The Basics of Entering an Iron Condor Option Trade

01/26/2011 3:03 am EST

Focus: OPTIONS

Mark Wolfinger

Educator, MDWoptions

I received a question this week about trading the Iron Condor (IC) strategy and thought it would make a great instructional article about the subject.

The Question

Mark,

Can you please provide some in-depth info on what would the preferable steps to leg into an IC—by spread—would be?

Example: If I open the put side today and next week index moves higher I sell the call side, that's great. But what if next week index moves lower? Roll down the puts? Take losses and wait for another opportunity? Sell the calls at current prices?

My second question is, from your experience, would an IC constructed around one standard deviation OTM (out of the money) be really ~68% probability of keeping all the premium (given we do not make adjustments, in plain theory)?

Thanks!

Dmitry

My Answer

An in-depth discussion on this subject is tough. That's the stuff of which long lessons and book chapters are made. However, I'll offer the major points in enough detail that it should satisfy everyone’s needs.

As it turns out, you do not need a lot of information about legging into iron condor trades. 

Legging Into Iron Condors

Here are the major points; everything else on this topic is far less meaningful.

I do not like the idea of legging into iron condor trades by selling puts first. It simply doesn't work as well as it should when considering the risk involved. I know that's not good news for the trader who usually has a bullish bias, but there are good reasons.

When the market rallies, implied volatility (IV) tends to shrink. When IV shrinks, the value of the call spread that you are planning to sell also shrinks. By that I mean it increases in value by less than you anticipate—often much less because it is an OTM spread. I'm assuming that the iron condor trader is not looking to sell options that are CTM (close to the money).

It takes a significant upward move for that OTM call spread to increase in value by enough to compensate the trader for taking the leg. If you do sell the put spread first, and the market cooperates, it's often better to buy back that put spread, take the profit, and forget about getting a little better price on the call spread.

It's different with calls. If you correctly (i.e., you are correctly short-term bearish) sell the call spread first, then you have the opposite effect. If the market declines, the put spread widens faster than expected and you have an iron condor trade at a good price.

Thus, unless bearish, I suggest not legging into iron condor trades.

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Managing the Single Leg

If you don't get an opportunity to sell the second leg of the iron condor, I suggest forgetting about it and managing risk for the one credit spread that you did sell.
Let me point out something that seems obvious, but may not be to everyone. More than that, a significant number of traders may have never considered this simple idea: Once you own the full iron condor position, my experience tells me that it is far more efficient to forget that it is an iron condor and manage risk as if it were two separate trades, one call spread and one put spread.

Thus, I recommend trading the situation described above as a put spread. The fact that you did not collect any option premium by selling the call spread no longer matters.

(If you had sold the call spread, and the market declines, the only important consideration is knowing when to buy back that call spread by paying a small price. Waiting for it to expire worthless is far too risky. Sure, it expires most of the time, but on those occasions when you get the big bounce (and that's what you (Dmitry) are in the market to find, isn't it?), there is no point in taking a good-sized loss on the call spread when it could have been covered by paying $0.20—or another low price that suits you.

That's why I suggest managing the put spread as you would normally manage such a spread. I understand that you are primarily a stock trader and have not traded a bunch of these, but there is no single best way to manage the risk. My advice is do not allow the fact that the call spread was not sold influence your decisions.

Yes, you can roll it down; and yes, you may be uncomfortable with the trade and exit at a loss. Yes you may sell a call spread now, but that is my least favorite adjustment method and I strongly recommend that you not do that. I base that on your bullish personality, and for you, losing money in a rising market would make you very unhappy—much more so than losing in a falling market. These psychological factors may not be a legitimate of scientific trading, however, I truly believe that a successful trader does not place him/herself in a situation that can result is a very unhappy outcome.  My strong guess is that if you were to lose a given sum, you would be far unhappier losing on the upside than the downside.

Standard Deviation

No. The chances of keeping the entire premium are nowhere near that 68%.

If you sell an option that is one standard deviation (SD) OTM, then yes, it will be out of the money approximately 68% of the time when expiration arrives. But don't ignore the fact that it may be in the money (ITM) far earlier than expiration (and then finish OTM), and you would probably elect to adjust or exit, rather than close your eyes and wait for expiration.

More importantly, you are selling a call and a put. The probability that the put finishes OTM is that 68%. The probability that the call finishes OTM is also 68%. However, you have both positions and the probability of finishing ITM is 32% for either option. These probabilities are additive.

Conclusion

The probability that either the put or call will finish ITM is ~64%, and the chance that the iron condor will expire worthless is only 34%. That is nothing near the 68% that you mentioned.

It gets worse. If you decide to determine the probability that the underlying stock or index will move to touch either the put or call strike price during the lifetime of the options, you will discover that the probability of touching is much higher than the probability of finishing ITM. Assuming you would make an adjustment, the probability of keeping the entire sum is now far less than 34%.

Iron condors are riskier than they may first appear. That's why risk management is so important.

By Mark Wolfinger of Options for Rookies

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