Learn to Soar: The Long Iron Condor
Do you remember when we discussed bear call spreads and bull put spreads? To an options trader, this seemingly backward-based lingo instantly translates to an options trade. Sometimes though, the lingo can get tricky, such as when using iron condors.
A bear call spread involves selling a call, while simultaneously buying a higher priced call option with the same expiration date. We collect a net credit on the trade, which has a bearish bias. We are hoping the stock moves lower or sideways into expiration, so our bear call spread expires worthless, allowing us to collect the full credit for the trade.
On the flip side, we have the bull put spread. In the case, we’re selling a put spread and buying a lower priced put option. The goal is for the underlying stock to trade higher or sideways into expiration, allowing our spread to expire worthless and enabling us to collect the full credit we received in the trade.
So what do you get when you combine both a short call spread and short put spread? You guessed it: An iron condor.
The iron condor trade requires us to sell a bear call spread for a net credit, while simultaneously selling a bull put spread and also collecting a net credit. The result has us holding onto two short option spreads. As a result, we get to collect a larger credit.
Why Would We Do This?
Some traders may be asking themselves why they should consider entering an iron condor position. Admittedly, the iron condor is not for everyone or every situation. But for traders that are neutral on a stock, this may be a good one to pull out of the old playbook.
Let’s say a stock has been rangebound between $32 and $38 for the past few months. It doesn’t look like anything is going to change, but with the stock trading at $35, it’s unclear if it’s going back up to $38 or down to $32.
Selling just one spread – either a bull put spread or a bear call spread – could be the wrong move if the stock moves in the undesired direction. Even if it ultimately closes out-of-the-money, some traders may see their stop-loss hit or have to stress that they chose the wrong trade.
Using the iron condor can help though. For starters, the trader will collect two credit payments. This will improve their cost basis on the trade and give them more cushion when it comes to using a stop-loss.
Regardless of what happens, one of these spreads will close out-of-the-money, and with any luck, they both will. That will enable our trader to collect the full credit they received. Let’s look at a theoretical example.
Shares of ABC are trading at $90 with 40 days until April expiration. It’s typical range has been $85 to $95 over the past few months. Without any news announcements scheduled or earnings on the way, it seems plausible that the stock will continue in that range. As a result, we do the following:
Sell 1 April $95 call and buy 1 April $97.50 call for a net credit of $0.22
Sell 1 April $85 put and buy 1 April $82.50 put for a net credit of $0.23
Because we are short two spreads, our break-even prices are different for each one.
Our break-even price on the bear call spread is $95.22, while our break-even on the bull put spread is $84.77. So long as the stock closes between $84.78 and $95.21 on expiration, our trade will show a profit.
Since our spreads are the same distance, ($97.50 – $95 = $2.50 and $85 – $82.50 = $2.50), calculating our maximum loss easy. As we mentioned before, the stock can’t close in-the-money on both sides. So in our worst case scenario, the stock is either trading above $97.50 or below $82.50 at the time of expiration.
Because we collected two credits, our maximum loss is the difference in strike prices, ($2.50) minus our combined credit, ($0.45). So in the event the stock closes above $97.50 or below $82.50, our maximum loss is $2.05.
Of course, our maximum gain is the credit we collected or $0.45. The way we realize our maximum profit is by the stock closing somewhere between $85 and $95 at the time of expiration.
Let’s Get a Real-World Example
One of the main keys to handling credit spreads is maintaining a proper risk/reward profile. While chasing a juicy credit may be tempting, it’s not worth taking on exu-berant amounts of risk to do. Because the losses can be so high in comparison to the gains, it could be like the equivalent of picking up pennies in front of a steam-roller.
In contrast, we are simply looking to pick up pennies without being run over by anything.
Thankfully, this exhaustive work is taken care of by Option Party’s screening methods, probability generator and the Party Rank feature. Otherwise, searching for iron condors could be a royal pain.
Of the top 10 results, Alibaba BABA looks like an attractive candidate. Coming in at No. 3 on the list, it sports a return on risk of 5.1%, with a total loss probability of just 2.6%. With an 88.9% probability of hitting our target return of 4% and an 89.5% probability of profit, the odds are clearly high that this trade will work out.
With the stock currently trading near $105, the trade involves selling the April $115/$120 bear call spread, along with selling the April $90/$85 put spread. In all, we will collect a net credit of $0.27 on the trade.
While the credit collected is small, investors also need to realize that the probabilities are heavily in their favor. Like we said before, we want to pick up change off the street, but want to do so after looking both ways first.
By doing so, we can maintain a low risk profile, while simultaneously having our trades pay out.