Vertical spreads are fairly versatile when making a directional stance. But what if you're stuck in a range-bound market? Consider the iron condor.
Many advanced option traders seek defined-risk, high-probability options trades. With options trading, active traders understand it’s impractical to expect every trade to be profitable. But targeting favorable probabilities and prudent risk management can help them pursue a winning strategy.
Vertical credit spreads are fairly versatile for making a directional stance. Selling a put vertical spread would be a bullish trade. Selling a call vertical spread would be a bearish trade. Plus, when selling verticals, your risk is defined: It’s limited to the width of the long and short strikes, minus the premium collected (and minus transaction costs). But what if your viewpoint is neutral, or if the underlying stock seems stuck in a range-bound market? Enter the iron condor.
The following, like all of our strategy discussions, is strictly for educational purposes. It is not, and should not be considered, individualized advice or a recommendation.
Don’t be intimidated by this options strategy. Sure, it sounds like a high school garage band name, or maybe a video game “super boss.” But when you open up the hood of the iron condor strategy, it’s really a combination of two fairly basic options strategies, coupled with one awesome-sounding name.
The iron condor is what you get when you combine an out-of-the-money (OTM) short put spread (bullish strategy) and an OTM short call spread (bearish strategy) using options that all expire on the same date. See figure 1 for the risk profile.
By selling two different OTM vertical spreads, you’re collecting the premiums from both sides of the iron condor as one order. But the market can’t be in two places at once. So at expiration, only one spread can go against you.
It sounds like you’re able to bring in the premium for two spreads without increasing your risk, right? Well, yes and no. Let’s look at an iron condor example to help explain.
Suppose a stock is trading at $112 and you sell the 110-105 put spread and the 115-120 call spread, as an iron condor, for a credit of $2.59. The maximum risk on either spread is $5 – $2.59, or $2.41 per spread (which is really $241 for a one-contract spread) plus transaction costs. At expiration, if the stock is above $110 and below $115, then both spreads expire worthless and you keep the $2.59 ($259 per spread) as the profit (minus transaction costs).
Yes, the maximum loss potential is $2.41 for either the put spread or the call spread, so you haven’t increased your dollar risk by selling both spreads. But you have increased the risk of loss in terms of where the market can go for that loss to happen. For instance, if you had sold just the put spread, then the stock could go to $125 at expiration without you worrying. Or, if you sold just the call spread, the stock dropping to $100 wouldn’t be an issue.
The iron condor’s success depends on the market staying within a range of prices. How might you decide on the range, or the strike prices, for a given underlying? Figure 2 shows the spread described above with 48 days until expiration. The light gray portion in the middle of the risk graph highlights the “one standard deviation” expected range based on the current level of the implied volatility. That’s just a fancy way of saying that, based on current options prices, it’s expected that about 68% of the time the stock will stay within this range until expiration. But that’s an expectation. In the real world, anything can happen.
Note that in this example the standard deviation falls outside the point of maximum loss. That’s not to say this spread has a high chance of losing money, but rather, such a move wouldn’t be out of the ordinary. Looking for a narrower standard deviation relative to the max profit and loss? Consider an iron condor with fewer days until expiration or one with tighter strike widths. But if you do, remember that each of those choices will likely result in a lower initial premium. Plus, because it’s a spread with four legs, it comes with four commission charges.
Alternatively, if you think the market is going to either stay in a tight range or move in a certain direction, then a basic short vertical spread might be the strategy to go with. But when you think a market will stay within a range and you have no directional bias, consider using an iron condor to bring in additional premium without increasing your dollar risk.
Options strategies are about trade-offs, and it all comes down to your objectives and risk tolerance.
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