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IRON CONDORS ONE SIGMA METHOD Version 5.0 Iron Condor Strategy - Version 5.0 – 3-28-10 [email protected] 1 Disclaimer • This is not an investment or trading recommendation. • The losses in trading can be very real, and depending on the investment vehicle, can exceed your initial investment. • I am not a licensed trading or investment adviser, or financial planner. • You should make your own trading plan decisions based your own research and tolerance for risk. • I am not a trading authority. • Most of this presentation is just information I have compiled from other sources and other authorities over the past year • Links , Footnotes, and Appendices have been added after the end of the show to help with your deeper research. • I am not an Iron Condor expert. All that follows here is just my current trading strategy. If you want to read in more depth on this type of trading strategy and see where I got some of my ideas, please see APPENDIX C which is roughly around slide 47 in this presentation 2 What is heck is Sigma ? Sigma is a symbol used as a reference in over 20 different science and mathematical applications The historical background is Sigma - it is the eighteenth letter of the Greek alphabet, which was a writing system developed in Greece 1000 BC and is the direct or indirect ancestor of all modern European alphabets. Sigma upper case is Σ and Sigma lower case is σ In Statistics and for our purposes , 1 sigma is a reference to 1 standard deviation. More on sigma later in these slides and in APPENDIX A 3 ROCKET SCIENCE First off, none of the following is Rocket Science. But on the other hand, it can get a tad complicated as it involves trading options using probability and statistical analysis I am not the expert on the subject So if you want to dive deeper into this trading style, you can get a better overview explanation from the experts at TOS Try to catch one of the ThinkorSwim / Option Planet seminars COMPLEX STRATEGIES FOR TRADER when they come around to a city near you. The seminars will not tell give you a “click by click” demonstration like you will see in this Power Point But the seminars will explain better the overall theory and concepts from people who are experts on the subject Here is a link if you want more detail on those Free seminars http://www.optionplanet.com/assembled/list.html Also, I have found the good group at CONDOR OPTIONS.COM do a pretty good job of explaining the general strategy. To me , it seems like they are trading similar to the TOS / Option Planet plan http://www.condoroptions.com/ 4 SPY Right now, I only trade these Condors in the SPY. SPDR S&P 500 International Consumer Discretionary Sector ETF - NYSE symbol SPY Reason being, the SPY is the #1 ETF for volume and thus it has nice liquidity. And Condors need a certain amount of liquidity for entry and exit I will be just trading the SPY for time being , mainly for simplicity and then expanding into other underlying products maybe later 5 WARNING – HAZARD NOTE : BEFORE GETTING STARTED, UNDERSTAND CONDORS HAVE A “HAZARD” CONDORS DO NOT DO SO WELL IN STRONG TRENDING MARKETS UP OR DOWN If the underlying goes “out of range” and stays there through expiration, you can lose your “max loss” amount. These trades have a known up front max lose figure - You can’t lose more than that. That is why they call the trades “defined risk” … and is one good feature about Condors Statistically, this “max loss” event should occur only 32% of the time if you enter 1 Sigma Trades But this lose can wipe out a number of past winners That is the Condor “Hazard” and it is still an area I am working on to improve There are ways to manage Condors to reduce this risk and they will be discussed in this presentation Of course, There is no single strategy which is good for all market conditions 6 WHEN IS A GOOD TIME TO ENTER CONDORS ? VOLATILITY - Try to enter (sell) SPY Condors when the VIX is relatively high compared to the last 1 to 3 months Watch the VIX chart daily your trading platform along with the SPY chart STOCHASTICS - Try to enter when the market is not extremely overbought or oversold which might indicate the market is getting ready to make a dramatic reversal. The long sustained directional moves can be rough on Condors 7 The Volatility Reference Chart Watching the VIX when trading SPY Condors When you enter Condors When you exit Condors High volatility (An easy way to track volatility is to watch the VIX) Low volatility