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Trading Combination Options Spreads (Part One)
04/07/2010 12:01 am EST
There are more option strategies than option strategists, but at their heart, they are all modifications of basically two ideas: Buying and selling options. The proliferation of option strategies comes from the infinite ways that these two concepts can be combined. Some of these combinations can be great ideas, but others are just commission generators with the difference usually resting on how you implement them as a trader.
In this article, we will start discussing one such combination strategy that is becoming more and more popular with option investors all the time: The iron condor. An iron condor is a combination of a long and short strangle, which is also the same as two credit spreads.
When abused, the iron condor strategy can be a great way to make money (if you are an option broker) because they are very high-cost trades. However, if they are applied appropriately, iron condors can be very interesting for risk-tolerant investors.
Iron condors are often marketed by advisory services and brokerages as a "high-probability" trade. Unfortunately, that phrase is very misleading and can give option traders a false sense of security.
We will discuss why the inexperienced call these trades "high probability" and why that is not necessarily true. This is important to understand because it will focus your attention on analysis that matters, rather than arbitrary and theoretical probabilities.
To illustrate this strategy, we will use a case study in the video. The steps we will follow to enter an iron condor are as follows.
1) Liquid ETFs and Index Options
Costs are the enemy of option traders, and many trading costs are contained in the bid/ask spread. Because and iron condor has four legs (four different options), it has four bid-ask spreads, which can really add up to your disadvantage. Liquid ETFs like SPY, IWM, or GLD, index options have tighter spreads, and therefore smaller costs. In our example, we will use the S&P 500 ETF (SPY), which fits this liquidity requirement.
2) Create Your Profitability Range
An iron condor starts with a short strangle. That means you are trading a short call and put that are both equidistant from the at-the-money strike price. You are paid the premium from these two short options, but have potentially unlimited risk if the market moves beyond either strike. This is why many iron condor traders are tempted to make the range between the two short strikes very wide. If you need more help to understand strangles and selling options, be sure to research further.
This is where we run into the "high probability" problem. A wide range seems to make it more likely that the trade will end successfully, but it also increases the potential losses relative to profits if you are wrong.
3) Cover Short Options with Long Options That Are Even Further Out of the Money
Short strangles make many option traders nervous because a short option has theoretically unlimited risk. One alternative to this problem is to cover each short option with a long option that is even further out of the money. This step adds a long strangle to the short strangle that has the affect of limiting the maximum risk in the trade.
This reduces the premium paid significantly, but it does provide the benefit of fixing the maximum possible loss. The other benefit from this action is to reduce the margin requirement. A naked short option requires a large margin deposit that is often 20%-30% of the total value of the highest strike price of the options you sold. The margin requirement for an iron condor is limited to the spread between the long and short calls or puts.
The mechanics of entering an iron condor are not that complicated when evaluated one component at a time. Like all option strategies, entering the trade is only one of the problems to be solved. In the next article in this series, we will cover how to make adjustments, exit early, and handle expiration issues.
By John Jagerson of LearningMarkets.com
LearningMarkets.com offers daily articles, videos, and investing guides—for free—about everything from investing in stocks and options to trading currencies in the forex market and more. Visit LearningMarkets.com to learn more about investing and to interact with other investors just like you.
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