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Condor Adjustments and Hedging

by Uncle Bob Williams

      • Condor Adjustment # 1 | Close
      • Condor Adjustment # 2 | Roll
      • Condor Adjustment # 3 | Emergency Adjustment

      • Condor Hedging | Mouse Ears

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We will evaluate popular Condor adjustments:

We will use this NDX trade as the basis for our analysis:
    NDX Call Condor
    4 contract spread ($10,000 maintenance)
    Short Strike: 2875, Long Strike: 2900
    Short Delta at purchase: 0.06
    Original credit: $1.32 (5.28% Yield)

Note: A typical adjustment might be 1 or 2 contracts to every 10 contracts in the original spread. (1:10 or 1:5 ratio) This example has a 1:4 adjustment ratio, which is a little exaggerated to better display the effect that adjustments have on the trade.

The graph below shows the "current" position, which has reached the conservative adjustment point with a Short Delta of 0.17:

= = = = =

Condor Adjustment # 1 | Close Trade

When the Delta of the Short Strike reaches the range of 0.16 to 0.30, close the trade. Accept the loss, and wait for another Condor spread that meets the ideal trading criteria.

The trade-off: A higher Delta gives the underlying more room to oscillate / pull-back which may result in a profitable trade, however the cost to exit gets more expensive as the Delta grows.

The Delta value you select as your exit point depends on two factors:

A) Your personal risk tolerance and your investment goals.

B) The actual cost to exit.
For example, smaller spreads like a 5 pt spread, have smaller price changes. (The Delta of the Short and Long strike are similar, so the price change between the two strikes will be small.) The Delta value may reach your exit point, but the price to exit may not reach your personal risk limit. (Your personal risk limit may be a % of the maintenance at risk for the trade or approximately how many months it would take to recover the loss: 1 month, 1.5 months, etc.)
Always check the actual cost to exit.

COST TO ADJUST / POTENTIAL PROFIT (based on the pricing in this example)

=> 9.52% Loss.
This could be recovered in 1 month with an Iron Condor. (trade both Call and Put sides)

=> Trade closed completely.

=> No further risk.

= = = = =

Condor Adjustment # 2 | Roll

When the Delta of the Short Strike reaches the range of 0.16 to 0.25, close the current trade. Place a new trade in the same expiration month where the Delta of the Short Strike is around 0.08, and increase the size of the trade by 1.5 times or more.

Depending on when you roll and the size of your new trade, you should be able to cover most or all of the loss that was incurred on the first adjustment.

Warning: Be careful adjusting PUT spreads when the Market price is dropping fast. It is best to wait a day or more for the price to level out before placing the new trade.

The "Roll" strategy will not work well under these circumstances:

A) Close to expiration (as early as 14 days prior to expiration) because the new Short Strike will not be far enough away to account for normal price swings.

B) When the volatility is low. The new short strike won't be far enough away to justify a safe roll.

COST TO ADJUST / POTENTIAL PROFIT (based on the pricing in this example)

=> 1.42% Loss.
    Original trade exit = 9.52% loss.
    New trade of 6 contracts [increase of 50%] = 8.1% profit

=> The new trade must be monitored.
If the Delta of the Short Strike of the new spread reaches the adjustment point, it's recommended to remove the trade and swallow the loss instead of fighting the trend.

=> The amount of risk increases with the size of your new position.

Note: Some people will 'roll' out to the next expiration. If you are going to roll out to a new expiration, we recommend that you close the original trade for a loss and then evaluate the new trade afresh with the same stringency and scrutiny that you would for any new trade.

= = = = =

Condor Adjustment # 3 |
The "Emergency Adjustment" / "Calendar Adjustment"

This is an 'emergency' adjustment technique that can be used when the Delta of the Short Strike is over 0.30. It works best close to expiration.

You purchase LONG position(s) in the next Expiration at your Short Strike.
(This creates a Calendar spread, which is where the name comes from.)

In our example, we are Short the September 2875, so you would purchase the October 2875. The amount of Long positions depends on how many Short positions, and you can start with a ratio of 1 long to every 8 short as a starting guide and adjust depending on the profit / loss graph in your Broker's software.

This technique can produce a profit near expiration. (see the graph below)

This strategy requires active monitoring. If the Market price reverses, you will need to remove the "Long" positions quickly to avoid losses.

If the Market price continues through your Short Strike, the losses can be very steep.

COST TO ADJUST / POTENTIAL PROFIT (based on the pricing in this example)

=> The price to place this adjustment can be costly. The price is 29.8% of the maintenance on the first example, and 15.7% of the maintenance on the second example.

=> Profit / Loss Varies, see graphs below.

=> The new trade must be ACTIVELY monitored.

=> The amount of risk can increase, especially if the price reverses and you do not remove the 'adjustment'. The trade off is that you can possibly turn a losing trade into a profitable trade.

= = = = =

Hedge your Condor from the Start with "Mouse Ears"

"Mouse Ears" is a Condor hedging technique that can limit the amount of loss if the Market moves against the spread.

You place 1 or more LONG contracts in FRONT of your Short Strike - at the time you place the original trade. (or very close to that)

Note: A typical hedge might be 1 contract to every 10 contracts in the original spread. (1:10 ratio)

We will use this RUT trade for our example:
    RUT Call Condor
    10 contract spread ($10,000 maintenance)
    Short Strike: 860, Long Strike: 870
    Short Delta at purchase: 0.10
    Original credit: $0.67 (6.7% Yield, the volatility was low at the time of this example)

The graph below shows this "normal" Condor:

Putting on the "Mouse Ears"

    Buy 1 Long contract at the 850 Strike
    Cost: $2.95 ($295 for 1 Contract)

The graph below shows the "Mouse Ears" Condor:

COST / POTENTIAL PROFIT (based on the pricing in this example)

=> Net Credit with Mouse Ears = $3.75, compared to $6.70 without.
    ($670 original credit - $295 mouse ear = $375 net credit)

=> The amount of risked is reduced:

    Position Maintenance is reduced from $10,000 to $9,000, so the total risk is lower.

    The cost to exit early if an adjustment is necessary is reduced around 40%.

=> You should look at the Condor spreads that are further out, and compare the price / benefit. You may be better off taking a 'safer' Condor that is further out at a similar price to the "Mouse Ears".
Many traders will limit the use of "Mouse Ears" to more risky trades where they require a little extra 'insurance'.

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There are other adjustments and hedging techniques, but many are unique to specific trading circumstances. We listed the most common ones here.

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