Comment Best scenario is to enter Condors when the VIX is high and then exit later when the VIX is low !! Low volatility Low volatility OK High volatility High volatility OK Low volatility High volatility Danger 8 INVESTOOLS CHART SHOWING STOCHASTICS Stochastics Be aware of these peaks and troughs 9 HOW TO ENTER THE TRADE 10 WHICH WAY IS THE MARKET GOING ? Selection of strikes could be based on "feelings" or "hunches" but obviously that won't get us very far. Some traders use technical analysis to help with strike selection. But that can bring directional bias into our trades Many experienced traders have given up trying to guess which direction the market will take in the future. So they place trades which are “market neutral” or have even odds of the market going up or down. Also you will hear this being referenced in “Delta Neutral” trading conversations. I am not going to get into the Greeks very much in this Power Point. 11 The One Sigma Method Perhaps the simplest way to construct an iron condor with a reasonable chance of success (while still generating sufficient premium) is to select short strikes which are one standard deviation (or one sigma) from the current price of the underlying. This means about 68% of the time, the underlying index or equity will close on expiration day within one standard deviation (or "one sigma") of the current price. If we structure trades so they can tolerate a one sigma move and still expire worthless, then we can expect success over two thirds of the time. 12 WHICH MONTH TO ENTER ? Just enter trades MIN 30 day and MAX 70 days before Expiration – Example – I will start looking for Feb Condors the week after Dec expiration (about Mon Dec 21) And I will start looking at June Condors the week after April Expiration, etc 13 FINDING THE DAYS TO EXPIRATION Click the TRADE tab and enter your underlying, these are the CALENDAR DAYS left in these option months before their expiration Enter trades MIN 30 day and MAX 70 days before Expiration – best seems around 50 days 14 WHICH STRIKE ? One of the key factors determining whether an iron condor will be successful or not is the selection of strike prices. But how do we decide which strike price ? 15 For this strategy , pick strikes which are : 1. DELTA NEUTRAL SHORT STRIKES will be equal distance from underlying on the day you enter (Sell) the Condor LONG STRIKES are just 2 points farther out from the shorts We are not trying to pick direction. We want to be DELTA neutral entering this trade. 2. ONE SIGMA The strikes will yield a 68% probability of success 16 CLICK BY CLICK The next slides will show how to enter the Condor trades “click by click” in the TOS platform 17 To start, Right click on the Blue dot next to your underlying, Then click TRADE 18 Open the Option Chain on the Month you want to trade RIGHT CLICK on the BID PRICE of the “AT THE MONEY” Call, 19 1. Left click SELL 2. Left click IRON CONDOR 20 This “default” IRON CONDOR will load up and look like this on the TOS platform. This is just a starting point. 21 First, make your verticals 2 points wide In other words, The long call should always be 2 points above the short call The long put should always be 2 points below the short put See below for example The basic logic behind the 2 point spread is it is a happy medium 1 is too close and 3 is too far For more detail on why 2 points, see the Option Planet Workbook in Appendix C 22 The Underlying SPY is at 110 today To be market neutral and have your Delta as close to zero as possible, your short strikes to be an equal distance from 110 Adjust your short strikes farther and farther out from 110 until you get about a .68 to .79 credit price Remember, Keep your long strikes 2 points away from your short strikes .68 credit would be close to a 1 sigma trade But you will rarely be able to get an exactly .68 credit I always try to get the next Credit higher than .68. In the example below, my starting Credit would be .77 23 You could enter this trade at .77 But it will normally not fill quick You could enter a Limit day trade and it might fill later today or you could enter a Limit GTC trade and it might fill sometime in the future If you want this Condor quick , you will need to cancel and adjust your credit down to .76 . Wait 5 or 10 minutes. If that does not fill, cancel order and retry order at .75 Generally speaking, in the SPY, 1 or 2 ticks below mid price should yield a fairly quick fill MID PRICE 24 You might not need it but the next Slide shows a snapshot