As a mentor, one of the more common questions I get is when to unwind a profitable condor trade. To me this is a very simple answer: When the capital is no longer efficient.
Capital efficiency is one of the least understood facets of option trading. Sadly it is often too often over looked. One of the most important ways to vault a trader’s success rate is for that trader to manage his capital properly. While mastering capital efficiency across a portfolio can be difficult, it is certainly not impossible.
Here is one good tip: Buy back those cheap options.
A trader sells a 10 pt iron condor in the RUT for $2.00 with fifty days to expiration. The trader has a couple of options:
Initially, the trade is betting $800.00 to make $200.00, thus the trader is working with a 25% risk to reward ratio. If one follows the way the condor wing option time premium decays during a normal month; at 25 days the condor will likely have lost more than half its value. In this case the condor might be worth $0.80. Should the trader still be in the trade? The trader started out with $800 of risk and in 25 days has collected a return of $120, or 15%. This is where the trader’s decision matters. I would argue that the trader’s cost of capital is now $920.00. The $800 of risk that the trade initially had, plus the $120 the trader has now collected. Thus, the trader is now risking $920 to make $80.00, or 8%. On top of this, anyone who has traded options before knows that the final few cents of a condor’s value decay at a much slower rate. It may take almost the full 25 days to collect all $80.
Comparing the time periods:
Day 50-25: 15%, the trader risked $800.00 to make $120.00.
Day 25-1: 8%, the trade risked $920.00 to make $80.00
Once the retail trader takes the time to review the thought process behind this math the answer is much clearer. The trader probably didn’t need to continue to hold this condor. Unfortunately, many traders do not follow this logic, many times these traders are taught the hard lesson of capital efficiency. You don’t realize how often I see a trade that was up 15% lose money.
For those of you who think "I can still make $80 I wasn’t going to before and I don’t want to pay commissions"
I ask you "Is this condor stopping me from making other trades?"
For traders with limited accounts this is the unspoken opportunity cost of inefficient capital. If a trader doesn’t properly manage his or her money, the capital can be tied up and stop a trader from entering in to new trades. What if I told you that at day 25 there was the opportunity to buy a calendar that would cost $500.00 and return 40%? How would that affect the thought process? The trader that exited the condor was able to jump into the calendar and make an additional $200.00. The condor trader that did not exit is stuck sitting on his or her $920.00.
Traders should never let commissions or a small return stop them from entering in a new trade.
This is not all there is to capital efficiency, but hopefully it was the glimpse you option traders needed to begin to learn about it.
Keep those questions coming mark@option911.com and stay tuned for a BIG announcement February 1st.
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