Iron Condors and “Flash Crash”

“Flash Crash” of May 6, 2010…

The market event that occurred on May 6, 2010 is now known as the “Flash Crash”. “Flash Crash” accurately describes the situation, as the market crashed for just a flash, as seen below:

Over before you know it…

For those not watching the market closely and not having stop orders, the “Flash Crash” happened and everything was pretty much just as before. But for investors watching the market tank and selling in a panic or for those investors with stop orders set, the “Flash Crash” was most likely a disaster.

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Optium, Chromium and Meridian…

The Iron Condor trades posted for Optium, Chromium and Meridian are configured with contingent orders for the short options. Contingent orders allow trades to execute automatically when a certain point is reached. Following execution of a contingent order, we follow-up with trades for closing the offending long put or call option. If there is a large amount of value in the offending long option, then we usually close it immediately, like we did yesterday. If there is little value in the long option, then we may leave it open in order to prevent further losses and also potentially generate a profit. During the “Flash Crash”, a stop-loss for one of Optium’s trades was executed by managing the long put option in this manner and was profitable. Orders were transmitted to close the long puts in a similar manner for the other positions as was executed for the Optium trade, but the market recovered too quickly resulting in losses for the positions.

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Contingent orders…

Previously, we offered four options for contingent orders for exiting an Iron Condor when experiencing a stop-loss:

Close “offending short option with contingent order:

• and if not much value in long option, leave long option open for an extended period of time.
• and if significant value in long option, close long option immediately.
• and if moderate value in long option, close a portion of the long option and leave a portion of the long option open.
• and if not sufficient funds to close short option, close everything.

This stop-loss contingent order strategy has worked fairly well over the previous five years. This strategy allows an investor the possibility of recovering from a loss and potentially making out like a bandit. The strategy also allows an investor to hedge other positions against further losses. However, this strategy is a disaster when experiencing a market condition like the “Flash Crash”, as the short option is closed by the contingent order, and then further losses are experienced for the open long option when the market suddenly recovers.

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New contingent order potential strategies…

Based on the experience of the “Flash Crash”, we’re proposing three different strategies for protecting against another “Flash Crash”. Unfortunately, there’s a good chance two of the three are not supported by your broker. The three contingent order possibilities are:

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• Four-legged contingent order (may not be supported by broker)
• “Other-trigger-other” spread contingent order (may not be supported by broker)
• Four contingent spread orders

Four contingent spread orders…

Since brokers may not support the first two options, we’ll focus on the third option, four contingent spread orders, which is supported by some brokers. For the four contingent spread order option the following contingent orders are entered:

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• Two contingent orders to close non-offending spreads
• Two contingent order so close offending spreads

A profit/loss graph for an Iron Condor illustrating the four contingent orders is shown below:

For example, consider an iron condor with a put spread of 385/395 and a bear-call spread of 500/510. For the new contingent order strategy, a contingent order for closing the bull-put spread could be set for a 1% margin at 399. Additionally, a contingent order for closing the bear-call spread could be set for a 1% margin at 495. Then two contingent orders for closing the non-offending spreads could be set inside of the first two contingent orders. For example, a contingent spread order to close the bear-call spreads could be set at 404, just inside of the contingent order to close the bull-put spreads. Additionally, a contingent spread order to close the bull-put spreads could be set at 490, just inside of the contingent spread order to close the bear-call spreads. The resulting profit/loss graph would look like this:

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Falling market…

For a falling market, the contingent order for closing the bear-call spread would be executed at 404. Since the bear-call portion of the Iron Condor position should be profitable, there shouldn’t be any issues with closing the bear-call spread. With a continued market fall, the contingent order for the bull-put spread would then be executed at 399.

Rising market…

For a rising market, the contingent order for closing the bull-put spread wold be executed at 490. Since the bull-put portion of the Iron Condor position should be profitable, there shouldn’t be any issues with closing the bull-put spread. With a continued market rise, the contingent order for the bear-call spread would then be executed at 495.

Trade-offs…

Implementing this new contingent order strategy has some positive and negative trade-offs. On a positive note, an Iron Condor position can be more cleanly exited with the occurrence of a “Flash Crash” as was experienced on May 6, 2010. Additionally the amount of reserve capital required for closing a position is none or minimal. On a negative note, recovering from a loss after experiencing a stop-loss has now been taken away, as the long option is not left open after a stop-loss condition. And on a further negative note, hedging other positions against further stop-losses not possible with this contingent order strategy.

Positives outweigh negatives…

The positives for the new contingent order strategy outweigh the negatives, especially when considering the potential for “Flash Crashes” occurring. With this new contingent order strategy, we may be attempting to shore up our defenses for the 20 year flood, but the market has been extremely volatile over the last ten years, so the next “Flash Crash” could be just around the corner.

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[tags] Flash Crash, bear-call spread, bull-put spread [/tags]