Iron condors are a widely used options strategy among both professional money managers and individual investors. Before diving into how to trade them effectively, it's important to understand what they are and how they work.
Key Insights
- Understanding Iron Condors: An iron condor involves four options contracts and is constructed by selling both a call spread and a put spread on the same underlying instrument. It represents a market-neutral strategy, offering neither bullish nor bearish sentiment.
- Implementing Iron Condor Positions: Implementing an iron condor involves selling out-of-the-money call and put spreads, with equal width, on the same underlying asset. The investor profits if the underlying asset stays within a confined trading range until options expire.
- Profit and Loss Dynamics: The ideal scenario for an iron condor is for all options to expire out-of-the-money, resulting in maximum profit. However, it's often advisable to close the position before expiration to lock in profits and eliminate the risk of loss.
- Maximum Loss and Premium Loss Protection: The maximum loss in an iron condor occurs when both call and put spreads expire in-the-money, but this loss is mitigated by the premium received at the time of sale. Risk exposure can be managed by choosing options with different strike prices and expiration dates.
Risk Management Considerations: While iron condors are low-risk strategies, risk management is crucial for long-term success. Traders may close positions early to reduce losses or adjust their portfolio to minimize exposure to unfavorable positions. Practice accounts are useful for testing iron condor strategies and determining their suitability for individual trading styles.
An iron condor is an options strategy that involves four different contracts.
Some of the key features of the strategy include:
- An iron condor spread is constructed by selling one call spread and one put spread (same expiration day) on the same underlying instrument.
- All four options are typically out-of-the-money (although it is not a strict requirement).
- The call spread and put spread are of equal width. Thus, if the strike prices of the two call options are 10 points apart, then the two puts should also be 10 points apart. Note: it doesn't matter how far apart the calls and puts are from each other.
- Most often, the underlying asset is one of the broad-based market indexes, such as S&P 500 (SPX), Nasdaq 100 (NDX) or Russell 2000 (RUT). However, many investors choose to own iron condor positions on individual stocks or smaller indexes as well.
- When you sell the call and put spreads, you are selling the iron condor. The cash collected represents the maximum profit for the position.
- The iron condor strategy represents market neutrality, meaning the investor has neither bullish or bearish sentiment with regards to that particular index or equity.
To illustrate the necessary components or steps in selling an iron condor, take the following two hypothetical examples:
To buy 10 ABC Oct 55/65/80/90 iron condors:
- Sell 10 ABC Mar 80 calls
- Buy 10 ABC Mar 90 calls
- Sell 10 ABC Mar 65 puts
- Buy 10 ABC Mar 55 puts
To buy three XYZ Feb 100/120/220/240 iron condors:
- Sell three XYZ Aug 220 calls
- Buy three XYZ Aug 240 calls
- Sell three XYZ Aug 120 puts
- Buy three XYZ Aug 100 puts
Profit and Loss Dynamics
You hope the underlying index or investment stays in a confined trading range from the time you begin the position until the options expire.
If all options expire out-of-the-money, you keep every penny (less commissions) from selling the iron condor. That's is the ideal scenario. It won't happen every time, but it will.
It is often advisable to forego the last few pennies of prospective profit and close the investment before expiration. This locks in a profit and eliminates the risk of loss. Correct risk management is a must for every traders, including those that are using this method.
The markets aren't always accommodating, and indices or securities can have unpredictable price fluctuations. In that case, the underlying asset's price (ABC or XYZ in the examples above) may change significantly.
Because this is not beneficial for your standing (or your finances), there are two essential pieces of knowledge that you need to have: first, how much money you stand to lose, and second, what actions you may take if the market begins to behave erratically.
Maximum Loss
When selling 10-point spreads (as with ABC), the worst-case scenario is when both calls and puts expire in the money (above 90 or below 55). The spread is 100 times the difference between the strike prices in that case. So 100 x $10 = $1,000.
If you sell two iron condors, the worst that may happen is that you must pay $2,000 to close the position. The stock's movement won't effect you further. Owning the 90 call or the 55 put protects you from further losses because the spread can't be worth more than the strike difference.
Premium Loss Protection
Good news: Keep in mind that the risk is mitigated by the premium paid at the time of purchase. Assume each iron condor is worth $400. $400 minus $1,000 equals $600. So the most you can lose is $600 per iron condor.
Note: If you keep the trade open until the options expire, you can only lose money on one of the spreads; they cannot both be in-the-money at the same time.
Depending on the options (and underlying assets) you buy and sell, a few situations can occur:
- By choosing further out-of-the-money will reduce the risk exposure. However also the potential reward will be reduced.
- On the other hand, by choosing options that are less far out-of-the-money will increase the potential reward. However, the probability of receiving that gain is less likely.
Finding comfortable solutions may require trial and error. Use indices or sectors you understand.
Risk Management Considerations
Although the iron condor is a low-risk strategy, that doesn't imply you should sit back and watch your money go when things don't go your way. Risk management is vital to your long-term success while trading iron condors. However the topic of risk management is too extend and can't be covered in depth here. So, we will limit to looking at a few but important points.
In the same manner that you do not always make the full profit when the trade is advantageous (because you terminate the position before the expiration), you frequently lose less than the maximum amount when the position swings against you.
This may arise for numerous reasons:
- You may close early to reduce losses.
- It's possible that ABC stock will reverse trend and start moving in your favor again.
- It's possible that ABC will reverse trend and start moving in your favor again. ABC may not reach 90. For example, if the settlement price of XYZ at expiration is 87, a call with a strike price of 85 is just two points in the money, or $200. Although you lose everything when the other three options expire worthless, you can still come out ahead after buying back the option, in this case by $50.
Open Practice Account
Even if you are a seasoned trader, you should use a trading simulator to test out iron condor strategies and see if it's right for you. This will give you the opportunity to gain experience without risking money.
Select two or three underlying assets to trade, or trade one asset using varying expiration months and strike prices. As time passes and markets change, you'll observe how the different iron condor positions perform.
The primary goal of paper trading is to determine whether iron condors are suitable for you and your trading style. Comfortable positions are key. When risk and reward are balanced, you will feel and trade relaxed. When your comfort zone is violated, adjust your portfolio to remove, or reduce exposure, to worrying positions.
Summary
Iron condors make it possible to invest in the stock market without having a certain leaning in any direction, which is something that many investors and traders find to be quite comfortable. This options technique allows for low-risk, high-probability bets.