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Options Trading: How to Use an Iron Condor

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This is a particularly appropriate trade for an options trader who expects a stock, index, or ETF to trade within a defined range of price for a specific period of time.

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I wanted to apologize to Minyanville readers as last week I did not issue a new options-based article. Unfortunately I was extremely sick, which prevented me from being able to do much more than run my own firm. I'm feeling better now, so let's get back to it!

Discussions in previous weeks have served to introduce the family of the "winged beasts." This family includes a number of members and is notable for its range of price of the underlying, which helps to yield a profitable trade. The various members include the call butterfly, the put butterfly, the iron butterfly, and the iron condor.

I wanted to reserve a weekly column to discuss the frequently useful iron condor. This is a particularly appropriate trade for an options trader who expects a stock, index, or ETF to trade within a defined range of price for a specific period of time.

This family member has a very simple anatomy that can be modified significantly in order to fit the trader's current market view. It is composed of both a call credit spread and a put credit spread.

These two separate spreads constituting the iron condor are classically constructed entirely in out-of-the-money strikes. The objective is to surround the current price with sufficiently wide boundaries that both credit spreads expire worthless, and maximum profitability is achieved.

This iron condor spread is closely related to the butterfly family, and in fact it is distinguished from the almost identical iron butterfly by a single structural feature. The iron butterfly places the short strikes at the same strike, while the iron condor places the short put and short call strikes at different points.

These iron condors can be constructed to have a wide range of probabilities of success. As is the case with almost all option trades, the higher the probability of success, the lower the risk-weighted return. Iron condors with a very narrow band of profitability have a much higher potential return based on total risk than do wide positions with a broad band of profitability.

As would logically be expected from the combination of two credit spreads, the trade results in an initial credit into the trader's account. It is important to recognize that the trade does have capital requirements in excess of the credit received, and for that reason the trader must have sufficient capital to take on the position.

As an example, consider the P&L graph below for an iron condor established in the ETF for the Russell 2000 (^RUT) (IWM) index. This position is constructed by combining both the February 83/81 call credit spread and the February 72/74 put credit spread. The resulting position has a broad range of profitability at options expiration, extending from $73.40 to $81.60.


Click to enlarge

There are several functional characteristics of this spread that deserve emphasis. Because the fundamental profit engine of this spread is that of "selling premium," it only reaches maximum profitability at expiration as time decay of the option premium sold reaches its peak.

The maximum profit that can potentially be captured with this strategy is the entirety of the initial credit received when the position is opened. Another corollary of this method of profit generation is that the "richer" the option premium, the more potential profit the trade contains. Therefore, this trade contains more potential profit in times of high implied volatility.

An important feature of this trade is unique to iron condors. The absolute risk / reward is, in a word, terrible. In our current example, the maximum potential profit is around $600, while the maximum potential loss is around $1400.

The high probability of success of the trade somewhat offsets this unattractive ratio, but it is also essential to manage the trade such that the maximum potential loss is rarely if ever realized. Details of trade management are beyond the scope of today's discussion, but it is essential to recognize the necessity of risk management when using this trade structure.

Another important characteristic is that risk is confined to one side of the trade. The trader can only lose on one side of the trade. It is for this reason that knowledgeable options brokers only require that one side of the trade be margined.

I want to emphasize the issue of margin because it brings to focus an important point. Not all brokers are "option friendly." Despite the fact that option trading volume has seen dramatic growth, many brokers have not yet adjusted to this new world. The policy of margining iron condors forms one of several litmus tests that define brokers who understand risk in our world.

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.
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No positions in stocks mentioned.
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