Option Investor
Trader's Corner

Ideas for Exiting or Adjusting a Condor

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Do you set goals for yourself as a trader each year? I do. Last year, my goal was to gradually scale up in the number of positions I held each option expiration period. This year, my goal has been to research various exit or profit-protecting strategies. Up until this year, my exit strategy had been to determine a get-out point before initiating a trade, depending on where I thought the absolute strongest support or resistance might lie. In other words, my adjustment or exit was contingent mostly on the price of the underlying. As you can imagine, that approach has its pluses and minuses. A big minus is the price risk incurred when letting prices test resistance or support near a sold strike.

I tended to step out of troubled positions and only occasionally did I roll up or down. So, mostly I operated on what Mike Parnos of Couch Potato fame would call a "get the funds out" strategy. Last year, I managed to keep losses, when they occurred, relatively small. I still wanted to determine an exit strategy that best balanced the needs to take as few losses as possible, to keep those as small as possible when they occurred and to undergo as little stress as possible in the process.

In April, the goals for those two years collided. I had just scaled up again in the number of positions I held when I attempted a new loss-hedging strategy. That strategy failed miserably, so miserably that I won't even mention what I did for fear that some other misguided soul might also attempt it. Let's just say that it sounded a whole lot better in theory than it turned out to be in practice, even though I had a notebook full of pages of computations I performed on iVolatility.com before considering the strategy.

I won't be employing that strategy again. However, in my continued quest to fine-tune my exit strategies, I happened across Dan Sheridan's name in a couple of places: a series of articles on options positions, including condors, in STOCKS & COMMODITIES magazine and a series of "Master Sessions" webinars on the www.cboe.com site. In both, he outlined his preferred procedures for entering and managing condors. Since I know that many of our readers trade condors, I thought I might mention what Dan Sheridan has to say about how they should be managed.

In his CBOE webinar, Sheridan claims that a condor "is a beautiful position, but it has a dark side." It's a beautiful position because probabilities favor the trader putting them on as long as the trader is careful not to get too close to the action. That dark side is that the risk/reward ratio "stinks in a condor." Remove risk whenever you can, Sheridan advises. He has suggestions for doing so both when a position is profitable and when it's going sour. Let's address the good outcome first.

His first suggested action point occurs when a spread narrows to a price that preserves 50-60 percent of the credit you originally received. For example, imagine that you originally received $800 for ten contracts of a bull put spread. Perhaps two weeks have gone by, and you discover that the spread on those contracts has narrowed to $320-400. You could close them, if you wanted, and keep $400-480 or 50-60 percent of the credit you originally received.

That's Sheridan's first action point. He's not telling you take profit. Instead, he wants you to make sure that the bull put spread is never allowed, from that point forward, to become a losing position. He advises you to change the point at which you would adjust or exit the position to one in which you would keep at least some of the profit. For example, you might reset that adjustment point to one at which you would keep $100 of your initial credit.

That's the first action point. If the spread keeps narrowing so that it requires only $0.15-0.20 per contract to exit, it's time to do so and remove the risk, Sheridan advises. The condor has done its job in providing income at that point, he believes, and the risk should be removed.

What about when a condor is going sour? Keep losses small, Sheridan advised. In his CBOE webinar, he provided an example of a spread in which the trader had taken in $1,000 for multiple contracts. The loss in that spread should never be allowed to accumulate above $1,500, he advised, before the position is exited or adjusted. In another place in the same webinar, he seems to counsel that no loss over $1,000 should be allowed to accumulate if the original credit was $1,000. The two bits of advice might not have concurred exactly, but the sense of them did. You just can't let losses mount on these condors or on any credit spread. Your losses can be large enough to wipe out many months of carefully accumulated profit if you don't manage the position. Trust me. I speak from experience.

Sheridan offers other specific guidelines related to adjustment points. He believes that a condor is in trouble and requires adjustment when the deltas measure +/- 25-30 for a sold call or +/- 20-22 on the sold put. Most online brokerages provide quotes that include measurements for delta.

For example, Brokersxpress.com provided these figures for the SPX July 2007 1565 Call, as of the close of trading on June 15.

Table for SPX JUL 2007 1565 Call (.SXMGM)

The delta shown was .2987, which would bring it up to 29.87 if the 100 multiplier for each contract were applied.

If a bear call credit spread involved selling the SPX JUL 2007 1565 Call, the spread should be rolled up at this point, Sheridan believes. He is adamant that both positions, the bull put and bear call spreads, be rolled up. When the sold put is the one with a delta that's indicating that the position is in trouble, both the bull put and bear call spreads should be rolled down.

When originally establishing a spread, Sheridan advises against selling calls with deltas greater than 7-9 or puts with deltas less than -6 to -8 (because deltas are negative on puts), he said on his webinar. However, the STOCKS & COMMODITIES article suggested that when rolling up or down, the new sold calls should not have deltas above +10 and sold puts, below -10. This keeps the probability that sold strikes will be violated low.

In an article on another strategy, Sheridan stresses his belief that any new strategy should first be paper tested and then employed in small numbers of contracts. I bet he'd advised the same about employing a new exit strategy, too. I have not tested these suggestions, although I did elect to roll up half of a JUN SPX 1555/1565 bear call spread last month when the delta of the 1555 reached about 0.24 (24 when the 100 multiplier was employed). That had been a 20-contract position, and I rolled up 10 of them into 20 May 1570/1580's for breakeven, thereby maintaining my original credit. I hadn't read Sheridan's article by that time, and this also fit with an exit strategy that a trusted trader friend employs.

Having a specific action point did make it easier to manage the emotions of the trade as well as that volatility risk that Sheridan cautions exists in these plays. He believes they're a great income-producing strategy as long as that risk is controlled.

So, it's obvious that I haven't tested out this exit or adjustment strategy fully, but I will be testing it this year as part of my trading goals for the years. I can't recommend Sheridan's suggestions yet, but I certainly can recommend thinking about how you want to manage risk, dollar loss and emotion when planning your own exit or adjustment strategies. If you want to hear about Sheridan's strategy from his own mouth, the webinar can be found at this link on the CBOE site. Happy planning.

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