of an Excel file I use for each of my Condor trades. It is just a simple “assistant” I used when picking my Condor Strikes and tracking the trade Email me if you want a copy of the Excel file [email protected] 25 For me, it is easier to use an Excel spread sheet like this to pick the strikes prices Just change the numbers in the Yellow boxes and it will show the strike prices you enter TOS. Price locations are same format as TOS trade File - CONDOR CALCULATOR - 12-5-09.xls 26 PRICE See APPENDIX G if you want more detail on why we picked price .77 in the above trade example APPENDIX G is approximately on slide 67 in this Power Point but it moves around plus or minus a few slides from time to time 27 ANALYZE TAB and the Probability of Success See APPENDIX F if you want more info on how to use the TOS Analyze tab on your Iron Condors APPENDIX F is on approximately slide 56 of this Power Point but it moves around plus or minus a few slides from time to time 28 EXIT STRATEGIES And CONDOR TRADE MANAGEMENT 29 CONDOR ENTRY IS EASY THE TRICK IS THE EXIT I AM STILL WORKING ON THE EXIT and MANAGEMENT SECTION One Condor loss can wipe out a lot of earlier Condor winners This is the CONDOR HAZARD This is an area where I am still doing research. Not done with this yet 30 MANAGEMENT and Exit Strategy This is my current Condor Trade Management and Exit Strategy - as of 3-28-10 – See other ideas in Appendix E 1. INSTALL PROFIT STOPS The idea is to Buy back either the Call or Put Vertical portion of the Iron Condor if you can ever get them back for .15 or less. ( Why .15 ? Some of the reason is just taking some profit when you can. The idea and price setting of .15 was also noted in the TOS Options workbook) So , a few minutes after the Iron Condor trade fills, I will put in two separate “GTC Limit” orders (or Profit stops) One order will buy back the CALL VERTICAL for .15 One order will buy back the CALL VERTICAL for .15 Then during the day when I am not in front of the computer, the TOS platform will automatically buy back VERTICALS if the price ever gets cheap enough The CALL VERTICALS get bought back as the market drops The PUT VERTICALS get bought back as the market rises. See the next slide for a recent trade sequence which seems to be a pretty representative example of how the trades have been transpiring over the last 12 months 31 4. The market turned upward so the profit stops filled for 4 March VERTICAL PUTS. In other words, I bought each VERTICAL PUT back for .15 each in this time range. The first 3 Condors are all completely closed now with 20%+ profit each 1. After expiration in Jan 2010, I entered three different March Condors in this general time range The Condors profit range is generally the 2 horizontal red lines 5. Expiration. The 4th March Condor had to be closed at a loss. The one VERTICAL CALL did not fill and I closed it expiration day at a loss 3. Entered a new March Condor here which is the 4th March Condor. The premium collected is financing the loses which were starting to occur on my 1st three trade VERTICAL PUTS 2. The 1st three VERTICAL CALLS profit stops filled in this time range. In other words, I bought each back for .15 each 32 MANAGEMENT and Exit Strategy (continued) 2. SELL MORE CONDORS You start to incur loses when the underlying crosses your short strikes. So when this starts to occur, sell new market / delta neutral condors to help finance those loses. Adding positions (inventory) is similar to the basic TOS / Option Planet idea. They have most sophisticated strategies of using Calendars and other underlying instruments But , In a sense, you are using the new trades to finance the loses which are occurring on the older trades 33 MANAGEMENT and Exit Strategy (continued) 3. EXIT – Start the Exit process 10 trading days or 14 calendar days before Expiration Scenario #1 – Underlying is still between your short strikes This is kind of a rare event More than likely, you are already out of this position with +20% profits if you had .15 profits stops in place If you are not already out, Exit now at 10 days before expiration. Take your profits now. Scenario #2 – Underlying is at a short strike or already past a short strike into losing trade zone CIRCLE THE WAGONS – see Next page 34 CTW – Circle the Wagons Scenario #2 continued – The Underlying is at or past the short strike and there is only a week or two until expire CIRCLE THE WAGONS Adjust your Profit stop so your overall trade just makes $1.00 after commissions Statistically, it should return to profit zone by expiration day But stats are based on historic data. Not all Condors will be winning trades Note: Friday expiration is normally the last day you can Exit SPY. But Quarterly, watch out for triple witching. You will need to exit Thurs before expiration during those periods. TOS will send you a warning email to exit Thurs when it comes around. 