Vertical spreads are fairly versatile when making a directional stance. But what if you're stuck in a range-bound market? Enter...The Iron Condor.
In our daily educational program, Swim LessonsSM, we seek to teach options traders about risk-defined, high probability options trades. In past columns, we’ve covered buying vertical spreads and selling vertical spreads.
Vertical spreads are fairly versatile when making a directional stance. Selling a put vertical spread would be a bullish trade. Selling a call vertical spread would be a bearish trade. But what if you are neutral, or if we’re stuck in a range-bound market? Enter… The Iron Condor.
The following, like all of our strategy discussions, is strictly for educational purposes only. It is not, and should not be considered, individualized advice or a recommendation.
Don’t be intimidated by this options strategy. We get it – it sounds like the band name you wish you would’ve thought of for your high school garage band, or the name of a video game “super boss” you encounter at the end of the game. However, when you open up the hood of this strategy, it’s really a combination of two fairly basic options strategies, coupled with one awesome sounding name.
An 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. By selling two different OTM vertical spreads you’re collecting two premiums, but at expiration, the market can’t be in two places. At expiration, only one spread can go against you.
So it sounds like you’re able to bring in the premium for two spreads without increasing your risk, right? Well, yes and no. Here’s an example to explain.
Let’s say you sell the 150-145 put spread and the 160-165 call spread, as an iron condor for a credit of $0.75. The maximum risk on either spread is $5.00 - $0.75, or $4.25 per spread (which is really $425 for a one contract spread) plus transaction costs. At expiration, if the stock is above $150 and below $160, then both spreads expire worthless and you keep the $0.75 ($75 per spread) as the profit (less transaction costs).
Yes, the maximum loss potential is $4.25 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 $170 at expiration without you worrying. Or, if you sold just the call spread, the stock dropping to $140 wouldn’t be an issue.
The iron condor requires the market to stay within a range of prices. How might one decide on the range, or the strike prices, for a given underlying? Figure 1 shows an iron condor with 10 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. The phrase "one standard deviation" is a fancy way of saying that, based on current option prices, it is expected that about 68% of the time the stock will stay within this range until expiration. It’s an expectation. In the real world anything can happen. Implied volatility is the estimated volatility of the stock's price.
FIGURE 1: IRON CONDOR RISK PROFILE.
Analyzing an iron condor showing the expected range until expiration. Chart source: thinkorswimÒ platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
With this example, the high-side short strike (the short call) is outside of this expected range. The low-side short strike (the short put) is near the edge of the expected range, with the expiration breakeven price of the stock right at the edge. If the stock were to stay within this range, then this iron condor wouldn’t lose. Of course, if the stock does move outside this range, then the iron condor will start to lose money, eventually losing the maximum if it moves below $145 or above $165.
If you think the market is going to move, then a basic short vertical spread might be the strategy to go with. But when you think a market will stay within a range, consider using an iron condor to bring in additional premium without increasing your dollar risk.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
Please note that the examples above do not account for transaction costs or dividends. Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade. Transactions cost for trades placed online at TD Ameritrade are $6.95 for stock orders, $6.95 for option orders plus a $0.75 fee per contract. Orders placed by other means will have higher transaction costs. Options exercise and assignment fees are $19.99.
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.