Iron Condors Fly On Fragile Wings

By Mark Wolfinger AAA

So, you've decided that buying iron condors is a strategy that meets your needs and will help you meet your financial goals. However, when you buy an iron condor, there are often many choices you can make that can affect its outcome. Among the decisions you must make when setting up an iron condor are the following:

  • How much you should try to earn per iron condor?
  • How much risk to take when trying to earn that profit?
  • Which options to trade?
  • Which underlying asset to choose?

Faced with these choices, it's possible to be frozen with indecision. This article provides guidance in helping you set up an iron condor that will meet your expectations and satisfy your personal preferences.

Determining Risk/Reward Potential
The probability of earning a profit is related to which options are sold (how far out of the money), not which options are bought. For readers who understand the Greeks, delta approximates the probability that an option will be in the money when expiration arrives. Thus, if you sell an option with a delta of .30 (or -.30), it will be in the money about 30% of the time on expiration day. (To learn about the meaning and importance of the Greeks, read Getting To Know The "Greeks" or check out our Options Greeks tutorial.)

Assuming you decide to buy an iron condor in a major index, there will always be many strike prices from which to choose. Although some strike prices are not tradable (no bids, and thus cannot be sold), with so many choices, you can find options that suit your preferences. (To learn more, see our Options Basics tutorial.)

The spread width (difference between the strike prices of the two calls or two puts) establishes how much money is at risk. Sadly this point is ignored by too many investors, who assume the position is so safe (because the options sold are far OTM) that it doesn't matter which option is bought, as long as some option is purchased. When the spread is narrow, the premium collected, the profit potential and the maximum loss (the spread × 100, minus the cash premium collected) are all reduced. When the spread is wide, more cash is collected, but the potential loss is higher. (To learn more, see our Options Spread Strategies tutorial.)

Remember: If you sell wide spreads to collect additional cash, you are placing yourself in danger of taking a large loss. The market can move further than what most traders think is possible. For example, Nassim Taleb has described how 'the tails of the curve' occur much more often in real life than is predicted by the mathematical bell curve. In other words, 'black-swan' (unexpected) events occur more frequently than randomness predicts, and it is important to be aware that these events can happen. If traders take on too much risk, they can lose much more than they bargained for. One of your tasks is to decide how much risk to take in an effort to earn the potential reward. It's a judgment call, and no specific 'rule' suits everyone.

If you decide to sell a put with a 1600 strike price when the index is 2000, that doesn't mean it's reasonable to buy the 1500 put and believe you are protected. Although it's a very unlikely occurrence, you risk losing up to $10,000 per iron condor (the spread between the strike prices of one hundred points multiplied by $100). If you buy the 1575 put instead, the loss is smaller ($2,500 or less) if that catastrophe occurs. Your choice is between more risk/reward or less of each.

Choosing An Expiration Date
Options with four to five weeks before expiration are a popular choice among iron condor buyers. Most sellers of option premium prefer short-term positions, but there's nothing wrong with moving out to a further expiration date when you cannot find a suitable iron condor in the front month (soonest to expire). Try not to go out more than an additional month or two.

Examining The Underlying
If the underlying has many strike prices, such as Google Inc. (Nasdaq:GOOG) or any of the broad-based indexes (such as SPX, NDX, RUT), then you have choices. The corollary is that low-priced and non-volatile stocks offer few choices.

Caution: Most index options have European-style options, which are very different from American-style options. Be certain you understand these differences before buying iron condors on the broad-based indexes.

Balancing Profit And Loss
Most iron-condor buyers enjoy the feeling of owning positions that are unlikely to become troublesome over the lifetime of the position. Writing options, collecting premium and watching the options expire worthless is a pleasant experience. It's a method that's touted far and wide over the internet. Please be aware that this is not the foolproof, guaranteed-to-make-money strategy that many claim it is. Disaster strikes without notice - frequently enough that the danger cannot be ignored. You don't want to see many months, or years, of profits lost in a single trade.

Thus, it's important to sell call and put credit spreads that meet your profit goals, tolerance for risk and overall comfort zone. Manage total risk by not buying too many iron condors at one time.

Your goal, as the buyer of iron condors, is to find the right compromise for yourself. Beware of accepting anyone else's guidelines. This is truly a matter of being comfortable with your positions. Most individual investors prefer options that are far out of the money. Their goal is to make a profit on a consistent basis, but that's not for everyone. Other investors prefer what they perceive as the 'safety' of collecting a large premium, thereby limiting losses. Despite the small chance of keeping the entire amount collected, they have the comfort of knowing their maximum loss is an amount they can accept. (For more on this strategy, see Take Flight With An Iron Condor.)

Conclusion
Buying iron condors is an attractive investment strategy for many because the probability of earning a significant profit is high. When trading iron condors on indexes (recommended), decisions must be made because there are often many options from which to choose. Remember that there is no single 'best' iron condor to trade. Each investor should be able to find an attractive profit potential and risk level that satisfies his or her own individual investment style. If you don't get overconfident, and if you are careful when managing the risk of your positions, iron condors represent an attractive strategy for all but the most volatile markets.

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