35 Overall Trading Strategy Idea Try to keep Delta as neutral as possible Try to keep Theta as high as possible Layer in inventory over time to keep delta neutral. If you can, enter Condors when the volatility jumps up This will give you a little extra premium and then hopefully volatility drops throughout the life of the trade 36 Thanks !!! And for other questions, you can contact me at [email protected] 37 APPENDIX A Sigma Sigma is the eighteenth letter of the Greek alphabet, which was a writing system developed in Greece 1000 BC and is the direct or indirect ancestor of all modern European alphabets. Sigma upper case Σ Sigma lower case σ 38 Sigma is a symbol used in a wide variety of applications Here are some applications just in science and mathematics Upper case Σ is used as a symbol for: – – – – – – the summation operator - See Excel a class of baryons in particle physics macroscopic cross sections in nuclear and particle physics self-energy in condensed matter physics the balance of the invoice classes and the overall amount of the debts and demands in economics the set of symbols that form an alphabet in linguistics and computer science • Lower case – – – – – – – – – – – – – – – σ is used for: sigma bonds in chemistry the sigma receptor the standard deviation of a population or probability distribution in statistics a quality model for business, Six Sigma, based on the standard deviation, often referred to as "6σ" sigma-algebras, sigma-fields and sigma-finiteness in measure theory; more generally, the symbol σ serves as a shorthand for "countable", e.g. a σ-compact topological space is one that can be written as a countable union of compact subsets. the generated sigma-algebra of a set A is denoted σ(A) the sum-of-divisors function in number theory the Stefan-Boltzmann constant the "sigma factor" of RNA polymerase a measure of electrical conductivity the Surface charge density in electrostatics Normal stress in continuum mechanics volatility of a stock generally needed for options pricing a syllable in phonology the spectrum of a matrix A, denoted as σ(A), in applied mathematics 39 For our purposes , We are using the sigma symbol for statistics and probabilities Lower case σ is used for: the standard deviation of a population or probability distribution in statistics More on Sigma later, but first the disclaimer and some current events 40 APPENDIX B ROR One way to calculate RATE OF RETURN 41 Condor trades April 2009 to March 2010 42 The method I used to calculate ROR – Rate of Return How to calculate returns: Return percentages for each trade can be calculated as the ratio of real risk to final net credit (debit) received. For example, say we have an iron condor with strikes at 50/52/60/62 and we open the trade for a credit of $0.90. The trade goes well, and a few days before expiration we close it out for a small debit of $0.10. To figure out our ultimate return on the trade, we need to calculate two elements: real risk, and final net credit. Real risk = distance between the short and long strikes on either side, minus the credit received to open the trade. In our example, the strike distance is $2.00, and the opening credit is $0.90, so our real risk is $1.10. $1.10 is the most that we can lose on the trade, i.e. that’s exactly what we’re risking. Final net credit = opening credit minus any debits incurred in adjusting or closing the trade. In our example, that’s $0.90 – $0.10 = $0.80. Now we divide our final net credit by our real risk: .80/1.10 = 0.72, or 72% For more in depth details, Check out the good summary on ROR at Condor Options.com Performance page Here is the link http://www.condoroptions.com/index.php/performance/ 43 APPENDIX C OTHER INFORMATION RESOURCES THE NEXT SLIDES NOTE WHERE YOU CAN DO MORE IN DEPTH READING ON IRON CONDORS 44 THE TOS OPTION PLANET IRON CONDOR SEMINAR WORKBOOK Here is a source for more information about the Condor Strategy discussed here. It is called the (COMPLEX STRATEGIES) WORKBOOK Link is xsprofits.com There are currently six User Groups in the Southern California area (link). This web site is common repository of information