Iron Condors
The number of things a sophisticated trader can do with simple calls and puts is truly amazing. The buying and selling of calls or puts can be combined in numerous option strategies, each offering its own unique way of capitalizing on the various market conditions a trader will encounter. The key for any option strategy is to know what market conditions a particular strategy should be utilized, how to execute the strategy, and whether the option strategy fits within a trader’s risk parameters.
One of the more popular option strategies is the Iron Condor. The Iron Condor’s popularity stems from the cash flow and potential monthly income it can generate. The Iron Condor is simply the combination of two of the first strategies that beginning traders learn:, the bull-put spread and the bear-call spread. These two credit spreads are used in different market conditions. If the broader markets are at least moderately bullish and your underlying stock is also moderately bullish, then the bull-put spread is a viable option strategy. Conversely, if the broader markets are at least moderately bearish and your underlying stock is also moderately bearish, then the bear-call spread is a viable option strategy. These two basic credit spreads serve as the basis of numerous trades that option traders make, as they can capture profits in both market conditions.
The Iron Condor is often used in a third market condition, one where the market or stock is neither trending up or down, but moving sideways. In combining the bull-put and bear-call spread in this particular market condition, a trader can collect credits on both spreads which leads to the option strategies strategy’s popularity. As with any potential trade a trader makes, proper due diligence should be conducted to ensure that the trade makes sense from both a technical and risk management standpoint.
Stage One: Technical Analysis
Whatever stock or broad market is being analyzed, you are looking for a market that has demonstrated the following:
1) No dominant trend; sideways moving stock or market
2) Clear area of resistance
3) Clear area of support
It is important to identify clear areas of support and resistance, along with properly identifying the trend of the stock, as this increases the probability of a winning trade occurring. Identifying these areas also help determine the strike prices that will be used, as they will be chosen above resistance and below support. A stock that has been trending sideways should have relatively clear support and resistance areas that you can identify. If it does not, then it might be best to look for another potential candidate.
Stage Two: Determining Strike Price and Expiration Date
Once you have identified areas of support and resistance, your strike prices need to be selected. Where you place these strike prices will depend heavily on your own trading rules and risk tolerance. For example, company XYZ has been moving sideways with clear support at $40 and resistance at $50. If a trader sells close to the money credit spreads, they will receive a higher rate of return if successful. However, aA trade with strike prices close to the money, however, will have a lower probability of succeeding than a trader who sells far out-of-the money spreads. Simply put, the stock has to rise or fall farther for you to be wrong. These out-of-the-money strike prices will produce a lower credit, and henceand rate of return, but, as a general rule, will have a higher probability of succeeding.
The expiration date traders choose between can also vary. A balance between the amount of time remaining in the option, versus the net credit received, heavily influences this decision. If a potential Iron Condor expires in three weeks, but offers little premium, then is simply would not make sense to do that trade. As a general rule, shorter term options are preferable, but often times, you have to go four to six weeks out to have sufficient time value associated with the premium. This can vary dramatically depending on market volatility.
Stage Three: Determining Risk vs. Reward
Your maximum reward will occur if the price of the stock at expiration is between the two spreads you created. This is why determining what strike prices to buy is critical, and why you should always determine the trend and support and resistance before entering the trade. Never blindly enter an Iron Condor trade simply because the credit looked appealing.
Your maximum risk occurs when support or resistance is broken and the price of the stock rises above or falls below one of the spreads you entered. At this point, you will lose the spread between the strike prices minus the net credit you initially received.
Other Risk-Reward formulas for Iron Condors:
Net Credit = Credit from bear call spread plus credit from bull put spread
Max Reward = Net credit
Max Risk = Spread between strikes of either credit spread minus net credit
Upper Breakeven = Lower strike call plus net credit
Lower Breakeven = Higher strike put minus net credit
If the risk of losing an Iron Condor trade violates your personal trading rules, then you should not make the trade. When properly executed, the Iron Condor trade is a high probability trade that can generate a significant rate of return. However, losses can occur, and, as with any trade, you should exercise sound money management principles.
Stage Four: Trade Management
Ideally, the stock stays in the expected range, and the options expire, worthless. In this scenario you keep the entire net credit. Many traders have developed their own personal rules involving Iron Condors (and credit spreads in general) that force them to close out of a trade when they have achieved the majority of their net credit. For example, an Iron Condor was placed on company XYZ. The price of the stock remains in a sideways trend, and enough time passes so the trade has realized 90% of its potential profit. In this situation, some traders might evaluate the risk remaining in the trade and made a determination on those factors. Others might simply close out the trade ,and move onto the next trade. How you approach this scenario is highly influenced by your own approach to trading.
Both of these scenarios involve managing a winning Iron Condor trade. Naturally, there are times that trades don’t work out as expected. There are numerous techniques that traders can utilize to help mitigate losses or repair Iron Condors. Next month, this section of the Rich Dad Ezine will address repairing Iron Condors trades.