How to Trade Iron Condors and Calendar Spreads

San Jose Options presents a short video on what would happen to an Iron Condor or a Calendar spread over a Flash Crash. Do these trades really deserve to be considered safe? Are these strategies scalable? Can you do them with large amounts of capital?

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The True Risk with Popular Option Strategies

How to Trade Iron Condors and Calendar Spreads

Video Transcript

Hi everybody! This is Morris from San Jose Options. In this short video, we’re going to illustrate the difference between reality and fantasy when it comes to analyzing your option trades.

What we’re looking at here is a typical iron condor. This trades out about 45 days. By many option traders, this would be considered to be a very high probability trade. I’m going to go ahead and move the 1’s to the breakeven to show you how certainly it does appear to be a high probability trade with nearly an 80% probability of profit. Now, let’s ask a few questions and analyze if this trade really deserves to have that 70% probability of profit.

Question #1: If you’re trading this strategy and you expect to make 5-10% in 2 weeks to a month, what the most you’re willing to risk on this trade? Do you think you would be comfortable risking 5-10%? Would you be comfortable risking more than that? How many of you would be willing to risk 20, 30, 40, 50% on this trade when in reality, you’ll probably average 6 or 7% on this trade in a month? How many are willing to risk 50%? What happens if you lose 50% on this trade the first time you try it? How long will it take you to make your money back? You might spend a whole year trying to get your money back or, worse than that, if you lose 50% of your portfolio, now you only have half the money to invest with so it’s probably going to take you 2 years of making money nonstop. That’s just assuming you never have a bad month to make the money back. You can understand, this strategy won’t work if you lose 50% on the trade. Think about that.

Now, let’s look at where would you lose 50% on this: somewhere around this zone right. Guess what happens if you’re in this trade and you have a flash crash. You end up right here. Notice when I reset the slices, 10% brings you over her. When we increase volatility on this trade, I just gave it a 25% boost, just like what happened over the flash crash. You end up over here. Essentially, you’re down close to 50% on this trade. That is if your investment here is about 8,000; probably a little closer to 40%. But again if you lose 40% on your first trade, now most of your trading capital’s gone. Let’s say you start with a hundred thousand, the next month you’re down to sixty thousand. How long is it going to take you to go from 60,000 back up to a hundred? You almost have to double your account. Obviously, that’ll probably take more than a year to do and that’s only if the year goes fantastic after you have such a bad start.

You can quickly see how this type of strategy is not scalable for one because it will constantly bring you back to where you were before. No matter how much you raise your account with some nice returns over a year or two years of consistent growth. At any point, you can lose most of that back. This type of trade is not scalable and if a trade is not scalable, what is the point of learning how to trade it? Because, again, the goal here is to make some money, to grow your account, to get to a point where if you’re a serious trader, to where you can live off of your trades and when you retire you still have some income. But if a trade is this risky, then, how is that scalable? How is this a trade that you can use in 10 years, 20 years, in 30 years from now? It’s not something that you can grow with.

Looking at the risk on this trade, and that’s if you’re in the middle, what’s the realistic probability of this trade? Actually, this one, let’s go ahead and reset this volatility, in this one here, there really is no comfort zone because no matter where you are in the trade, you’re always risking about 40%. This trade, to us, really has a 0% probability because, again, we base our probability on safety and there is no safety at all in this trade. This is not a trade that we can do by our rules. Let’s look at a different trade. Now, we’re looking at another popular trade. The option traders do call it the calendar spread. Again, notice where a 10% move brings you, which could happen in 5 minutes; it’s already proven to happen.

There’s no comfort zone in this trade either. What looks like, in this case it’s a low probability trade to begin with, but what looks to have a 20% probability this whole zone here is the danger zone. This to us has about a 0% probability when we consider the risk. The whole trade is in the danger zone. But if you just look at the breakeven points, it shows about a 28% probability of profit. If you consider it well, maybe in this zone here, it’s just a little bit narrow for Thinker Swim, but you may consider. If this trade stays within this zone, it’s a comfort zone. But again, this trade has no comfort zone because 10% makes you lose about 90% of your investment.

Ask yourself; is a trade like this scalable? These marks represent a 10% move. If the market can move here in 5 minutes, is this scalable? Is this something you can do the rest of your life? Is this something you can do when you retire? If your $100,000 savings would go $200,000, can you do this trade? I think the answer is pretty obvious. That’s what we’re talking about. A lot of option traders, they just use the software and they look at the breakevens and that’s what they call their probability. I’ll just share with you the strikes that we were looking at. They were looking at a July iron condor. It’s out about 45 days and then we looked at the calendar which is even a shorter term trade, about 20 days. Moving back to the condor, this one’s even more popular than that calendar and you can see perhaps it can handle a 10% move a little bit better. But you saw with increase in volatility, it can still have an instant 40% draw down. And that’s just not acceptable.

You really need to think about these concepts when you’re analyzing your trades and if you’re going to consider this type of trade to have this high probability of 78%, then, I think it’s important to realize that’s not a very realistic approach because how can you be risking 40% of your portfolio at any moment? That’s not a way to trade. That’s not a way to have long term growth. It is not something you can risk when you’re retired because, again, most of us that trade options, we’re looking for a way to have some income when we retire. Or supplemental income to what we’re doing now. But our goal certainly is not to lose the money that we make from our regular job. We’re trying to find safe ways to grow our savings. These aren’t ways to do it.

Anyways, I just wanted to show that and add that in with the article. Thank you very much and have a great day!