Iron Condors: Everything You Need to Know

06/13/2012 2:00 pm EST


Options traders often want to make bets on volatility. However, doing so can entail taking on inordinate downside risk. To limit this downside risk, we can use combinations of spreads, the most common of which is the iron condor.

While iron condors can be bought or sold, they are typically sold for a credit to take advantage of a stock or index that is in a trading range. They benefit from both time decay and a decline in implied volatility. Selling an iron condor is a bet that the underlying shares will remain in a limited range and have an accompanying low or decrease in volatility. If you were to buy an iron condor, you are banking on a break outside the range that is defined by the condor's outer strikes, or "wings."

Before jumping fully into iron condors, let's do a quick overview of put/call combinations. Astraddle is the simultaneous purchase or sale of a put and a call that have the same strike and same expiration. For example: On Friday, with the Spyder Trust (SPY) trading at $140.50, one could construct a long at-the-money straddle by buying:

The April $140 call for $1.40
The April $140 put for $0.70

In buying this straddle for $2.10 ($1.40 + 0.70), you are betting that the SPY will finish below $137.90, or above $142.10 at expiration. Note that both of these numbers are $2.10-or the cost of the straddle-away from the $140 strike price. In other words, the stock has to make a move greater than $2.10 in order to offset the purchase of the options.

A straddle is an uncovered position, meaning if you are long both puts and calls, your potential profit is theoretically unlimited should the underlying stock make a dramatic move. Conversely, if you sell a straddle, the profit is limited to the premium collected, while the potential loss is unlimited.
Let's reverse the example above, and assume we sold the April $140 call for $1.40 and sold the April $140 put for $0.70. In this case, the maximum profit would be the $2.10 credit received for selling the options, assuming the stock is trading above $137.90 or below $142.10 below expiration. So, on the short side of a straddle, we want the stock to make a move less than $2.10.

These uncovered positions make sense if you're willing to roll the dice ahead of an event like earnings, FDA decisions, or even an election. But otherwise, the probability of profitability is unattractive-particularly on the short side where your losses are theoretically unlimited.  

Another common call/put combination is the strangle. A strangle is a position that employs two different, typically out-of-the-money strike prices. So in the example above, instead of buying the $140 strikes, you might buy the $138 put and the $142 call. This allows you to pay just $0.50, but the breakeven points are further out at $137.50 and $142.50. So in exchange for a lower probability of making a profit, we pay out less in premium.

On the flip side, if we were to sell the strangle by selling the $138 put and the $142 call, we would take in just $0.50 worth of premium, but the probability of making money would be higher since our breakeven point would be further out. However, keep in mind that like a straddle, selling a strangle carries unlimited downside risk.

Button It Up to Limit Losses

That possibility of an unlimited loss is why I button up the strangles and straddles and turn them into condors.

A condor is a butterfly in which the "body," or midsection, is comprised of two strike prices instead of one. By constructing positions that are built on spreads, we not only limit risk, but also keep the margin clerks off our back in the event a position makes a big move in the wrong direction. 

A condor, or more specifically, a short iron condor, consists of selling two out-of-the-money spreads. Sticking with the SPY, an example of an out-of the-money iron condor might be:

Sell 1 April $142 at $1.50 a contract
Buy 1 April $144 at $0.50 a contract
Sell 1 April $139 put at $0.80 a contract
Buy 1 April 137 put at $0.42 a contract
This gives a net credit of $1.38 (calculated as $1.50 + $0.80 - $0.50 - $0.42).

Given that the width between strikes is $2, the maximum loss has been contained to $0.62 ($2.00 - $1.38), no matter how far below or above the SPY might fly outside the $137 and $144 strikes. The maximum profit of $1.38 would be realized if SPY is between $142 and $139 on the April expiration. We call them "iron" because turning these strangles into spreads limits their risk, making them like iron.

Playing the Probability

An iron condor is a time and volatility play. In selling premium, we benefit from time decay or theta and a decline in implied volatility that would accompany a range-bound stock price. On the other side, I see no reason to use condors as a long volatility play. To bet on a rise in volatility, straddles or strangles makes more sense. In particular, when it comes to the broader markets, buying a straddle or strangle on the SPY is far more effective than playing with something like (TVIX), which as we've seen, isn't particularly good at fulfilling its mandate. But if I think a certain stock or sector is range-bound, then selling a pair of out of-the-money spreads, a.k.a. our friend the iron condor, makes sense.

It helps to find names that have a relatively high-implied volatility while exhibiting a relatively defined trading range. While Wal-Mart (WMT) fits the bill of trading in a narrow range, the option premiums offered are low as it has just an 11% implied volatility. On the other hand, many of the commodity names, like Mosaic (MOS) or Potash (POT), which have been in range for the past four months, carry an implied volatility above 35%, which is a premium to their 30- day historic volatility, which is running below 25% in both cases. Furthermore, since they have a defined risk and reward, iron condors should be held until expiration. Meaning, even if the underlying shares move above or below the outer strikes and threaten a maximum loss, you should not close out the position prematurely. This is because iron condors have a natural stop-loss level. The maximum loss assumed on establishing the position is the credit minus the width.

For example, if you think Mosaic will stay between $54 and $60, then selling the April $50/$52.20-$60/$62.50 iron condor for a $0.33 net debit might make sense. Based on historic volatility levels, there is a only a 9.5% probability that shares of Mosaic will move the 6% up or down that will create a loss. On the other hand, implied volatility is pricing in a 7.5% move in the next month. This puts the odds in your favor that time decay and the reversion to the mean of IV (implied volatility) toward HV (historic volatility) will result a profitable position.

When establishing iron condors, assess the risk and reward and be prepared to hold it until expiration. The odds are known. Don't mess them up by trying to trade around them.

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