A Great Iron Condor Trade Example

02/12/2010 12:01 am EST


Tuesday morning on the market open, we found an interesting and sizable option trade initiated in Biogen Idec (NASDAQ: BIIB). My colleague, Karla Yeh, found 4,000 March options cross the tape in a very recognizable strategy. Here was her analysis of the stock and options action she saw:

“Biogen Idec Inc. (NASDAQ: BIIB) announced earnings of $1.20 per share this morning, which beat estimates by 15 cents a share. The company also issued upside guidance for the year, which sent the stock up 86 cents, or 1.6%, to $53.70 during the first 30 minutes of trading. We saw heavy strangle action out of the gate, as an investor sold the March 50-55 strangle and simultaneously bought the March 45-60 strangle. The investor collected a net premium of $1.50 for the package.”

This pattern of strikes bought and sold, equally spaced and one-for-one, is a classic option strategy known as an iron condor. The iron condor is a great way to bet on a stock or ETF staying within a certain range. You sell option spreads with your choice of strikes and expirations and profit if your view of that range is correct. Here’s a look using the OptionsHouse Trading Tools at the risk/reward dynamics of this BIIB trade and the potential profit/loss at expiration.

Click to Enlarge

I labeled this profit/loss diagram as the two different spreads that make up the iron condor: One out-of-the-money (OTM) put spread and one OTM call spread. But you can also speak of this trade as selling an inside strangle and buying an outside strangle to hedge. The investor collects $1.50 for the four-legged strategy and retains the maximum amount of this potential profit if BIIB stays between the short strikes (in this case, the 50 put and 55 call). Outside of these strikes, the profit begins to gradually evaporate.

What I didn’t label were the breakeven points where profits turn into losses. On the downside, just like any short put spread, you subtract the credit received from the short strike. Fifty dollars minus $1.50 gives you $48.50, and below this level, the losses begin with the maximum potential loss equal to the width of the spread, minus the credit received, or $5 – $1.50 = $3.50.

On the upside, you add the credit received to the short call strike, so $55 plus $1.50 gives you $56.50. Above this level the losses accumulate, again, to a maximum of $3.50 since this is also a $5-wide spread. These breakevens of $48.50 and $56.50 create an $8-wide trading range in which the investor can be profitable. And beyond the long strikes at $45 and $60, the losses stabilize as you would expect with any short-spread strategy.

Customizing Your View of Volatility

The great benefit of iron condor strategies is that if you are confident about an expected trading range for a stock, you can get paid for taking the risk. Since the stock at expiration cannot finish through both of your short strikes, you only have risk on one side of the trade. Your stock may even have substantial volatility, bouncing between both of your spreads, and you can still realize profits as long as it finishes between them before you want to exit.

The above trade we saw today in BIIB was a conventional iron condor in the sense that the investor used evenly spaced strikes and spreads and identical quantities. But you can build iron condors—and plain vanilla all-call or all-put condors—with any strikes and spread widths you choose to completely customize your risk/reward preferences. To check out a very unique—and sizable—condor we spotted in Goldman Sachs two weeks ago, see my article GS Put Condor, With a Twist.

By Kevin Cook, contributor, TheOptionsInsider.com

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