Risk Profile: Defined
Directional Bias?: Market Neutral
Number of Legs: 4
Level of Complexity: 3/5
Buying Power Needed: 4/5
Net Short or Long Premium?: Short
An iron condor is a market neutral options strategy that is made of two short spreads, a call spread, and a put spread. The ideal outcome for us is that the underlying price barely moves, and stays within our two spreads.
The iron condor is quite similar to a short strangle, we just add another “wing” to the trade so we can define our risk at entry, and limit our buying power requirements. When we hedge the trade in this fashion, it allows to us to be more aggressive in trade selection. Because of this, an iron condor is usually a better choice than the short strangle when it comes to trading high volatility instruments.
When we sell an iron condor, we want the underlying to trade sideways, and for all four of our legs to expire worthless, allowing us to keep our net credit. This strategy is quite similar to the short strangle, however, the key difference is that the iron condor’s risk is defined, and the short strangle’s risk is undefined. Because of this, an iron condor requires less buying power and is generally a lower risk trade.
Save for the most capitalized traders, you won’t see many selling strangles in high-priced stocks like AMZN, Booking, or GOOGL. Remember, all American-style options are 100-multiples of the share price, so a call option in a a low-priced stock like Groupon will only give you $300 of exposure, as opposed to a high-priced stock like AMZN, which will give you $163,000 of exposure.
With this said, the main reason most traders opt for the iron condor instead of a short strangle is for buying power requirements and risk reduction. In a vacuum, a strangle probably has a higher expected value, however, we do not have fixed parameters in our capital markets.
Here is what the payoff of a typical iron condor looks like:
Our ideal iron condor trade setup is an instrument with high implied volatility that we expect to stay within a price range for the next few weeks. We’re going to examine an iron condor setup within Netflix, previously a Wall Street darling that has taken quite a hit in the last few months. The stock recently began trading below its 200-day simple moving average for the first time since 2016, and with earnings in January, we don’t expect a great deal of price movement until investors know where they stand with the January earnings report. Further, because the stock has been making a series of lower highs and lower lows, the mostly likely scenario seems to be Netflix continuing to trend downwards slowly.
Acknowledging these factors, we’re going to trade an iron condor with 43 days to expiration, so our contracts will expire before their earnings report. We find that around 45-50 days to expiration is the sweet spot for iron condors, the amount of premium built into the options makes the risk/reward most favorable to us, without having to spend too much time in the trade.
Now we have an ideal expiration date, December 28th, 2018, which gives us 43 days until expiration. Here’s the option table, as you can see there’s a good deal of premium built into these options, making this Netflix play especially attractive.
Now that we know which expiration we want to trade within, we need to formulate our iron condor by choosing some strikes. We can trade an infinite amount of iron condors, some giving us a 99% chance of success, with others giving us a 1% chance of success.
In choosing strike prices for our short and long contracts, we have to keep in mind why we’re trading an iron condor: because we think an instrument will remain range-bound for the duration of the contract length. With this in mind, we need to construct a trading range that Netflix is likely to trade within for the next 43 days.
Here’s price chart of the Netflix stock for the last year. The stock has been lower than $200 and higher than $400 at times, it’s certainly earned the expensive options premiums. Given that there’s not obvious trading range that jumps off the page at us, how do we best put the probabilities in our favor? There’s a few ways.
The first tool we’ll use to construct our range is the Average True Range indicator. The ATR tells what the average price move for a given time period will look like in a tradable security. Rather than looking on a day-to-day basis, let’s look at Netflix’s monthly ATR, which is $48, which means that, based on the price action of the last 14 months, an average trading range for the current month should be around $48 points. To reduce our margin of error, our trading range will be at least twice the monthly ATR.
This is what our range would look like on the daily chart, with one ATR plotted to the upside, and one to the downside. Looking at the recent price action, it still looks like it need some work. In adjusting it, we’ll start with the recent resistance level around $375, we want our range to be well above those, in case the market wants to retest that level
NFLX seems too volatile for a 2ATR range, even with just 40 days to expiration. To really put odds in our favor, we want a wider range. Of course, a wider range will change our risk/reward equation. Sometimes, while the range between iron condor spreads looks attractive for a trade, the profit/loss potential simply isn’t worth the trade.
