By: Steve Smith
After the initial post election jet propulsion pushing stocks to all time highs, we seem to have settled into a wait and see trading range until we get more clarity on Trump’s policy push. That means selling option premiums is a good way to generate income. Let’s discuss credit spreads in general and iron condors specifically.
Many traders of iron condors and credit spreads tend to enter their trades every first or second week of the month, or they have established a hard number of days before expiration, where they force themselves to enter their positions mechanically.
In my experience, this is not the best way to trade these strategies. This doesn’t mean you cannot be profitable trading that way, merely that I personally think there are better ways.
The problem with Iron Condors and Credit spreads is you are usually risking a lot to win a little. So, entering a position is not something you should take lightly. It is my personal belief they should only be traded when odds are clearly in your favor. If the conditions are not given, then staying put is the best decision.
These are the ideal conditions under which I would enter a trade:
For Bear Call Spreads:
- 70% or more of stocks above their 20 Simple Day Moving Average.
- Stochastics Oscillator (80, 20, 8, 3) above 80.
- McClellan Oscillator above +150
For Bull Put Spreads:
- 30% or less of stocks below their 20 Simple Day Moving Average.
- Stochastics Oscillator (80, 20, 8, 3) below 20.
- McClellan Oscillator below -150.
The logic behind these entry conditions is that for those elements to be present the market usually has to make a pretty sizeable move, and by then chances are increasingly higher that it will need to digest the move, i.e. trade sideways, or pull back.
Let’s say 70% of stocks are above their 20 SMA, and both Stochastics and McClellan are overbought. At that point the market has probably made at least a 5% run upwards. If at that point you can sell a Call Credit Spread 5% above the current price, then you are challenging the market to make a total run of 10% upwards. All in a period of a month, or a little bit more than a month. Needless to say, a market moving 10% in one direction over only a month is a highly unlikely event. It will happen from time to time, but your winners should outnumber your eventual losses if you play them all.
Many traders get killed trying to pick the exact bottom or exact top. That’s impossible. So, my advice is that even though the markets are overbought or oversold by the parameters described above, never sell your credit spreads less than 3% away from current market price. Try to always sell at strike prices at least 4% or more away from current prices. That gives you room for error. You may not guess the exact top or bottom, but the market still needs to make another big move to cause you a loss.
Going back to the previous example, in the event the market threatens your Bear Call position you can adjust it further up. That is, close it (for a temporary loss) and open another Bear Call spread 3 % to 4% even further up, and now you are challenging the market to a total move of 13% – 14% in a month, a very unlikely event.
The Opportunity Factor
If you were to wait for all three conditions to be present, then you would only end up trading 3 or 4 positions in the year. Those would be very good trades and potentially profitable and easy to ride, but very few for many traders. In order to mitigate this effect and give myself some more trading opportunities I tend to relax the rule in certain periods.
For example during historically bearish periods, I would only need two of the three rules to be true in order to sell Call credit spreads. But I would expect to see the three conditions fulfilled for selling Put Credit spreads. Likewise, during December and January I would expect all three conditions to be met in order to sell Calls, but I could relax the rules, expecting only two of them to be met in order to sell Puts, because it’s a naturally bullish season of the year.
It is my personal preference to risk 20% of my capital in one position. Now, that doesn’t mean I am willing to lose 20% of my portfolio, that would be bonkers, it means that is the amount of money I put to work.
If I am allocating, let’s say, $10,000 to this strategy, I would put around $2000 to work for each position.
For example, on February 3, 2012 I entered a Bear Call Spread on IWM selling the 88 strike price March Call and buying the 90 Strike March Call option for protection.
I entered the trade for a 0.25 credit, and on a two point wide spread, the maximum risk was consequently 2.00 – 0.25 = 1.75. That is $175 per spread. I traded 14 spreads, for a maximum risk of $2450 which is approximately 20% of the portfolio size at that point.
IWM had rallied from 77 to almost 83 in just two weeks; all the overbought conditions were perfectly aligned. There had been this 7% move, and there I was selling the 88 strike Call, basically selling a strike price 5% above the current price back then. IWM would have to make a total run of 12% (7% + 5%) in a month in order for this position to be a loser. Those are clearly odds in favor of the trader.
You won’t win all the trades, but you are confident you are trading a system where odds are clearly in your favor. You have an edge, and over time it will express itself in the form of a healthy up trending equity curve.
The trade turned out to be a winner, where I kept the 0.25 credit ($25) per spread for a total profit of $350 without too much hassle.
If you could do that only 3 or 4 times a year you would be ahead of most traders out there, including institutional traders. If you put 20% of your money to work on a position like this, and you get a 15% – 20% return, it will represent a 3% – 4% portfolio growth in that single trade. Be able to do it 3 or 4 times a year and you will be ahead of the majority and with low trading costs needed.
Without a doubt, the toughest part in order to be able to carry out this trading style is the need for patience. Patience is a necessary virtue for trading this system. Most of the time you will see traders discussing ideas and going crazy on twitter and forums talking about Apple or Netflix or any other trendy stock at the time, and you will have to restrain yourself and stay put. You will only trade once or twice a month. The ability to control yourself is paramount. While everybody else is out there losing money, and jumping in and out of positions you are sitting idle, waiting like a sniper for the perfect opportunity to only trade when odds are clearly in your favor.
The second hardest factor in my opinion is the contrarian mentality. It is easier said than done and I’m alerting you because you can guarantee it will happen to you. It is very tough to sell Puts when everybody else thinks the sky is falling and it is very hard to sell Calls when the market has been uptrending like an unstoppable train.
Looking back to 2012 I could say I entered all my trades probably when the vast majority considered I was crazy if I did so. At first it was hard to do it, but later, you study the system, analyze the odds, back test the data and find the evidence. The practice itself makes you grow out of that initial state of permanent fear of being against everyone else’s opinion. That is what it takes to be a consistent winner.
Human beings are social being in nature, and the herd mentality comes impregnated in our brains at the time we are born. It feels just too comfortable to trade in agreement with the crowd, but that’s the best way to lose this game. Paraphrasing Warren Buffet, you will enter a bullish trade (Bull Put spread) when everybody is scared, and you will enter a bearish trade (Bear Call Spread) when everyone is greedy.
When establishing credit spreads and iron condors give yourself some room for error, selling at least 4% away from current price and that room is there to give you the confidence boost that you need in order to bet against the crowd.