Traders make most investments with the expectation that the price will go up. They make some with the hope that the price will move down. Unfortunately, it is often the case that the price doesn't do a whole lot of moving at all. Wouldn't it be nice if you could make money when the markets didn't move? Well, you can. This is the beauty of options and, more specifically, of the strategy known as the iron condor.
- An iron condor options strategy allows traders to profit in a sideways market that exhibits low volatility.
- The iron condor consists of two option pairs: a bought put OTM and a sold put closer to the money versus a bought call OTM and a sold call closer to the money.
- Combined with prudent money management, the iron condor puts probability, option time premium selling, and implied volatility on the trader's side.
How to Take Off
Iron condors sound complicated and do take some time to learn, but they provide a good way to make consistent profits. In fact, some very profitable traders exclusively use iron condors. So, what is an iron condor? There are two ways of looking at it. The first is as a pair of strangles, one short and one long, at outer strikes. The other way of looking at it is as two credit spreads: a call credit spread above the market and a put credit spread below the market. It is these two "wings" that give the iron condor its name. These can be placed quite far from where the market is now, but the strict definition involves consecutive strike prices on the same expiration month.
A credit spread is essentially an option-selling strategy. Selling options allows investors to take advantage of the time premium and implied volatility that are inherent in options. The credit spread is created by buying a far out-of-the-money (OTM) option and selling a nearer, more expensive option. This creates the credit, with the hope that both options expire worthless, allowing you to keep that credit. As long as the underlying does not cross over the strike price of the closer option, you get to keep the full credit.
Tips for a Smooth Flight
There are several things to keep in mind when using this strategy. The first is to stick with index options. They provide enough implied volatility to make a nice profit, but they don't have the real volatility that can wipe out your account very quickly.
But there is another thing you must watch out for: You must not ever take a full loss on an iron condor. Your potential loss is much higher than your potential gain. This is because the probability that you are correct is very high. In the above example, it is more than 80% on both sides (using delta as a probability indicator that the market will not close beyond those strike prices).
To avoid taking a full loss, if the market does what it typically does and trades in a range, then you don't need to do anything, and you can let the whole position expire worthless. In this case, you get to keep your full credit. However, if the market moves strongly in one direction or another and approaches or breaks through one of your strikes, then you must exit that side of the position.
Avoiding a Bumpy Landing
There are many ways to get out of one side of an iron condor. One is to simply sell that particular credit spread and hold the other side. Another is to get out of the whole iron condor. This will depend on how long you have left until the expiration. You can also roll the losing side to a further out-of-the-money strike. There are many possibilities here, and the real art of the iron condor lies in the risk management. If you can do well on this side, you have a strategy that puts probability, option time premium selling, and implied volatility on your side.
S&P 500 Iron Condor Spread Example
With the S&P 500 at 3,330, one might buy the March 3,500 call option (orange dot below point four on the above chart) for $2.20 and sell the March 3,450 call (orange dot above point three) for $4.20. This produces a credit of $2 in your account. This transaction does require a maintenance margin. Your broker will only ask that you have cash or securities in your account equal to the difference between the strikes minus the credit you received. In our example, this would be $4,800 (1 x 50 x 100 – $200). If the market closes in September below 3,450, you keep the $200 credit.
To create the full iron condor, all you need to do is similarly add the credit put spread. Buy the September 3,100 put (orange dot below point one) for $5.50, and sell the September 3,150 (orange dot above point two) for $6.50 for another $1 of credit. Here, the maintenance requirement is $4,900, with the $100 credit (1 x 50 x 100 – $100). Now you have an iron condor. If the market stays between 3,150 and 3,450, you keep your full credit, which is now $300. The total maintenance requirement will be $9,700 ($4,800 + $4,900). Because this does not presently meet the Securities and Exchange Commission's (SEC) strict definition of an iron condor, you will be required to have the margin on both sides. If you use consecutive strikes, you will only have to hold margin on one side, but this clearly lowers the probability of success.
The Bottom Line
The iron condor option strategy is one of the best ways for an option trader to profit from an insignificant move in the price of an underlying asset. Many traders believe that a significant move upward or downward is needed for them to make a profit. However, as you've learned from the above strategy, traders can generate handsome returns when the price of the asset is non-directional. The structure of this strategy may seem confusing at first, which is why it is used primarily by experienced traders, but don't let the complicated structure intimidate you away from learning more about this powerful trading method.