Summer is fast approaching and traders know what that means…lower volatility. Markets slow during the summer, why is that? Institutional investors leave their desks and stop moving large volume. That is why the iron condor can be considered an ultimate summer strategy. For those who may be a little ahead of the game and are wondering why the iron condor? Why a credit strategy if volatility is low? Won’t that generate lesser than usual premiums? Well in short, yes. Just take a minute to remember the risk to reward principle, this is a lower risk strategy, taking into account market circumstances. Therefore would be expected to generate lower returns. Perfect for the sideways movement that we expect throughout the summers. To add to that below we’ll explain how you can further mitigate risk even with this strategy.
The Iron Condor-The Basics
Before we dive into strategies and the complexities of the credit spread. The iron condor. We should explain the basics behind the credit spread. For those that are new, the iron condor is an options strategy. For more information on options check out our Elite package. It is an options strategy that combines two legs to generate credit. Which is deposited in full into your account because the iron condor is a net option “sell” position. You will collect all of the credit as the option expires worthless on the expiry contract chosen. Prior to that, you may close the position for a gain or loss depending on the standing of the position.
So what is the iron condor? It involves two legs, as mentioned before. It is a combination of the two credit spread options. The bear call and the bull put. Both of these are credit options combinations in which risk is capped. Instead of selling naked calls or naked puts, one would use bear calls and bull puts respectively.
The bear call
They are strategically named as well. The bear call involves selling a call at a strike, out of the money and buying another strike further out of the money (capping risk). The idea is for the price to move away from your spread, or fall. This is where the “bear” portion of the name comes from. However, it does not matter how far the price falls. The maximum gain on the position is the credit collected. Take a look at the example below:
This is an example of PayPal, the green lines represent the two strikes of the bear call. The first, $107 is the short call while the $108 is the long call. the risk is capped to the difference in the strikes multiplied by contracts and shares. So the risk is (1*100)-(credit received). The long call helps cap the risk. If price moves above both calls, the long call will gain value.
The bull put
The bull put is the opposite of the bear call. It involves two put positions. A short out of the money put combined with a long put more out of the money than the first. The premise is the same as the bear call. In this instance traders expect the price to move away, to the upside. Collecting again a maximum of the total premium of the options spread. Take a look at the example below:
Again, PayPal’s chart is displayed below. This time with two red lines which represent the puts. The higher put ($99.00) represents the short put, while $98 represents the long put.
What do we get when you add the two together? The iron condor! Check out this video we’ve got on the topic. The iron condor has capped risk as well. On expiry, the price cannot be between both spreads at the same time, so if you lose one trade, you will win the other. The net result, if premiums received for both: break even.
Check out the illustration below, again on PayPal. Two premiums collected from the credit spread above and the one below. The ideal scenario is that price remains between the two spreads into expiry so you collect both premiums.
The Iron Condor-Finding the Opportunity
What assets are best for iron condors? Stocks vs ETFs! That depends, how risk averse are you as a trader, what is the current market volatility, there are many more variables. In this section, I will outline the pros and cons of both the ETF iron condor and the stock iron condor.
Beginning with stocks. Two things to consider when looking for iron condors on stocks is are they optionable and how volatile are these stocks? Not all stocks have options, and a lot have unfavorable spreads. Which could cause deep break-even prices and instant losses. Next is the stock’s volatility, if a stock is prone to wild swings (high beta) it might not be optimal for iron condors. The iron condor is best for low volatility moving assets, during periods of low volatility. Alternatively, trending stocks are not optimal for iron condors either. Either in a bull trend or a bear trend, one side of the iron condor is almost certain to be a loser.
Onto ETF’s, such as the SPY and IWM. An ETF represents an index, however, it is cheaper in many respects and gives you access to that market. ETF’s are all optionable and have good volume to back each expiry. Meaning that the spreads will be tighter than most stock spreads. In general, liquidity is higher in an ETF than an average stock. ETF’s also have a 1.0 beta, meaning they move congruently to the index they reflect. So in the summer, when index markets slow down, so will their respective ETF’s. Of course, trend moves affect ETF’s just as they do stocks and the iron condor might not be optimal in a bull or bear market. Retrospectively we’ve found more success in average ETF iron condors more than in individual stocks. Meaning, for the next portion of the article we will use the SPY as the primary example.
The Iron Condor-Risk Management
What should a trader consider when taking an iron condor position? Assuming that markets have slowed and volatility has dropped. One should consider the expiry, strike levels, premium collected and risk. First things first, the longer the expiry, the more risk you take of the price not expiring within your iron condor. However, you are compensated for taking the risk. For example, an iron condor that expires on April 1st yields a total credit of $0.185. That same iron condor, that expires on April 22nd yields a credit of $0.32 per contract.
Next, are the strike levels. Ideally, traders will pinpoint a wide enough iron condor to give the underlying room to move throughout the period chosen. The closer the expiry the tighter the iron condor can be. If you chose an expiry that is weeks or months out, you should consider a wider iron condor. Then comes the spread between the short call/put and long call/put. The difference between the long and short call should be equal to the difference between the long and short put. The difference is the max risk you are willing to take per contract. Assuming that we use the SPY to create an iron condor and the difference between the long and short call/put was 1 point and credit received was $0.10, the max risk would be (1-0.20)*100= $80 for one contract. Now if you collect $20 and are risking $80, isn’t the risk/reward off? Not if you take into account the probability of a max win vs a max loss. This is a feature that Interactive Brokers has within the platform.
Check it out below, the chance of max return is 51%. That is not as optimal as we would like so we could adjust strikes for a more favorable probability. For a detail explanation of how to use the iron condor effectively and manage risk check out our Swing Trader Package, link below.
Final thoughts on the Iron Condor
The iron condor is a very effective strategy to use when market volatility slows. The prime time for low volatility markets is the summer! Day traders pull their hair out in frustration while swing traders collect passive income through the strategies mentioned above. The iron condor involves the combination of two credit spreads, but with capped risk! You cannot lose both spreads at the same time on expiry! Traders can limit their risk by collecting the same premium for each spread and closing out the trade at a break-even level one price creeps between one of the spreads.
This strategy is not optimal for trending of volatile markets, keep that in mind traders. You are compensated for managing risk, not chasing gains!
The most important thing that you can do now to cut down your learning curve is to find a mentor and join a community of professional traders.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.