How to Trade Option Iron Condors

There are more option strategies than option strategists, but at their heart they are all modifications of basically two ideas – buying and/or selling options. The proliferation of options strategies come from the infinite ways that these two concepts can be combined. Some of these combinations can be great ideas but others are just commission generators with the difference usually resting on how you implement them as a trader.

In this article I will start discussing one such combination strategy that is becoming more and more popular with option investors all the time – the iron condor. An iron condor is a combination of a long and short strangle, which is also the same as two credit spreads.

When abused, the iron condor strategy can be a great way to make money (if you are an option broker) because they are very high-commission trade. However – if they are applied appropriately – iron condors can be very interesting for risk tolerant investors.

Iron condors are often marketed by advisory services and brokerages as a “high probability” trade. Unfortunately that phrase is very misleading and can give option traders a false sense of security.

In this video series we will discuss why the inexperienced call these trades “high probability” and why that is not necessarily true. This is important to understand because it will focus your attention on analysis that matters rathe r than arbitrary and theoretical probabilities.

The video has a case study of an iron condor and the steps for entering one yourself follow below.

[VIDEO] Iron Condors – Part One

 

1. Liquid ETFs and index options

Costs are the enemy of option traders and many trading costs are contained in the bid/ask spread. Because and iron condor has 4 legs (4 different options) it has 4 bid-ask spreads, which can really add up to your disadvantage. Liquid ETFs like SPY, IWM or GLD and index options have tighter spreads and therefore smaller costs. In our example we will use S&P 500 ETF (SPY), which fits this liquidity requirement.

2. Create your profitability range

An iron condor starts with a short strangle. That means you are trading a short call and put that are both equidistant from the at the money strike price. You are paid the premium from these two short options but have potentially unlimited risk if the market moves beyond either strike. This is why many iron condor traders are tempted to make the range between the two short strikes very wide.

This is where we run into the “high probability” problem. A wide range seems to make it more likely that the trade will end successfully but it also increases the potential losses relative to profits if you are wrong. In the video we will walk through some specific strike prices for our case study.

3. Cover the short options with long options that are even further out of the money

Short strangles make many option traders nervous because a short option has theoretically unlimited risk. One alternative to this problem is to cover each short option with a long option that is even further out of the money. This step adds a long strangle to the short strangle that has the affect of limiting the maximum risk in the trade.

This reduces the premium paid significantly but it does provide the benefit of fixing the maximum possible loss. The other benefit from this action is to reduce the margin requirement. A naked short option requires a large margin deposit that is often 20-30% of the total value of the highest strike price of the options you sold. The margin requirement for an iron condor is limited to the spread between the long and short calls or puts.

The mechanics of entering an iron condor are not that complicated when evaluated one component at a time. Like all option strategies, entering the trade is only one of the problems to be solved. In the next video in this series we will cover how to make adjustments, exiting early and expiration issues.

An iron condor can be designed to accommodate your risk tolerance and account objectives but those adjustments will always have a trade off. As with most option selling strategies this means there is an exchange of a higher probability of a successful outcome and lower premiums or higher risk and larger premiums.

Most iron condor traders opt for a fairly wide spread between the two short strikes to increase the probability that the underlying ETF won’t close at expiration beyond those prices. This obviously reduces the premium paid and should not be taken to extremes.

How far apart those short strikes “should” be is a difficult question to answer. As with trading any option or stock strategy, the answer probably depends on your personal risk tolerance. Getting to know what kind of risk you can tolerate within a trade like this requires some experimentation and paper trading.

We have spent a fair amount of time talking about the trade off between probability and premiums so that you will understand the importance of appropriate expectations. Managing risk is a function of position size as well as the choice of strike prices. Getting into a position that is too large for your peace of mind can be a disaster.

Position sizing for an iron condor is relatively simple because the maximum loss is known in advance. You can consistently size your iron condor trades by allocating a consistent percentage of the portfolio available for these strategies per trade. In the example we used in the first article we knew that the max loss was $1.04 per share or $104 per iron condor. If we assume that we are willing to risk 5% of a $5,000 portfolio then we can use that maximum risk amount to calculate the appropriate position size as 2 spreads.

