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Placing an Iron Condor Option Trade: What You Need to Know (Part 1)
10/13/2009 12:01 am EST
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Is it possible to have a nearly perfect setup for an iron condor but not the right premium in the underlying to actually place it? Yes. Here is the what and the how of it.
In order to place an I.C. (iron condor), I usually start by looking at the overall market environment. Such a trade is unsuitable for a market that is trending either up or down. Consequently, those committed readers have probably noticed that for several months that I have not entertained the topic of condors, either iron or otherwise.
By the way, the adjective "iron" means that the position is built by using both option classes, calls and puts, while the condor without the adjective in front of it means that only one kind of option was used, either calls or puts.
Count the Candles
Anyhow, going back to the current market environment, by looking at the chart below, which shows the monthly candles of the Standard and Poor's 500, it is evident that for the last six months, the market has gone straight up. Even if a simplification is made to the point of plainly counting the green candles, there were five green candles over the last six months and only one red one.
It is interesting to notice that the size of the body of that red one isn't significant. The Japanese term for that particular formation is a spinning top, which represents indecision and not necessarily bearishness.
If the market is so bullish, then the question arises whether it makes sense to place an iron condor, which is a directionless trade. The answer to this question depends on the time frame we are aiming to hold our iron condor, as well as the levels of support and resistance. Hence, let us look at the technicals and then proceed with the selection of the strike prices that are to be sold.
In Figure 2 below, I have changed the monthly chart into a weekly chart in order to get a better look at it. I have also drawn Fibonacci retracement lines on it from its highest point to its lowest point. Observe that different Fib levels are colored differently. For instance, the 23.6% Fib is in light blue, while the 50% is in dark blue. Also, examine on the chart that I have drawn in black a diagonally descending line from its high towards the current price.
What I have actually done to the weekly chart is called expansion. In order to better forecast the future possible movements of the underlying, I have added some extra white space to the right side of the chart. Moreover, while drawing the black diagonal line, I made sure that the line has more than a single touch; otherwise, it is not very valid. Usually, the more touches the better. In this particular case, the reader should observe that the underlying's 50% Fib line and the black diagonal line coincide at the same point.
NEXT: Keys for Locating Resistance Levels|pagebreak|
Locating Resistance Levels
In simpler terms, I am expecting the underlying to possibly go up to that 1122 level, or zone, and then to find resistance. Again, I am using the words "level" and "zone" because 1122 won't be the exact resistance level, but it'll be plus or minus a few points.
Having located the possible resistance level for my future iron condor, I also need to look at the level of support. From Figure 2 above, I could either make a claim that the 38.2% Fib line could act as one, or I could use the 23.6% Fib line. Let me start with the first one, the 38.2% Fib line. The area of 1015.25 has acted for the past couple of weeks as resistance, and it was only last week that it was broken, for the price closed above it. The current week, which is still unfinished, has created a spinning top.
Embracing the assumption that this particular level is going to hold is somewhat risky, so I like to consider the 23.6% instead. The 882.76 area for the past couple of times has acted as a solid support line, and therefore, it isn't illogical to forecast that most likely, if the underlying goes lower, it is at the 23.6% where it will find solid support.
Going back to creating an iron condor, these are the facts that we have observed:
The next step is to pull up the option chain to see what strike prices are available for trading as well as what strike increments. In our particular case on the S & P 500, the increments are five points wide and if this trade was to be done according to this T.A. (technical analysis), then the steps should be those listed in Figure 4.
To be continued tomorrow in Part 2.
By Josip Causic of OnlineTradingAcademy.com
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