Iron Condor - Part Two: Position Sizing

According to Van K. Tharp, "Perhaps the greatest secret to top trading and investing success is appropriate money management or what we now call position sizing. I call it a “secret” because few people seem to understand it, including people who’ve written books on the topic. Some people call it risk control; others call it diversification."

While Tharp doesn't write a lot about spread trading, at least not that I've seen, position sizing is no less important with Iron Condors and other vertical spreads. The main reason is that the size of your position defines the risk. There are a couple of ways to look at this with spread trades.



One method is to look at your risk as the total margin required for the trade. In other words, take the distance between your long and short strike and subtract your credit. For example, if I sell a 570/560 bear call spread in the RUT for .60, then my risk is $10.00 (570-560), minus .60, or $940. So if I only want to risk $940 then I would only do this one time. If I only wanted to risk $500 I might have to do it 5 times in the IWM (the ETF version of RUT, which is normally priced about 1/10 of RUT). Normally with a strategy like this, you would put the trade on and just let it ride until your defined exit, but not do any sort of adjustment along the way.


A quick word about strategies... I hesitate to call one approach "bad" or "good" because normally there are trade-offs to all of the different approaches. The markets are very efficient and so prices normally reflect the various approaches. The above approach is NOT the way I do it, but it doesn't make it wrong or bad. It's just not the way I approach position sizing and risk management.



My approach looks at the amount of loss that I can expect to take over time with a given set of trading rules. I have tested my rules over many years and I know that the max loss that I normally take is about 10% of the total position size. Therefore, if I want to risk no more than 1% on any given position, then I would allow up to 10% of my account to be traded in that position (10% risk of 10% position size equals 1%). Get it?



Scaling


Now that I know how much I want to risk in total on the Iron Condor position, I will typically manage risk further by scaling into positions. The exact timing has a lot to do with the chart, as you have seen in Part One, but usually I start looking for my first position at 50-55 days from expiration. The first position will normally be 1/2 of my total risk. The numbers above are what I use (10% of account size), so this first position will be about 5% of my account size for total margin required. It's never exact, as prices are always changing, but I get as close as I can. The reason I start with 1/2 is that I want to get a fair amount on as early as possible in order to take advantage of the time decay. Second and Third positions are then 1/4 (about 2.5%) each.

After the first position is on I will look to add additional positions by watching the chart in the following week. Over time the position ends up with various spreads on at different strikes, hopefully giving me the full position, but also with the widest possible space between short strikes. Below is an example of the Analyze page from my ThinkOrSwim account which describes my current position (as of 1/23). It might not make complete sense at first, just remember you are looking at the middle of the trading time. In other words, several legs have been put on and taken off so far, since the whole thing started around 12/22.




So that's the position sizing story. It's actually really easy once you get the rules down and understand what is at risk.


Next Time - Part Three: Choosing the Strikes