1. $5,000 (capital) X 5% (maximum acceptable loss) = $250 (available capital per trade)
2. $250 / $104 = 2 spreads

[VIDEO] Iron Condors – Part Two

 

Being consistent in your position sizing is important and varies based on what strategy you are using and you personal preference. A bad trade can be emotionally trying but you can minimize those issues by understanding the risk in the trade and staying with small position sizes. You can learn more about position sizes here.

Iron condors are a relatively straight forward in the pre-trade analysis and order entry process. It is a high cost strategy to trade so most options-centered brokers have made it easy for traders to execute easily. The difficulty of an iron condor is in the trade management and adjustment process. Effectively managing an iron condor trade when the market is moving is ambiguous and subject to your own personal risk tolerance.

Iron condors are typically entered with a very high risk/reward ratio and a very high win/loss ratio. That means that if you set each trade and left them alone through expiration you would probably be right much more often than you are wrong, however, when you are wrong the losers are much bigger than the winners.

In the example that I used in the prior two articles I had a risk/reward ratio of nearly 1:1 however the short strikes were very close together and based on prior experience I would expect to be wrong frequently. You may choose to move the short strikes much further away from the current index price to increase the win/loss ratio but remember that this will also increase your risk/reward ratio.

When the short strikes are moved very far away from each other the risk/reward ratio increases against the trader. If you were to look at the iron condor orders currently working on the SPY for next month’s expiration there are more traders trading with risk/reward ratios in the 2:1 or 3:1 range than in the 1:1 region. This tendency to take on more risk and less reward in order to increase the win/loss ratio is common, however, this kind of exposure makes adjustments to the trade very difficult.

When the short strikes are moved very far away from each other the risk/reward ratio increases against the trader. If you were to look at the iron condor orders currently working on the SPY for next month’s expiration there are more traders trading with risk/reward ratios in the 2:1 or 3:1 range than in the 1:1 region. This tendency to take on more risk and less reward in order to increase the win/loss ratio is common, however, this kind of exposure makes adjustments to the trade very difficult.

There are many rules of thumb for how and when to adjust an iron condor but there isn’t a “rule set” that can be reliably applied to all markets. However, there are a few concepts that you should keep in mind as you evaluate an adjustment when the trade moves against you.

[VIDEO] Iron Condors – Part Three

 

The probability of expiring is not the same as probability of touching

When you execute an iron condor you may evaluate the short strikes’ deltas or other estimates to place a probability on whether the trade will expire inside the short strike range (win) or beyond them (loss.) This probability of expiring within that range is not the same as the probability of the stock’s price touching or passing those short strikes and then pulling back before expiration.

It is far more likely that at some point during the trade, prices will touch or pass one of the short strikes temporarily before expiration than that prices will actually expire beyond those strikes. These fakeouts or whipsaws will make an iron condor trader very nervous and can motivate over trading behavior. It is best to make sure you are using a small enough trade size that these “touches” do not affect you emotionally.

Be careful when adjusting a trade by entering a new spread

There is nothing wrong with exiting a losing iron condor and reentering with more time before expiration; or with a tighter spread between the short strikes; or with a larger trade size in order to offset losses but those actions should be carefully evaluated. In fact most experienced iron condor traders will recommend that a new trade should only be entered if it looks like a good opportunity on its own. Only enter a new spread if you would have wanted to trade that new spread anyway.

If the loss is unacceptable plan to exit

Many option sellers already have a predetermined maximum loss that they are willing to endure. If losses are mounting, know when you want to get out and be ready to take action. Iron condor traders with a very large risk/reward ratio may be surprised to find several months of profits eliminated by one trade that they let reach their maximum loss level. This account volatility can be difficult to come back from.

Option pricing changes over time

There is a lot of variability in option pricing so it can be very difficult if not impossible to transpose rules that work today into the future. For example, in 2008-2009 option premiums are high so the spread widths can be very wide. That was not the same in 2005 when premiums were lower. This means that your analysis has to be flexible in order to make sure you are accounting for current prices.

