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Iron Condor: Profit Big on Small Moves
02/08/2012 7:00 am EST
The iron condor option strategy allows traders to earn outsized profits on little or no movement by the underlying asset, explains Chris McKhann, reviewing important execution and risk management items.
Most investments are made with the expectation that the price will go up. Some are made with the expectation that the price will move down. Unfortunately, it is often the case that the price doesn't do a whole lot of moving at all.
Wouldn't it be nice if you could make money when the markets didn't move? Well, you can. This is the beauty of options, and more specifically, the beauty of the strategy known as the iron condor.
How to Fly Like an Iron Condor
Iron condors sound complicated, and they do take some time to learn, but they are a good way to make consistent profits. In fact, some very profitable traders exclusively use iron condors.
So what is an iron condor? There are two ways of looking at it. The first is as a pair of strangles—one short and one long—at outer strikes. The other way of looking at it is as two credit spreads: a call credit spread above the market and a put credit spread below the market.
It is these two "wings" that give the iron condor its name. These can be placed quite far from where the market is now, but the strict definition involves consecutive strike prices.
See related: Basics of Iron Condor Options
A credit spread is essentially an option-selling strategy. Selling options allows investors to take advantage of the time premium and implied volatility that are inherent in options. The credit spread is created by buying a far-out-of-the-money option and selling a nearer, more expensive option. This creates the credit with the hope that both options expire worthless, allowing you to keep that credit. As long as the underlying does not cross over the strike price of the closer option, you get to keep the full credit.
In the following example, the puts and calls would have the same month of expiration (two months out perhaps). With an index at, for example, 1270, one might buy a 1340 call option (black dot below point 4 on the above chart) for $2.20 and sell a 1325 call (black dot above point 3) for $4.20. This would produce a credit of $2.00 in your account. This transaction does require a maintenance margin.
Your broker will only ask that you have cash or securities in your account equal to the difference between the strikes minus the credit you received. In our example, this would be $1,300 for each spread. If the market closes in September below 1325, you keep the $200 credit for a 15% return.
To create the full iron condor, all you need to do is add the credit put spread in a similar manner. Buy an 1185 put (black dot below point 1) for $5.50 and sell a 1200 (black dot above point 2) for $6.50 for another $1.00 credit.
Here the maintenance requirement is $1,400 with the $100 credit (for each spread). Now you have an iron condor. If the market stays between 1200 and 1325, you will keep your full credit, which is now $300. The requirement will be the $2,700. Your potential return is 11.1% for less than two months!
Because this does not presently meet the SEC's strict definition of an iron condor, you will be required to have the margin on both sides. If you use consecutive strikes, you will only have to hold margin on one side, but this clearly lowers the probability of success.
Tips for a Smooth Flight
There are several things to keep in mind when using this strategy. The first is to stick with index options. They provide enough implied volatility to make a nice profit, but they don't have the real volatility that can wipe out your account very quickly.
But there is another thing you must watch out for: you must not ever take a full loss on an iron condor.
If you have been paying attention and are good at math, you will have noticed that your potential loss is much higher than your potential gain. This is because the probability that you are correct is very high. In the above example, it is more than 80% on both sides (using Delta as a probability indicator that the market will not close beyond those strike prices).
See related: Using Delta to Predict Option Prices
To avoid taking a full loss, if the market does what it normally does and trades in a range, then you don't need to do anything and can let the whole position expire worthless. In this case, you get to keep your full credit. However, if the market moves strongly in one direction or another and approaches or breaks through one of your strikes, then you must exit that side of the position.
Avoiding a Bumpy Landing
There are many ways to get out of one side of an iron condor. One is to simply sell that particular credit spread and hold the other side. Another is to get out of the whole iron condor. This will depend on how long you have left until expiration.
You can also roll the losing side to a further-out-of-the-money strike. There are many possibilities here, and the real art of the iron condor lies in the risk management. If you can do well on this side, you have a strategy that puts probability, option time premium selling, and implied volatility on your side.
Let's use another example. With the XYZ stock at roughly $697, you could put on the following iron condor (with hypothetical premium prices):
- Buy Sep XYZ 770 call for $2.75
- Sell Sep XYZ 760 call for $4.05
- Buy Sep XYZ 620 put for $4.80
- Sell Sep XYZ 630 put for $5.90
The total credit is $2.40 with a maintenance requirement of $17.60. This is a potential gain of more than 13% with an 85% probability of success (again based on an appropriate Delta).
The iron condor option strategy is one of the best ways for an option trader to profit from an insignificant move in the price of an underlying asset. Many traders believe that a large move upward or downward is needed for them to make a profit, but as you've learned from the above strategy, handsome profits are possible even when the price of the asset does not really move far.
The structure of this strategy may seem confusing at first, which is why it is used primarily by experienced traders, but don't let the complicated structure intimidate you away from learning more about this powerful trading method.
By Chris McKhann, contributor, Investopedia.com
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