You know that feeling you get, right?
You've spent hours analyzing charts, you've looked at numerous expiration graphs for your next options trade, and you're pretty sure that you've picked out a great trade with a high probability of success.
Let's suppose you chose a 60 day, ten Delta Iron Condor and the expiration breakevens give you an 90% chance of making money. You're feeling good about the trade, and you're ready to click "Send Order."
Here's the issue. . .
The Iron Condor you chose is that your profit and loss line today doesn't look anything like the expiration graph, and you need a plan to get safely from today to expiration.
Anything can happen between the time you place the trade and the time the options expire. If you have a plan when you go into the trade, you'll always know what to do and survive to trade another day.
These three numbers below will help:
#1: Percentage Profit Target
Everyone wants to make money. Profit targets are everyone's favorite thing to think about because it's what we want to happen.
But going into a trade without a clearly defined profit objective is both risky and careless.
While there can be benefits to holding an options trade close to expiration, in many cases the Gamma risk outweighs the Theta benefits.
In other words, if price makes a big move around expiration, a large open profit can quickly become a large loss. If you know exactly what you want to get out of a trade, you will know when to close the trade without giving away a large open profit.
The Rule of Thumb for the Iron Condor: If you enter a 60 day, ten Delta Iron Condor, a reasonable profit target is 40-60% of the initial credit. Once you've reached this point, you should exit the trade and take your money.
#2: Adjustment Point(s)
Options adjustments should always be used to reduce risk and increase the time you can hold a trade. We cover this in depth in our free options course.
By reducing risk, you can wait longer for the options to decay and hopefully exit at your chosen profit target. However, adjustments need to be made early enough in a trade to avoid disaster.
Put another way, if you just had a car crash, it's too late to buckle your seat belt. By identifying where you will adjust the trade in advance, you won't be caught off guard if the market makes a fast move against your position.
The Rule of Thumb: A simple Iron Condor adjustment is to roll up the side that the market is moving away from once the "tested" side of the trade reaches a 30 delta. This way you increase the overall credit on the trade thus moving out your break-even points.
#3: Risk Exit and Maximum Loss
While everyone "knows" they can lose money trading, nobody wants to believe their next trade will be a loser. I sure as hell never go into a trade thinking it's going to be a loser.
If you know in advance how much you are willing to lose on a trade, you have now done as much risk management as you can do.
The tricky part about knowing how much you can risk leads to a discussion on position sizing.
For example, a $200 loss is a 4% loss in a $5,000 account, a 2% loss in a $10,000 account, and only a 0.4% loss in a $50,000 account.
Sizing your positions so that your maximum loss is a small percentage of your account enables you to take many consecutive losses and continue trading.
The rule of Thumb: Iron Condors can have a relatively high probability of success. If you win on 50% or more of the trades and never lose more than win, you should end up in positive territory.
Let's Bring It All Together
Once you know those three numbers, the absolute best thing you can do is write them down. Have them handy to review during the course of the trade to keep you honest and emotion free.
When you enter a trade with a commitment to yourself, it makes managing the trade much easier. The secondary benefit is that if things go wrong (and they will go wrong sometimes), you can still feel good about the trade if you followed the rules.
As long as your trading plan includes the three numbers above, you'll be better equipped to trade successfully over time.
Guest Post by Dan at ThetaTrend.com