Don’t believe the hype

Lastly, keep in mind that there are a lot of “advisors” seeking to help you enter, adjust and exit these trades on a monthly basis. The promise of 10% monthly returns is common. These are scams. There are legitimate sources for help with these kinds of strategies and they are typically registered as actual investment advisors and will not make these too-good-to-be-true promises. If you need help to get started, check them out and follow their picks for a while as you get the hang of this option selling strategy.

Profit in Bear or Bull Markets With Calendar Spreads

Calendar spreads are a great modification of the diagonal option spread strategy. The calendar spread is useful when you are more uncertain about the direction of the market and want to increase the effectiveness of the hedge during periods of market volatility. In this article I will demonstrate this strategy with a trade that has a slightly bearish bias. You could experiment by shifting strike prices in a paper trade to be more neutral or bullish.

A bearish calendar spread consists of two options.

1. The first option is a long put with a long term expiration date. Often traders will use LEAPS or options with expiration dates longer than a year. The long term put establishes the bearish bias and will grow in value as the market drops.

2. The second option is a short put with a short term expiration. The short put has the same strike price as the long put you purchased. The identical strike price but different expiration dates is what makes this a calendar spread.

The ratio of the premium received from the short put to the price you paid for the long put is much larger than the same ratio in a diagonal spread. However, because the short put has the same strike price as the long put, there are smaller potential profits if the market breaks out to the downside. In the video, I will cover the details of entering a sample bearish calendar spread.

The larger premium compared to the amount invested in the long put creates a large hedge against upside movement in the market. If prices rise, the larger premium from the short put will offset more losses than a short put in a diagonal spread. However, if the market never returns after a rally the long side of the trade will have accumulated losses. This is still a great way to implement the benefits of a diagonal spread in the market when you are uncertain but have a bearish bias.

[VIDEO] Put Calendar Spreads – Part 1

The original trade setup included a long put position with a September 2009 expiration on the mini-sized S&P 500 index option ($XSP). The long position with a strike price of 65 had cost $6.60 per share or $660 per contract to open. The long term put established the trade’s initial bearish bias.

A short put with a March 2009 expiration and a 65 strike price paid $1.30 per share or $130 per contract. When combined with the initial long position, the total first month debit or cost is $530 per spread. The short leg of the calendar spread is designed to reduce the amount of the spread cost attributable to time value thereby increasing the possibilities for profits.

Calendar Spreads – Part Two:

Since initially setting up this trade the market has rallied. This is a great opportunity to look current option prices before March expiration and see how the calendar spread has protected the trade against some losses. The short leg of the trade is essentially a bullish hedge (selling a put is bullish) and will have offset some of the losses on the long side.

[VIDEO] Put Calendar Spreads – Part 2

As this article is being written the long leg of the spread has fallen in value to $4.90 per “share” or $490 per contract. That is a loss of $170 or 25% ($170 / $660 = 25%) on the long term put. However, the short leg has also lost value with a current quote of $0. If expiration were to occur today the option would expire completely worthless. That means that the short leg has profited $130 per contract so far.

If you offset the losses of $170 on the long put, with the $130 gain from the short put, the actual loss is $40 or 7% ($40 / $540 = 7%) per spread. As you can see, the short spread leg has helped to smooth volatility while the market trends against the initial forecast. At this point the spread could be closed by buying to close the short leg and selling to close the long leg.

However, for the purposes of this series of articles I will leave the spread alone and see how prices look at March expiration. The third article in this series will examine what the possible actions are at expiration and how the trade might be managed for the next month.

Calendar spreads can be market neutral or slightly biased to the upside or downside. In the example we used in this series, the calendar spread was biased to the downside in at least two ways. Each of these biases become more important as expiration nears or the market moves with more volatility than the original forecast.

Calendar Spreads – Part Three:

This trade was originally established with a moderate bearish bias, which seemed prudent to account for the downward momentum in the market. The maximum gain in a calendar spread on a monthly basis, occurs if the market price equals the strike prices used at expiration. Therefore some downside movement would have put the market price closer to that maximum gain.

The second bias can be seen by the use of puts in the calendar spread. Because a calendar spread is fairly neutral, calls would offer a similar risk profile as a spread but at expiration the short position expires and a long call or put is left. A bearish trader could leave the long put position active to take advantage of further downside momentum.

[VIDEO] Put Calendar Spreads – Part 3

At expiration there are three things that can be done to end, extend or modify the calendar strategy.

