Find Profits By Hedging Iron Condors

By Ryan Campbell AAA

It has been said that "options were made to be sold" because of their depreciating premiums. Many investors ventured into the options world because of leverage, which allows them to control hundreds of shares with a small amount of money. Over time, options investors quickly learn that the premiums' melting time value make speculation difficult. Those who stick with and study options markets commonly sell them because success is easier to achieve. A popular option selling strategy is that of selling iron condors. However, if you've tried this strategy, you may have found iron condors move quickly against you with a stock sell-off as implied volatility swells and the lower wings' cost increases. This article should help you learn how to hedge iron condors against implied volatility surges and market movements. (For a review on option pricing, check out Understanding Option Pricing.)

Flight of the Iron Condors
Most investors move into iron condors because they tend to be positive theta trades, which means that simultaneously selling the two vertical spreads will work as long as the stock price remains in between the two short positions known as the body of the condor. Depending on the stock instruments employed, you may be able to stretch your iron condor wings well out of the money (OTM). The further you stretch them, the higher probability of success you may achieve. However, stretching them too far may cause the gained premium to be too small to be worth your while.

Figure 1 is a risk profile tool available to thinkorswim® subscribers. The lighter-shaded area denotes one standard deviation using the probability of success calculator. The calculator uses the implied volatility of options to help determine a likely area in which the stock price could remain through expiration. In this example, the condor strikes are at 89/93/115/119 with approximately 46 days to expiration. For this example, the stock needs to remain between the short 93 put and the short 115 call strikes to achieve maximum profitability. This is a very wide area for the price to stay within, even without any unforeseen events. The stock's current price is $104.52 and the spread, if five condors are sold, nets a credit of $305, not including commissions. At this point, option sellers listen to the Rolling Stones and wait because they know that "time is on [their] side."

Figure 1 - Trade Risk Profile
Source - thinkorswim


Iron Condor Weaknesses
As long as the stock stays within the short strikes, the trade will be profitable; in fact; if the stock moves up, the iron condor will likely become profitable faster as long as it stays below the short call. This is the case because of the inverse relationship that normally exists between price action and implied volatility. Commonly, when price rises, implied volatility or vega decreases. Decreasing vega helps theta eat away at the option premium's extrinsic value. Figure 2 shows the relationship of the S&P 500 (SPX) and Volatility Index (VIX). The VIX is the implied volatility of the index options for the SPX. Notice that when the price of the S&P 500 (black) rises, the VIX (blue) tends to fall or deflate. This is very positive for iron condors because the width of the spread allows for some price movement, but more importantly, capitalizes when vega collapses. This may actually result in a wise option seller closing out of the position earlier than expected to lock in profits. (Discover a new financial instrument that provides great opportunity for both, hedging and speculation, read Introducing the VIX Option.)

Figure 2 - S&P 500 vs. Volatility Index
Source - ProphetCharts®

Of course, falling price action typically results in rising implied volatility, making it harder for the theta in an iron condor to do its job. If the stock price keeps moving lower and threatens the short put while vega is rising, it can result in larger losses. Theoretically speaking, theta can move to infinity, and therefore, the loss could be unlimited if the stock trade isn't closed. Hence, it's important to hedge the downside of an iron condor to prevent loss or at least reduce losses. Please note the security-to-implied volatility relationship is conversely correlated in stocks but can be different in futures markets and their associated derivatives.

Put Calendar Hedge
To offset the falling prices and rising vega, option sellers should consider using OTM put calendars as a hedge. This type of trade does well in down markets and when implied volatility rises. Many investors have likely used or considered using long puts to hedge a position; however, a calendar can be more efficient because it turns a negative theta position into a positive theta position, keeping in harmony with the trade's original intent.

Even though the calendar's long and short sides will be inflated by the rising implied volatility, the longer-term long put will be more sensitive to the rising vega and help offset the rising implied volatility in the short-term short positions. In fact, Figure 3 shows a new risk profile for the iron condor when the put calendar is placed near the break-even point. In Figure 1 the breakeven point was at $92.38, but with the new calendar hedge, the break-even point moved lower to $91.73. Also, notice the difference in the decline of the loss; it is much more difficult to realize a maximum loss because the profile has what statisticians refer to as a fat tail. It isn't difficult to notice that at this point our fairly neutral trade now has a bearish bias.

Figure 3 - Risk Profile Iron Condor with a Put Calendar
Source - thinkorswim

The Figure 3 example is the same 89/93/115/119 iron condor for a $305 credit when five condors are sold, plus one 93 strike put calendar of a short current month option and another long option four months later for a $210 debit. At first glance, it is likely that new option sellers will experience sticker shock on the cost of the hedge. At first the trade was making a decent credit of $305, but when the cost of the hedge came in, the credit was reduced to a paltry credit of $95 (305 – 210 = 95). First off, it's important to realize that the put will usually pay for itself over time. Currently the cost of the four-month long put is about $315, but the short put in the calendar offsets some of the cost by bringing in an additional credit of $105. Not only do we have this month to sell the credit, but we have three additional months to sell short positions against. At the same time, we can sell iron condors month after month with our hedge already in place. Each month we can sell a different strike price on the calendar, so the first month may be a calendar but the next month may change to a diagonal spread to achieve greater returns.

What If?
Using the thinkorswim Bjerksund-Stensland calculator located on the platform, we can experiment with the trade in various scenarios. If price moves up to $114 and implied volatility drops 10 percentage points, the trade could be closed at a profit as early as four days before expiration. However, we expected that, so our real concern was with the downside risks. If the stock price fell to $93 and implied volatility spiked 10 percentage points, we could actually make more than $370. It's vital to note that without the hedge in place, we have a loss of nearly $109 on the trade. (For an overview of metrics implemented by hedge funds, refer to Quantitative Analysis of Hedge Funds.)

Almost any professional investor who has a period of continued success in the markets will tell you that investing and trading is all about controlling losses. Hedging iron condors is one way to help control losses and can even make you more profitable in some cases and will commonly pay for itself. Therefore, options sellers looking to increase their success will find hedging with calendars to be very important.

comments powered by Disqus
Related Articles
  1. The Better Inflation Hedge: Gold or ...
    Investing News

    The Better Inflation Hedge: Gold or ...

  2. How To Buy Oil Options
    Options & Futures

    How To Buy Oil Options

  3. Hedge Fund Fees: Exotic Expenses
    Investing Basics

    Hedge Fund Fees: Exotic Expenses

  4. What You Need To Know About Financial ...
    Insurance

    What You Need To Know About Financial ...

  5. Narrow Your Range With Stop-Limit Orders
    Investing Basics

    Narrow Your Range With Stop-Limit Orders

Trading Center