In our last few Options trading articles we have taken a look at how we can use credit spreads to put on higher probability trades with less risk.
- We started by showing how we can sell Call Credit Spreads to put on bearish positions with 5 ways of making money.
- We then transitioned into how we can sell Put Credit Spreads to put on bullish positions also with 5 ways of making money.
In both of the earlier examples, it’s necessary to have a bullish or bearish outlook on the market you are trading.
However, what if instead you believe the market is doing to stay in a sideways range and not go anywhere?
This is where the Iron Condor comes in.
What Is An Iron Condor?
An Iron Condor is put on by selling an out of the money call spread and an out of the money put spread at the same time.
On the call side we are selling an out of the money call option with a strike price closer to the current stock price and also buying a further out of the money call option to define our risk.
On the put side we are selling an out of the money put option with a strike price closer to the current stock price and also buying a further out of the money put option to define our risk.
When Should I Use An Iron Condor?
Instead of selling either the Call Credit Spread or the Put Credit Spread, we can also do both at the same time and create what we call a profit window.
What is a profit window?
A profit window is defined by the strike price of the call option that we are selling and the strike price of the put option that we are also selling. As long as price stays between this range we can make money on the trade.
You want to sell an Iron Condor when you are looking for a neutral position with defined risk. If you are expecting a big move higher or lower there are better strategies to take advantage of that outlook (long calls and puts, debit spreads).
Ideally, you want to sell a credit spread when volatility is high. Doing so will allow you to take advantage of higher priced options. While not required, trading credit spreads in higher volatility markets will produce better performance than trading them in lower volatility markets.
The Iron Condor will still give us 5 ways of making money on the trade but will move slower than the other trade types.
In most cases, we will need to hold these trades longer in order to hit our profit targets. These can be great trades for generating an income in a slower market environment or when you don’t have a strong directional opinion one way or the other.
Let’s dive in and talk about how to use an Iron Condor which is our preferred strategy for putting on a neutral trade.
Do We Use Weekly Or Monthly Options?
The Iron Condor can be used with short term weekly or monthly options. The key is to make sure you are trading options with good liquidity as your fill prices can make a huge difference in the P/L.
When starting out with this strategy we recommend using monthly options with between 20-60 days left to expiration. As you get more comfortable with the strategy you can then move into the weekly options. The weekly options will react much faster to changes in stock price and are less forgiving than the monthly options.
Setting Up An Iron Condor
Once we decide whether we are using the weekly or monthly options, then the next step is to determine which options to use. We like to start by selling the call and put options that have a 65% chance of closing out of the money. See screen shot below for example. We will then buy the call and put options further out of the money that will allow us to put on the trade for 50% of the width of the strikes.
How Much Can I Make?
Our max profit on the trade is whatever price we collect to put the trade on. For example, if we sell an Iron Condor for $1.00 then our max profit is $100 per spread. We make money on the trade as long as the stock or ETF price stays between the strike prices of the call and put options that we sold to open the trade.
What Is The Risk
The nice part about a credit spread is they are fully risk defined trades. We know what our maximum loss is right up front before ever placing the trade. Our max risk is the difference between the strikes minus the credit received for placing the trade.
If we sell a $2 wide Iron Condor for $1.00 then our risk would be $1.00 or $100 per spread. Even if we are dead wrong on the trade, the most we can lose is $100 per spread. While the Iron Condor might seem more advanced, it’s actually a much safer trade than buying an outright call or put.
Why would we risk $100 to make $100 on the trade? We are ok with this ratio as these trades have a high probability of success. Having 5 ways of making money on these trades make them very forgiving. We are ok risking between 1 and 3 to make 1 as we can get the numbers to work for us over time. We are not ok risking 5 or 6 to make 1 as the numbers don’t back it up.
5 Ways To Profit
With a credit spread we will have 5 ways of making money on the trade. When selling an Iron Condor, we make money if the stock moves up, down, or sideways as long as the stock stays between the strike prices of the call and put options that we sold to open the trade.
We also make money from time decay adding up. In other words, we make money from every day that passes as the options will get cheaper.
Finally, we also make money from volatility decreasing. The goal is for the options to get as cheap as possible so we can buy the spread back to close the position at a cheaper price than we sold it for when opening the trade.
