Learn how an trading an iron condor can be an effective options strategy during earnings season.
Earnings season is upon us, and with it brings increased volatility for those stocks reporting results. Highly anticipated by investors, quarterly earnings announcements can provide important insight into how well a company is doing. These one-day events can be extremely volatile for individual stocks because of the uncertainty surrounding these announcements.
The timing of earnings will affect the pricing of options differently depending when they expire. Because of this, option expiration cycles that encompass an earnings date typically have higher implied volatilities in that cycle. If the market believes a stock might move more following an earnings announcement, that expiration cycle’s implied volatility will be elevated.
The implied volatility of a particular option expiration cycle is made up of normal volatility days, plus any volatility event (earnings) days from now till those options expire. As an earnings announcement approaches, there are fewer normal volatility days and the effect of the earnings event volatility will become more pronounced.
The short iron condor is a risk-defined strategy with characteristics designed to allow a trader to take advantage of elevated option premium during earnings. Just in case you're new to iron condors, let’s go over some of the basics of the strategy.
A short iron condor is a four-legged spread constructed by selling one call vertical spread and one put vertical spread simultaneously, in the same expiration cycle. Typically both vertical spreads are out of the money and centered around the current underlying price. Similar to a single vertical spread, the risk is determined by the distance between the strikes of the vertical.
If the vertical spreads are $2 wide, the risk would be $200 per contract, minus the credit received for selling the iron condor, plus transaction costs. In the best-case scenario, the price of the underlying stays between the two short strikes through expiration, and both vertical spreads expire worthless. This allows a trader to keep the full credit that the iron condor was sold for, minus transaction costs.
Let’s look at a hypothetical example. Suppose a trader would like to create a neutral short iron condor position on XYZ, which is currently trading at $52.50. To create the position, the trader could sell a $47.5 put, buy a $45 put, sell a $55 call, and buy a $57.5 call for a combined credit of $0.70. This would give the trader a $7.50 range between the put, with a low strike at $47.50 and the call, with a high strike at $55, in which the trade could achieve its maximum profit potential. The position would have an upside breakeven level of $55.70 and a downside breakeven level of $46.80, as shown in figure 1. If the stock remains between the short $47.5 and $55 strikes through expiration, the maximum potential profit would be $70 per contract, minus transaction costs (the credit received when the position was initiated). The maximum potential loss would be $180 ($250 max risk - $70 credit received) per contract plus transaction costs.
FIGURE 1: EXAMPLE IRON CONDOR PROFIT AND LOSS.
The upside breakeven level for this example iron condor is at $55.70 and the downside breakeven level is at $46.80. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
When volatility levels are elevated, so are the credits that can be collected when selling an iron condor. Any increase in volatility typically expands an option’s premium, which inflates the prices of the individual vertical spreads. No matter where the volatility goes, the risk lies with the underlying moving outside the outer strikes ($45 and $57.5, in the example above), but is defined by the distance between the vertical strikes.
The short iron condor is a strategy to potentially consider implementing in times of uncertainty, such as prior to earnings announcements. This strategy is designed to take advantage of inflated risk premium in a risk-defined manner. By taking this position prior to earnings, a trader is making two basic assumptions:
The key is to understand that the market is pricing in what it feels the potential move will be, and a short iron condor can be used when a trader feels the market is overstating the potential move.
Get step-by-step TradeWise trade ideas from former floor traders delivered directly to your inbox. At checkout, enter coupon code "ticker."
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
*When the two months have passed, keep the TradeWise service for just $20 per strategy per month.
TradeWise Advisors, Inc. and TD Ameritrade, Inc. are separate but affiliated firms. Advisory services are provided exclusively by TradeWise Advisors, Inc. and brokerage services are provided exclusively by TD Ameritrade, Inc. For more information about TradeWise, please see ADV 2 on www.tradewise.com.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2018 TD Ameritrade.