Small caps have led the way during the post-Trump rally. Since the election, the Russell 2000 (NYSE: IWM) has managed to gain 10.6% in 21 trading days. Before I get to how to trade the current state of IWM, let me discuss the current state of the small-cap ETF.
Just look at the RSI over all time frames . . . we are witnessing one of the most overbought readings in decades. That’s right ̶ decades. The move this past week was certainly an anomaly and it only topped off what has been an incredible short-term advance.
If we go back to look at the probability of IWM closing above 138 (where it currently trades) at December expiration, which at the time of the election was 38 days away, the probability is 0.40% and even less if you consider IWM reached 138 in nine days less. Even more staggering is that the probability of touching the 138 strike was only 0.82%.
Who said the market doesn’t crash higher? This is certainly one of those rare moves.
The move is just another reminder of the importance of diversifying options strategies and proper position-sizing. Losses will occur; it’s how we plan for them that matters most.
There are several strategies that I could use here, like verticals spreads or, for the more aggressive, buying a put outright, although I would rarely recommend the latter as the probabilities just don’t make sense.
One of my favorite strategies ̶ and one I would use here ̶ is the iron condor strategy. While I think a reprieve will occur, I don’t think a collapse over the short term is in the cards.
The Bearish Iron Condor Strategy
OK, let’s get started.
First, a disclaimer of sorts. If you don’t understand the terminology, don’t be discouraged. Focus on the concept. Pay attention to the numbers; you’ll learn the terms with repetition. Best of all, if you need some help, just email me at [email protected] and I will gladly attempt to answer your question.
An iron condor strategy is a non-directional options strategy that profits when the option on the underlying stock or exchange-traded fund of your choice expires within your chosen range at expiration.
The basic premise of the strategy is easy. You choose the price range of the trade. Increasing the range will decrease your potential profits, but will increase your likelihood of success.
The first requirement when trading iron condors is to make sure you are using a highly liquid security, in most cases an ETF. Highly liquid, in the options world, just means that the bid-ask spread is tight, say within $0.01 to $0.10, at least in most of the ETFs I trade.
In our case, we want to focus on the Russell 2000 (NYSE:IWM).
The ETF was recently trading for $138.04.
IWM is just one of 50 to 60 ETFs that is considered “highly liquid” among most options traders. I focus my attention on roughly 30 of those ETFs.
I then move on to my mean-reversion indicator, otherwise known as RSI.
RSI can be seen at the bottom of the IWM chart above. You’ll notice peaks (overbought) in green and valleys (oversold) in red. I typically want to place a trade when the indicator is in between those areas. It’s called being in a neutral state, but I’m going to offer a slight variation to the strategy today due the extreme overbought nature of the IWM.
Again, IWM is trading for roughly $138.
I typically like to start with a trade that has a probability of success around 80%, if not higher. But I use 80% as my starting point.
First I look at the call side of the iron condor, also known as a bear call spread. I want to find the short strike with an 80% probability of success.
The January 144 calls fit the bill, as it has an 80.80% probability of success.
Next I take a look at the put side with the same goal in mind: a probability of success of 80% or higher. However, since I am little bearish on the market I want to increase my probability of success slightly. I’ll have to forgo some of my potential return to do so, but it’s a reasonable approach given my view on the market.
At 84.85%, the January 128 puts work. If I were to go with my typical 80% probability of success I would need to sell the 130 strike. But again, in this example I want to take a more conservative approach, so adding a 1.5% margin of error to increase my probability of success by roughly 5% is worth forgoing an additional $0.08 in total premium on the iron condor trade.
So, right now I have my starting range of $144 and $128 established. Obviously, I can alter it as needed, but first I want a good base for my iron condor trade.
Iron Condor Strategy: What’s the Return?
By selling the 144/146 bear call spread and the 128/126 bull put spread simultaneously – thereby forming an iron condor – you can make $0.48, or 31.6%, over the next 43 days.
Again, with IWM trading at $138, the liquid ETF would have to breach the break-even levels of $144.48 or $127.48 by January expiration before the trade begins to take a loss.
It would take a 4.7% move to the upside or a 7.6% move to the downside over roughly a five-week period before the position is in jeopardy of taking a loss.
Best of all, the probability of success on the trade is a staggering 80% on the upside and over 85% on the downside. I like those odds.
I typically manage the trade by taking a loss if the spread increases to around $0.90-$1.00 – roughly double the premium sold. I want to keep my losses small, knowing that I can make up for the loss if all goes well in the next trade.
Remember, we are trading math here. It’s all about allowing the probabilities to work themselves out, so we want to try and keep losses to a minimum, knowing that if the statistics play out, our wins should far outweigh our losses.
Again, if you wish to learn more about the iron condor strategy and how I trade iron condors, check out my upcoming webinar.
As always, please do not hesitate to email me at [email protected] if you have any questions.