Ways Of Making Money With A Put Credit Spread:
- We make money if the stock moves up, down, or sideways as long as the stock stays between the strike prices of the call and put options that we sold to open the trade.
- We make money from time decay adding up on a daily basis.
- We make money from volatility decreasing.
Any combination of the factors above will allow us to make money with the Iron Condor.
Manage Your Options Trade
The only way we can book the full profit on the trade is if we hold to expiration. However, we don’t like to hold all the way to expiration. We will typically close out of the trade early when we can keep 50-75% of the max profit on the trade.
If we collected $1.00 to open the trade, then we will look to close the trade when we can buy it back for between $.25 and $.50 as that would allow us to book 50-75% of the $1.00 that we collected to put the trade on.
Example Iron Condor Trade
Looking at IWM which is the Russell 2000 ETF, we determine that we want to place a neutral position using an Iron Condor. We decide to go with the Nov 20 Monthly options that have 44 days left to expiration.
We go to the 165 out of the money call option that has a 65% chance of closing out of the money and sell that option as part of the spread. To start we will also buy the 167 call at the same time to make sure we are in a risk defined trade on the upside.
We go to the 151 out of the money put option that has a 65% chance of closing out of the money and sell that option as part of the spread. To start we will also buy the 149 put at the same time to make sure we are in a risk defined trade on the downside.
When pricing out this Iron Condor we need to make sure we are collecting 50% of the width of the strikes. There is a $2 difference between the strike prices so we would like to collect a $1.00 credit.
Looking at our first example, the Iron Condor is trading for $1.33. While this would give us a bigger profit potential, we would rather adjust the strike prices of the options farther away from the stock price.
Doing so will give us a lower profit potential but bigger profit window and higher probability of success.
To adjust the strike prices of the Iron Condor we are going to move both the call options and the put options farther away from the current stock price. We will look to sell the 170/172 call spread (Sell the 170 call and buy the 172 call at the same time) and also sell the 148/146 put spread (Sell the 148 put and buy the 146 put at the same time).
Adjusting the strike prices will now allow us to collect the $1.00 that we are looking for which is 50% of the width of the strikes.
While we give up some profit potential on this second trade option, we get a bigger profit window on the trade.
In other words, IWM has more room to move around higher and lower and still allow us to make money on the trade. By collecting 50% of the width of the strikes we are left with a 1:1 risk to reward ratio on the trade.
Selling this spread to open for $1.00 will allow us to collect $100 per spread. This $100 is the most we can make on the trade.
Our max risk on the trade is also $1.00 or $100 per spread which is calculated by taking the $2 difference between the strike prices of the options and then subtracting the $1.00 that we collected to open the trade.
We will have 2 breakeven points on this trade.
Our breakeven point on the upside is $171 which is calculated by taking the 170 strike of the call option that we are selling and adding on the $1.00 that we are collecting to open the trade.
Our breakeven point on the downside is $147 which is calculated by taking the 148 strike of the put option that we are selling and subtracting the $1.00 that we are collecting to open the trade.
We make money if IWM moves higher, lower, or sideways as long as the stock price stays between $171 and $147.
We also make money from time decay adding up and from volatility decreasing.
While we could hold to expiration hoping to keep the full $1.00 or $100 profit per spread, we don’t like the risking of holding all the way to expiration. We prefer to close the trade out early when we can keep between 50-75% of what we collected to open the trade.
In this case, we would look to buy the spread back for between $.25-$.50
Using proper position sizing is crucial on this trade.
While we do have high odds of making money on this trade, it’s still just an individual trade that could win or lose for us. Loading the boat on one big trade is a recipe for disaster. We recommend keeping the risk on each individual trade at between 2-5% of your account.
This way if you do have a losing trade it’s not going to wipe your account out. If you get your sample set of trades big enough you will absolutely make money over time.
Iron Condor Wrap Up
Having a diversified toolbox of options strategies is crucial in today’s market environment.
While we all love going for the big home run trades, in reality markets won’t always give us those big moves. There are times that we need to be ok going for the smaller profits that can make us money even in a slow sideways market.
The Iron Condor is a great trade type to have access to as it will allow you to stay active in quiet markets which are typically the markets that give traders the most trouble.
You will have a high probability of success with the Iron Condors and these trades will be much more forgiving.
You don’t need to be perfect on your market direction to make money. It’s a much lower stress approach which is why it’s a go to strategy for most successful options traders.