The Iron Condor Has a Soft Spot

06/12/2012 10:05 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

Under certain conditions, a bear call spread is a superior option strategy to the iron condor, explains Josip Causic of Online Trading Academy, citing an example where the bear call achieved max profit.

Recently, the following question was posed: “When do we use a bear call spread instead of an iron condor?”

The simple answer would be when the time frame that we are trading is showing a clear downtrend with no obvious support (demand zone) from which the underlying could violently bounce back up. However, there is so much more to this question than meets the eye, so let us look at one short vertical call spread that would have worked well and compare it against a short iron condor that would have gone wrong.

Part 1: Bear Call with a Max Profit

Let’s assume that the underlying is trading at the time of entry at $81.82 and a vertical call spread is sold. The sold vertical call spread is also known as a bear call, for it is built by calls, yet the strategy is not a bullish one.

The aggregate of the two options’ Deltas (sold call and bought call) produces a negatively correlated Delta. Whenever Delta is negative, the position’s outlook is bearish by nature. A short bear call benefits from time decay, hence, it is wise to sell a bear call when the implied volatility is high or at its higher range.

When placing the actual bear call trade, it is essential that the trader determine where the price will not be at expiry. If, for instance, the trend is bearish and an underlying is trading below a major area of resistance, then that resistance could be used for strike price selection. For instance, if an optionable stock is trading at $81.82 and the $95 zone is acting as a significant level of resistance, then selling the front-month 95 call would make perfect sense.

However, prior to the sale of the 95 call, the next higher strike price needs to be purchased; otherwise, the trader would end up with a naked 95 call position. Such a position might require a large maintenance by the brokerage house, or the trade might not even go through if the size of the option trader’s account is not big enough. In that case, the trade would simply get rejected.

Let’s assume that a sold vertical call spread is made up of the following components: Long June 100 call and short June 95 call. The specifics below are for a single contract of each leg (BTO stands for “buy to open” and STO stands for “sell to open”).

BTO + June [.16 Delta] 100 call @ – 1.15 (four strike prices OTM) (a minus means money taken out of the trader’s brokerage account)

STO – June [.24 Delta] 95 call @ + 1.90 (three strikes OTM) (a plus means money deposited to the trader’s brokerage account)

Max Profit = $0.75 (Max profit is also known as max reward, credit, prize, or gain)

Max Loss = $4.25 (Max loss is also known as max risk, cost, or pain)

Max Loss is calculated by subtracting the max profit from the spread width (100 call – 95 call equals five points, and $5.00 - $0.75 gives $4.25)

Risk/Reward Ratio (RRR) or ROI (return on investment) is found by dividing the max profit by max loss (RRR = $.75/$4.25, or 17%)

Break Even Point (BEP): Sold call strike price plus the credit received (95 call + $0.75 = $95.75)

Figure 1: Stock closes below $95, or specifically, at $70 and the spread trader keeps the max profit

chart
Click to Enlarge

NEXT: The Iron Condor Sustains a Max Loss

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Part 2: Iron Condor with a Max Loss

Next, let us assume that an iron condor was placed on the very same underlying. An iron condor is a complex vertical spread built of two short verticals: a bear call, already explained above, and a bull put. Knowing that the current price is at $81.82 and the trader forecast of the time frame traded is neutral, then the following could be the case for the bull put side of an iron condor:

STO – June [+.24 Delta] 75 put @ + 1.90 (two strikes OTM)

BTO + June [-.16 Delta] 70 put @ – 1.15 (three strike prices OTM)

Max Profit = + 0.75

Max Loss = 4.25

Max Loss is calculated by subtracting the Max Profit from the spread width (75 put – 70 put equals five points, and 5.00 – 0.75 gives 4.25)

Risk/Reward Ratio or ROI (return on Investment) is found by dividing the max profit with max loss
(RRR = .75/4.25, or 17%)

Break Even Point (BEP): Sold put strike price minus the credit received (75 put – $0.75 = $74.25)

The iron condor’s max profit would be $1.50, which is the aggregate of both the bear call’s max profit and the bull put’s max profit. The iron condor could only be wrong on one side at one time; hence, $5.00 wing spread minus $1.50 = $3.50 max loss on the entire iron condor.

Next, let us assume that, just as we had in the earlier example, Figure 1, the underlying tanked and closed at $70. Figure 2 shows the outcome for the stock that closes on the expiry at $70.

chart
Click to Enlarge

Although Figure 2 shows the max loss of $4.25, it is only for one side of the iron condor, the put side. The bear call side had achieved its max profit as shown in Figure 1; therefore, the total loss on the iron condor is reduced by $0.75 because of the bear call working out, so it is only $3.50.

In conclusion, this article has presented the scenario of an iron condor that has gone bad. Keeping in mind that iron condors are built using two short verticals, it is easy in hindsight to state that the trader should have placed either a bear call or a bull put instead of placing the whole thing.

Nonetheless, either trade, the iron condor or vertical spread, must be monitored, and if something goes wrong, action needs to be taken. Proactive traders are more profitable than the ones who react after the fact.

When the trade is clearly planned out, there is no time for hesitation. Once it is planned, it is much easier to follow the predetermined course of the action. Always plan trade exits beforehand and trade the plan.

By Josip Causic, instructor, Online Trading Academy

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