and presentations the groups share 45 SOURCE INFORMATION TOS IRON CONDOR (COMPLEX STRATEGIES) WORKBOOK 46 BELOW ARE MORE SOURCES WHERE YOU CAN READ IN MORE DEPTH ABOUT THE CONDOR TRADING STRATEGY This presentation is essentially my interpretation of a Condor trading strategy taught at the TOS - Option Planet - Advanced or Complex Strategies for Traders seminars Here is a link if you want more detail on the free TOS seminars http://www.optionplanet.com/assembled/list.html Here is a link to the TOS seminar workbook for the Complex seminar http://xsprofits.com/Documents/OP%20Complex%20Strategies.pdf A very similar Condor strategy is discussed at length at CONDOR OPTIONS.COM Here is a link to the Condor Options web site http://www.condoroptions.com/ Of course, the strategy in this presentation is not exactly the same strategy as the above 2 sources It is just my version and my interpretation So , Please - Study the above sources and develop your own interpretation and application of this strategy 47 APPENDIX D PROBABILITY CONES These can be used on charts on the TOS trading platform 48 Here is a good place to find an explanation of using Probability Cones on the TOS platform Link - http://xsprofits.com/tues_nites.aspx 49 PROBABILITY CONES And STANDARD DEVIATION A standard deviation is a measure of the distribution of a given set of values. In trading, we usually assume prices will be normally distributed, and therefore any given possible value will fall within one standard deviation of the mean about 68% of the time. Two standard deviations from the mean would account for for almost 95% of all possible values, and three standard deviations would account for nearly 99%. You can also see the standard deviations (sigma) by using the Probability Cones on the TOS trading platform 50 PROBABILITY CONES And The One Sigma Method Perhaps the simplest way to construct an iron condor with a reasonable chance of success (while still generating sufficient premium) is to select short strikes that are one standard deviation (or one sigma) from the current price of the underlying. This metric means about 68% of the time, the underlying index or equity we're using will close on expiration day within one standard deviation (or "one sigma") of the current price. So if we structure our trades so they can tolerate a one sigma move and still expire worthless, then we can expect success over two thirds of the time. 51 APPENDIX E OTHER EXIT and CONDOR MANAGEMENT IDEAS EXPLORED 52 MANAGEMENT and EXIT STRATEGY # 1 Reference TOS seminars – Don Kaufman - Option Planet Exit method Always exit 4 to 10 days from expire Do not exit sooner (unless you can buy back for 80% of the profit) Be consistent Just add Inventory (Sell more Condors, etc) Keep Delta as neutral as possible Sell more Condors or other positions (to reduce delta) when market trends up or down and is threatening your short calls or short puts The idea is to sell future Condors and collect that money as a way to pay for the loses (if any) of near term Condors. Selling future Condors will tend to keep your Delta closer to zero That is why Don uses the Greeks to manage his positions. He is always adding inventory to keep Delta more neutral TOS says this adding of inventory process is a way to “ finance the loses” 53 MANAGEMENT AND EXIT STRATEGY #2 JUST BUY CALLS OR PUTS (Peter idea being explored) when the underlying starts to threaten your short strikes Just Buy calls (Next month out) when the market trends up and crosses your short call strike. Or Just Buy puts (Next month out) if market downtrends and crosses your short put strike Example: If your current Condor is a November contract, then you would be buying December Calls or Puts for protection. What if you buy the call and the market immediately turns south and goes against you ? This exit strategy needs some testing. You don’t want to lose more on the call than you can make in the Condor. Sizing will need to be tested more 54 APPENDIX F THE ANALYZE TAB 55 ANALYZE TAB I don’t use the Analyze tab much for the way I trade Condors, but the next few slides show you how to use features of the Analyze tab when trading Condors USING THE ANALYZE TAB TO CHECK YOUR CONDORS 56 A more in depth Power Point presentation on the Analyze tabs is in my file ANALYZE TAB - ALL - 2-18-10.ppt The next slides are a cut and paste from that larger file and just a quick summary on Condors 57 1. First load up any trade like below or pull up any trade from the past 2. Left click BLUE dot 3. Click ANALYZE DUPLICATE TRADE 58 The page will default and show all your open and other trades Click ALL to clear checks from all boxes and then put a check mark only by the trade you want to analyze 59 1. Click RISK PROFILE to show this graph 2. Click [email protected] into this box 4. Click SET SLICES – Click BREAKEVEN – Click March 20th 3. Change this date to Expiration date of Front Month. In this case , it is March 19th 60 These VERTICAL RED DOTTED lines are what they refer to as the “SLICES” 61 This light shaded area is the 1 sigma or range of one standard deviation. This range is dynamic and changes as volatility changes. 