Fly Sideways with an Iron Condor

05/05/2014 8:00 am EST

Focus: OPTIONS

Steve Smith

Reporter (Options Columnist), Minyanville

A lack of a true directional bias does not have to mean a lack of profits; there's an option strategy that can generate profits in sideways markets, says Steve Smith of Minyanville.com.

March was full of scary dips and sharp rips, but April has proven to be equally frustrating for investors. We've seen eight intraday moves of 1% or more, but only a 4.5% trading range. The net result is that the S&P 500 (SPX) is up 0.2% since March, and up just 1.6% for the year-to-date. And what you owned has seriously mattered.

Momentum stocks like FireEye (FEYE), Netflix (NFLX), and Amazon.com (AMZN) have been smashed, while Utilities SPDR ETF (XLU) and Energy Select Sector SPDR ETF (XLE) moved straight up.

That was a sharp reversal from 2013 through early 2014 when momentum ruled.

I see us as stuck in a range-bound market for the next few weeks as the S&P gyrates back and forth, grating on traders' emotions. However, a lack of a true directional bias does not mean a lack of profits.

One options strategy that can generate money in a sideways market is the iron condor.

Cranking out profits in this type of market environment usually means selling option premium. One common move is selling both puts and calls to create a strangle.

But these positions involve selling options naked, meaning the risk is theoretically unlimited. Another disadvantage is high margin requirements.

To get that margin clerk off your back and reduce risk, use an iron condor strategy instead.

An iron condor is constructed by simultaneously selling both a call spread and put spread that have the same expiration dates.

Let's look at a trade example using the SPDR S&P 500 ETF Trust (SPY). I see SPY as having defined a range between support at $184 and the old high at $189 per share. With the SPY trading around $187.80, one could sell the May $190/$192 - $184/$182 iron condor.

Here's what it looks like:

-Sell $190 call at $0.90.
-Buy $192 call at $0.30.

And:

-Sell $184 put at $0.85.
-Buy $182 put at $0.55.

As you can see, the call spread would net $0.60 and the put spread would net $0.30, for a total net credit of $0.90. This premium collected represents the maximum profit which would be realized if the SPY is between $184 and $190 on the May 17 expiration.

Within that range, each spread would be worth zero, meaning maximum profitability for those who sell the spreads. The maximum loss of $1.10 would be incurred if SPY is below $182 or above $192 at expiration. That is calculated by taking the width between strikes in the spreads, minus the premium collected.

For example, if SPY was at $193 at expiration, the long call spread would be worth $2 ($192 - $190), while the put spread would be worth zero. That would mean a loss of $2 on the short call spread, from which we would subtract the $0.90 premium collected at the outset, for a net loss of $1.10.

While the maximum risk outweighs the maximum reward, the probability of the trade achieving profitability is 70% based on current implied volatility levels.

Iron condors benefit from time decay, so it makes sense to use options with less than 30 days until expiration. If the market still seems range-bound at expiration, the position can be reestablished with the same or slightly altered strikes. 

As a probability play that has defined risk and reward, iron condors should usually be held until expiration. Unlike a long position, which can be rolled to more favorable strikes, adjustments to an iron condor usually mean you are whittling away at profit potential, or even locking in a loss. I like to set them and forget them.

Iron condor profits come slowly, and they can be scary during extreme market moves, but they can be an effective way but to generate steady income in a sideways market.

By Steve Smith, Contributor, Minyanville.com

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