to or less than the profit you can hope to gain in your typical trades. That's just good business sense. Barring a Flash Crash or an extreme gap higher when you were near but not quite at an adjustment--the action that got iron condor traders in trouble on October 31--don't let losses accumulate beyond your planned level.

The second lesson is that volatility sometimes creates more volatility. Prices may appear to settle but then crash through support. They may crash through support and then hurdle higher into a relief rally that decimates your trade. When volatility is high, exercise caution about entering any trades. Some traders elect to wait until the VIX or some other metric has settled back into a range the trader considers acceptable. Some want to wait until an underlying such as the SPX is staying within a normal range for a certain amount of time. I notice that Dot Hazlin often cautions that suggested weekly trades should not be entered if the underlying has moved more than a standard deviation for the day, for example.

If volatility is unusually high but you've decided to enter anyway, consider entering with smaller amounts than normal as one method of controlling risk. Sure, you should also have adjustment plans, but volatile times can decimate a trade that ended the previous day in relatively good shape. Starting with less at risk automatically cuts the risk to which your trade will be exposed. I dropped the number of contracts from my typical size of trades for November because I thought that volatility might be increasing. Lower risk makes it easier to make saner decisions.

For me, that saner decision included closing out my trade entirely on Tuesday, October 28, the day before the FOMC meeting. I'd been in the trade 21 days. I'd had to roll butterflies lower during the drop and then raise deltas as the relief rally began. I'd kept the PnL line flat, and the trade was down less than the amount of the two-way commissions. However, it wasn't making money. Conditions could get dicey after the FOMC meeting, especially with mid-term elections coming up, I reasoned. Because I had fewer butterfly contracts than normal, I was able to manage the adjustments along the way and then make that decision to exit with more equanimity than I would otherwise have been able to do. I worked hard for 21 days without any recompense and I paid some commissions to do that, but the trade wouldn't have been much fun the rest of the week if I had stayed in.

I usually advise traders to stick with their plan, so my exit may seem contrary to what I typically advise. However, my trading plan encompasses my preference to exit my trade at least two weeks before expiration. Because of the out-sized market action, I reasoned that my trade was unlikely to accrue much profit before that exit period was reached. However, unusual market action meant that it was likely to face a lot more risk.

Rabid relief rallies sometimes follow or come during strong downdrafts. Consider that possibility when you're entering a new trade and plan accordingly. However, that's not the most important point of this article. The point of this article is that entering a trade that starts going wrong isn't the same thing as getting your foot caught in the stirrup of a runaway horse. You can get off if your trade is running away with you, and, sometimes, that's exactly what you should do. You may be a great trader, but you just picked the wrong horse to ride this time. Don't let your emotions keep you going when you should get off. The best adjustment might be to exit.

Linda Piazza