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.