97.5 and 120.1 match the numbers on the chart Probability cones 62 If you set your red dotted line “slices” just to the edges of the LIGHT BLUE areas, your probability of success number will always be around 68% because the LIGHT BLUE areas is the 1 standard deviation area or 1 Sigma Probability of success number You can change the LIGHT BLUE area by adjusting this field 63 If volatility increases after you enter your trade, then this probability of success number will decrease because the vol will be recalculated and your short strikes are too close and thus prob of success decreases If you set your slices to BREAK EVEN POINTS, then you can get a number like 55.62% which is more precise calculation of probability of success of your particular trade. This number is the probability of your trade being in a positive range between the break even prices between now and expiration data. This figure will change as the market volatility and prices change. In this case, mathematically, the .76 Credit here yields a 62% probability of success. But that 62% is just rough mathematic calculation. The 55.62% Calculation shown on this analyze page is a more accurate “live” figure 64 If you want, you can click this date day be day into the future to see how your position changes with time 65 APPENDIX G PRICE 66 PRICE Trade entry is based on Price Price can be used to calculate probability Below is more info on how Option Prices are developed …if you want to read more The price of your option includes: Intrinsic portion – Underlying current price – strike price PLUS Extrinsic portion - determined by 4 main factors : Time to expiration, Interest Rates, Volatility and Dividends payable. Calculated by using a pricing formula such as the Black-Scholes Model Price includes all of the above So price can be used to calculate probability 67 PRICE MORE DETAILED NOTES if you want more info The goal of every Condor manager is to Collect as much money up front as possible Shoot for a 60 to 70% chance of success 68.27% is one standard deviation in a normal distribution i.e. One Sigma Let time and volatility cause the options to decay in value Then, Try to buy back the position as cheap as possible later. When you enter a trade, TOS will summarize what your Max possible $ loss or Risk You can review and print the summary page before you click the final button to send the trade Condors are “defined risk” trades When you sell a Condor, you collect some money up front. This is the premium. Max $ Loss Possible – The premium = Your actual $ possible loss or $ risk So as your premium decreases, your max possible $ financial loss increases. The less you collect up front, the higher your probability of success. So what is strange here is your probability of success can increase but your Max Possible financial loss will also increase. The Long call and Long put in a Condor are just thrown in there as insurance. You don’t want to sell a Naked Put or Call without some insurance. 68 PRICE USING PRICE TO ESTIMATE PROBABILITIES Below is a Rough calculation for figuring trade Probability of Success (The Analyze Tab in TOS gives a more precise calculation of probability of success but this is pretty quick) • First figure your max loss • Max Loss = The Width of your vertical (this is always 2) – your trade credit (say we are getting .77 credit in this case) • So the math for your Max loss is • Probability of Success = Max Loss / Width of your vertical • So that is 1.23 / 2 = 61.5% is your probability of success • If you would have picked a .65 credit, the probability of success would be 2 - .65 = 1.35 standard deviation or a 1 sigma trade • Above is just a rough calculation. The Analyze tab in TOS will yield a more precise figure for probability of success. See next slide on more about the Analyze tab. 2 - .77 = 1.23 and 1.35 / 2 = 67.5% which is closer to one 69