The Basics Of Iron Condors

An iron condor is an advanced option strategy that is favored by traders who desire consistent returns and do not want to spend an inordinate amount of time preparing and executing trades. As a neutral position, it can provide a high probability of return for those who have learned to execute it correctly.

Most new traders are taught to execute this strategy by creating the entire position all at once, which neither maximizes profit nor minimizes risk. An alternative method is to build the position in parts and to execute the separate credit spreads in relation to price trends of the underlying security. Creating the position in this way maximizes the credit available and trades a profit range.

Traders also need to understand how to negotiate with the market and "get inside the bid-ask spread." By understanding the various risk management techniques available, the iron condor can provide traders with a very consistent way to build a trading account. (To learn more, read Take Flight With An Iron Condor.)

The construction of an iron condor involves the creation of two credit spreads. A credit spread involves the sale of an option (put or call), and the subsequent purchase of another that is farther out of the money. The difference between the premiums received for the sold option and the cost of the purchased option provides the profit. This profit is realized by later buying back the position for a gain or by keeping the entire premium, when the options expire. (For a comprehensive look at option spreads, see the Option Spreads Strategies Tutorial.)

The number of strike prices between the two options (or spread) determines the total amount of capital at risk and amount held by the brokerage firm determined as:

Spread – Credit x 100 x # of Contracts = Margin

The iron condor is made up of a bear call spread and a bull put spread. The two credit spreads are often used together, not because it is necessary, but because they share the same amount of capital at risk. Because losses cannot be realized by both credit spreads, brokers only hold margin for one of them.

The iron condor creates a trading range that is bounded by the strike prices of the two sold options. Losses are only realized if the underlying rises above the call strike or fall below the put strike. Because there is no additional risk to take on the second position, it is often to the trader's benefit to take on the second position and the additional return it provides.

The iron condor is known as a neutral strategy because the trader can profit when the underlying goes up, down or trades sideways. However, the trader is trading the probability of success against the amount of potential loss. With this position, the potential return is usually much smaller than the capital at risk.

Iron condors are similar to fixed income, where the maximum cash flows and the maximum losses are both known. The decision to make a particular trade becomes a risk-management issue. The key is to receive as much credit as possible while increasing the profit range or the distance between the two sold strikes. (To learn more, read Should You Flock To Iron Condors?)

Many new or novice traders learn to create the iron condor position by determining support and resistance for a security and then create the position so that the sold options are outside the predicted trading range. Some will also enter the position when the stock is in the midpoint of the range or an equidistant point between the sold options.

By creating the position this way, the trader believes that he or she has created the best possible scenario, but in fact has minimized both the credit and risk management aspects of the strategy. By designing order forms that make it easier for traders to execute this position all at once, many online brokerage firms perpetuate it being traded this way. (For more, read Support & Resistance Basics.)

Although a neutral position, trading credit spreads is a way to take advantage of either volatility or implied volatility. Only when the underlying is expected to move significantly or the stock has been trending in one direction do option premiums increase. For this reason, creating both legs of the condor at the same time means sub-optimizing the potential credit of one or both of the credit spreads, thus reducing the overall profit range of the position. In order to receive an acceptable return, many traders will sell at strike prices that are more in the money than if the credit spreads were executed at different, more profitable times.

One approach that can maximize credit received and the profit range of the iron condor, is to leg into the position. "Legging in" refers to creating the put spread and the call spread at times that when market makers are inflating the prices of either the sold call or put. (To learn more about this strategy, see An Alternative Covered Call: Adding A Leg.)

The best time to create either the bull put spread or the bear call spread is when the underlying has moved significantly in the direction of resistance (for the call spread) or support (for the put spread) or maintained the trend for several sessions in a row. As the underlying loses value over a period of time, buyers will obtain puts for profit as insurance against further losses. When this happens, market makers will significantly increase the cost of puts, which increases the premiums for sellers. Conversely, when the underlying increases, more buyers go long. This increases the premiums for calls and credits for the call spread.

Another way to increase the credit received from the position is to negotiate with the market maker. Many novice traders accept the natural spread that the market provides without realizing that market makers will accept limit orders that can get them additional credit of as much as one-third of the bid-ask spread. For example, a 30 cent spread can add as much as 10 cents per share or 40 additional cents per share for the entire iron condor position.

By waiting for an opportune time for the natural spread to inflate and then getting inside the bid-ask spread, a trader can sell at strike prices that originally had no credit at all. By dictating the terms that they are willing to receive for the position, traders can even turn negative natural credits (the market difference between the sold and purchased option) to amounts that provide acceptable risk-adjusted returns.

There are other techniques that can be used to limit losses. One way is to trade index options (such as the S&P 500 or Russell 2000) instead of stocks. Single stocks have the potential to swing wildly in response to earnings, or other news can cause them to gap significantly in one direction or break through significant support or resistance levels in a short period of time. Since indexes are made up of many different stocks, they tend to move more slowly and are easier to predict. The fact that they are highly liquid and have tradable options every 10 points reduces the bid-ask spreads and provides more credit at each strike price.

One of the most practical risk management techniques is to be patient. Determine the minimum amount of credit necessary to cover yourself for the capital at risk. Find a strike price at which you are comfortable selling, set limit orders at that position and let the market maker take one of your trades when enough credit has been established. Don't worry if you can't get your second leg in right away. Time is working in your favor: the closer to expiration you can trade and still receive an acceptable credit, the better. Time decay, the nemesis of option buyers, benefits option sellers.

Traders should always know the exact point at which they should attempt repairing a position if it is threatened. If the index arrives at that point or threatens one of your sold strike points, there are alternatives other than liquidating the position for a loss. You can always roll out into a new credit spread, (into a higher strike for the call spread or a lower strike for the put spread). This is often the best course of action, since you can receive additional credit without having to post any additional margin. Since the index would have had to be trending significantly to threaten your position, it is often possible to find enough additional credit to considerably reduce, or even cover, losses at a strike price even further out of the money.

Many new traders avoid advanced option strategies like the iron condor believing them to be too complicated to trade consistently. The reality is that most traders only make one condor trade per index per month. A summary review of the market is usually sufficient enough to determine when to set or revise limit orders. If executed correctly to create the maximum profit range, the iron condor promises a high probability of success, which keeps traders from having to be glued to their computers to manage their trades.