Instead of focusing on NFLX’s daily chart, we moved out to the weekly chart, and plotted it’s entire 2018 price range. As you can see, NFLX experienced a huge breakout in early 2018. While stock had been going consistently up for the last five years anyways, 2018 was NFLX’s most significant rally. Not only was the momentum behind teh move massive, but it was a $100B+ company during this rally.
We can assume that, if this range is broken, NFLX’s days as a “story stock” are limited, and the market would price it like a more mature company.
If we decide that this looks like an attractive range for our strikes, now we have to look at how this trade would look in the market–what type of risk/reward are we being offered to take on this trade?
We’re writing two options and buying two options. Because the risk exposure of our written options is unlimited, we hedge them with long options that are just one more strike out of the money than the options we wrote, limiting the loss to 5 points minus our net credit.
Is this trade worth our time, capital, and outlying of risk? Let’s do some math.
Our max loss on this trade is $426, which is the five points between each of our vertical spreads, minus our net credit. Our max profit is $52, our net credit. That means the market is pricing in a 10.4% chance that, at our Dec 28th expiration, NFLX will be above $420 or below $225. Taking a trade like this all comes down to your own discretion. Whether that discretion stems from a knowledge of technical analysis, fundamental analysis, or simply market sentiment doesn’t matter, you just have to be comfortable with small wins and big losses.
Max Profit & Loss
Here is a payoff matrix for this trade:
As mentioned, the iron condor is a small profit, large loss strategy. You’re very likely to profit on any given iron condor, but one loss can knock out many wins. Making a living off a strategy like this one will only work with certain types of traders.
The max profit we can make on an iron condor is our net credit, which is the premium we take in from our written options net of the premium we paid for our long options. In this trade, the net credit is $52.
To solve for our net credit, we just need to do some addition and subtraction.
First, we take the price of both of our written options (the $420 call and $225 put) and add them together. We get $4.30 for our $225 PUT and $0.09 for our $420 CALL. The sum of these two is $4.39–this is our gross short premium exposure.
Second, we take the price of both of our long options (the $425 CALL and $220 PUT) and add them together. We get $3.78 for our $220 PUT, and $0.09 for our $425 CALL. The sum of these two is $3.87–this is our gross long premium exposure.
Third, we subtract our gross long premium exposure from our gross short premium exposure. $4.39 – $3.87 = $0.52
On the rarer occasions when iron condors book a loss, they outsize their winning trades.
The maximum we can lose is the width of strikes minus our net credit. This can vary if the two vertical spreads that make up your iron condor have different widths.
For example, both sides of our NFLX trade have 5 point-wide strikes. So, whether NFLX is below $225 or above $420 at expiration, we would lose the same amount. However, if one spread was 10 points wide, the max loss on that side would be 10 points minus our net credit.
In this case, because both spreads have the same width, figuring out our max loss as simple as subtracting our net credit from the spread width. In this case, it’s $5 – $0.52 = $4.48, or $448.
We’ve gone over three timeless options strategies here, all of which can make you a lifetime of income if traded correctly. Each of these three strategies brings something different to the table.
The vertical spread is for directional traders who favor a profit/risk ratio closer to 50/50, while the short strangle is for cowboy traders who have conviction in their calls, and the ability to quickly scrap a losing trade and admit when they’re wrong. The iron condor is for the trader who loves hitting singles all day. Lots of small wins that compound on each other, and the occasional larger loss.
In reading through this guide, there was probably one strategy that spoke to you the most, because traders all have different mindsets. Some would rather profit on 30% of their trades, with their winners being much larger than their losers. On the other hand, certain traders need to have constant winning trades to help their trading psychology–they benefit from the positive reinforcement that comes with consistent winning trades.
The goal of this guide is to help you choose a direction as an options trader. When first getting acquainted with the options world, there are so many strategies and schools of thought, it’s overwhelming.
What we do here is simplify things. So, we broke down three of the most commonly traded strategies in the options world, all of which appeal to different psychological profiles. Some of you reading this are probably wondering why anybody would trade an iron condor, while others can’t wrap their head around the idea of short strangle.
The point is, whichever strategy appealed to you, go become the master of that strategy. Don’t worry about learning 10% of every strategy out there, instead learn everything you can about one, until you can trade it profitably with discipline and consistency.