1. Unwind the trade by selling the long put
The market has rallied since this case study started at the beginning of March 2009. The move has been enough to create a loss in the trade, however, the losses have been reduced by the premium from the short put. In that way, one of the strategic objectives have been achieved. At this point, if you thought the market was likely to continue to rally, exiting the position may be the best alternative.

2. Sell another 65 strike short term put
In the original trade setup the 65 put with a March expiration was sold against the long 65 strike put with a September expiration. Although the market has moved, it is still possible to sell another short term 65 strike put for April’s expiration. The extra income helps to reduce the basis and maximum loss that this trade could still be exposed to in the long term. Reselling another short term put extends the strategy and resets the price at which a maximum profit is achieved to $65.

3. Leave the long put uncovered
As an analyst you may decide that the market is at a potential resistance level and the long put could become profitable again as prices move back down. Leaving the put uncovered provides for unlimited upside if the market falls significantly. This strategy would be superior to the second alternative of extending the spread if the market falls below the original strike price.

All three alternatives are acceptable depending on market volatility and your own personal tolerance for risk. The take-away from this segment of the series on calendar spreads is to understand that time spreads require some decision making after the short term expiration. This allows for some flexibility and may offer cost savings over shorter term vertical spreads as the long side of the spread does not always have to be reentered or adjusted.

 

Images courtesy theogeo and surlygurl

Fighting Time Value with Vertical Spreads

Buying a long option is a great way to speculate on an expected increase or decline in a stock or ETF’s price but they also come with a couple of big disadvantages to account for when planning your trades.

First, long options have a time limit or expiration date. If the market doesn’t move in the direction of your forecast between the time you buy the option and expiration, you will lose your opportunity to profit.

The second disadvantage that faces long option buyers is the impact of time value. Even if the market moves the direction of your forecast, time value eats away at your profits and can turn a potential winner into a loser.

There is a partial solution to the second problem. You can reduce the impact that time value has on your long option trade by turning it into a long vertical spread. That means that you are still buying a long option but you are selling another, further out-of-the-money, option with the same expiration date against that long position.

The premium you receive from the option you sold helps to offset the decline in time value on the long option. Like short vertical spreads, a long vertical spread has a fixed amount of risk and a capped maximum gain.

Balancing the advantages and disadvantages as you evaluate spread opportunities starts with understanding how they related to each other and how to construct the trade. When done correctly, a vertical option can be a great way to make money in an uncertain market.

In the video above, I will walk through setting up a long put vertical-spread on the QQQQ. Assume in this case, that your attitude has become bearish on the market and you are expecting a drop in price and therefore a long put position looks good.

I will show you how to add a short put position (creating a long vertical put spread) against that long put to significantly reduce the cost of the trade and the impact of time value.

The trade off between reduced time value erosion in return for lower upside potential in a long vertical spread is a classic example of one of the truths in the options market. If you want lower risk you will get lower potential returns. Greater probability of a loss usually comes with higher potential gains.

Calculating the maximum risk in a long vertical spread compared to your maximum gain is relatively easy and can help you plan your trades. If the maximum gain in a particular trade is too low compared to the potential loss then the trade is probably not a good candidate.

With vertical spreads you have an advantage over an outright option position where you have very high costs but traders may be reluctant to give up on outright call or put positions because they have theoretically unlimited gains.

However, depending on what you are trading, the probability of very large moves in the underlying stock that would result in those big gains is very low. This is particularly true of ETFs. Realistically, giving up the “unlimited” gain potential of a long call or put is probably not a bad trade off at all.

Here is how you can easily calculate the maximum loss or gain potential of a long vertical spread:

Maximum gain: Take the difference between the two strike prices and subtract what you paid for the spread when you entered the position originally. In the video above I will run through this calculation on our example on the QQQQ. This is the most you can possibly gain – assuming that the stock rises the direction you forecasted.

Maximum loss: Like an outright long call or put position, your losses are limited to the amount you spent (the debit) to enter the trade in the first place.

In our example from the video above, I paid $.45 per share or $45 per contract to enter the long put spread. This was considerably lower than what it would have cost if I had just purchased the long put alone.