New Ways to Interpret Iron Condors

03/26/2012 11:20 am EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

By breaking down the fairly complex iron condor strategy into the sum of its parts, traders can better understand the risk and manage their positions more effectively, explains Dan Passarelli.

Have you ever watched a baseball player warming up before a game? Or watched footage of a baseball player at practice? What are they doing? Swinging a bat, throwing and catching balls, running bases; working on the fundamentals. To be good at anything requires learning the fundamentals and constantly working on them throughout your career.

Option trading is no different. Even traders who have traded for years, or who trade complex strategies, return to the fundamentals to make their trading decisions. Take trading iron condors: trading iron condors requires utilizing the fundamentals. Traders who are trading iron condors are trading a fairly complex, four-legged option strategy. They need to be able to visualize the strategy in order to analyze it and ultimately decide whether or not they should be trading iron condors or something else.

Traders trading iron condors should consider the spread from several different perspectives. Specifically, they should consider it as combinations of other spreads. When a trader is trading iron condors, the trader is in fact trading a pair of credit spreads. An iron condor is a put credit spread combined with a call credit spread. That’s one way to look at it.

See related: Iron Condor: Profit Big on Small Moves

Trading iron condors can also be considered from the strangle-trading perspective. An iron condor is a short strangle combined with a long strangle with wider strikes. The profit (and risk) comes from the short strangle, while the long one provides protection.

An iron condor can also be thought of as four individual option positions. Traders trading iron condors have a position in a long put, in a short put, in a short call, and in a long call. Thinking of trading iron condors from this perspective, in particular, can help traders make an adjustment and closing decision more effectively.

And, of course, an iron condor is, well, an iron condor! It is a single strategy in which the risk can be observed on a profit & loss (P&L) diagram, or through the option “Greeks.”

See also: Option Greeks: The 4 Godfathers of Risk

This strategy-break-down technique is not just suited for trading iron condors, but for trading all multi-legged strategies. It is an effective analysis technique akin to how car shoppers consider buying a car. They look at the front; then walk around to the side, then the back; they look under the hood and at the interior. All the while, they are considering this one purchase, but just from many different perspectives.

By Dan Passarelli of MarketTaker.com

Related Articles on OPTIONS