Options are highly versatile financial instruments. They can be used to bet on market direction, to bet on changes in implied volatility or even to collect premiums. Options can also be used as a risk management tool for positions in the underlying stock or asset.
Premium collection is a highly popular use for options, although such strategies can carry unlimited risks if options are net short, or “naked.” Credit spreads and similar methods can allow the trader to collect premiums while keeping risk defined. One such strategy is the iron condor.
Description of the Strategy
The iron condor consists of four options: two calls and two puts. A simple way of looking at an iron condor is a position consisting of a short call spread and a short put spread. The iron condor is designed to potentially profit in two distinct ways: The first is from the market moving sideways in which case all options expire worthless and the trader keeps the premium collected. The second is from a decline in implied volatility levels, in which case the options may also lose value.
Let’s look at an example: Suppose that you have been watching stock XYZ for several weeks. The stock has traded in a range from $40 on the low end to $45 on the high end. There are no earnings announcements or other big data points set for release, and you feel the stock is quite likely to stay in that range for an extended period of time.
To bet on your forecast, you elect to initiate an iron condor position. To construct the trade, you sell the $40 put and buy the $35 put for a net credit of $.25. You also sell the $45 call and purchase the $50 call for a net credit of $.25. You have now, therefore, sold a call spread and a put spread, collecting a total of $.50.
If the market stays between the short strike prices of $45 and $50 at expiration, all options will expire worthless, allowing you to keep the $.50 collected.
If there is a significant decline in implied volatility levels before the options expire, you may also have the potential to close the spread early at a profit. For example,if two weeks after selling the spread it is now valued at only $.10, you could purchase it back to book a profit of $.40.
The trade starts to get into trouble when the market starts moving near or beyond the short strike prices. The maximum risk of the trade can be calculated as the difference in strike prices ($5.00) minus the premium collected ($.50) for a total risk of $4.50.
You will notice that the risk on the trade is significantly greater than the potential reward. Due to this, risk management is critical and only trades with great setups should be considered.
When to put it on
There a few cases in which an iron condor may be appropriate. If a market looks as if it is likely to stay relatively range-bound, the iron condor may be a great way to try to capitalize on sideways price action.
If a market has gone through a period of unusually high volatility, the option values may be juiced with extra premium. if implied volatility levels decline rapidly through mean reversion, the trade can potentially profit quickly without the need to hold it until the options expire.
Pros of Strategy
The iron condor can have a number of potential advantages. One of the primary advantages of the iron condor is its defined risk. Options traders can collect premiums knowing their risk exposure. Another big plus is the idea that markets tend to spend most of their time range-bound. Unlike other strategies, which need market movement in order to profit, the iron condor may do the opposite by profiting from a lack of movement. The position can also potentially profit from a decline in implied volatility levels.
Cons of Strategy
The iron condor does have some downside as well. Due to how the trade is structured, the risk/reward equation is heavily skewed to the risk side. In addition, without sufficient levels of premium in the options markets, such positions may not collect enough premium to justify the risk and make the trade worthwhile.
Due to the high risk/reward ratio, risk management is absolutely essential for the iron condor to be successful. There are numerous ways to manage risk on such trades. One simple method is to close the trade once it is valued a a certain amount above the premium collected. Using the above example, a trader could elect to close the trade if the premium doubles from $.50 to $1.00
Another simple method is to close the trade if the market reaches a predetermined level. For example, if the market gets to within a dollar or two of the short strike prices, you could close the trade win, lose or draw.
The iron condor can be adjusted in numerous ways to manage risk or to try to achieve greater profitability. One such method for adjusting is the “roll” out. In this method, you would buy back one side of the trade (the call spread or the put spread) depending on which side is threatened. You would then sell the same spread or a different spread for a later expiration date, collecting a new premium in the process.
You could also elect to roll the entire position out to a later expiration date, or even roll out to varying strike prices.
The iron condor is a very flexible strategy that can potentially profit with the right market conditions. That being said, however, it is not a trade to be taken lightly. A big loser can wipe out several winners using the methodology, and markets can and do break out from trading ranges in swift fashion.
With proper risk management techniques, and careful trade planning, the iron condor can potentially be a very valuable tool in a trader’s arsenal. With deeper options markets and increasing liquidity, many markets can be considered for trading iron condors.