Yesterday I responded to a
reader’s question regarding iron condors. This may be an appropriate time to introduce this strategy. Keep in mind this is only an introduction.
Before being prepared to trade
iron condors, it’s important to have a good understanding of credit spreads and
debit spreads, including why you would want to have such a position, what you
have to gain, and the risks. But for
now, let’s skip ahead with a brief discussion of the iron condor. We’ll return for a discussion of the
prerequisite material soon.
Iron Condors
1. A market neutral
strategy.
a. These positions
perform best when the market does NOT make a significant move in either
direction.
b. These positions
are in danger of incurring significant losses when the underlying stock or
index makes big moves in either direction.
c. The passage time
is your friend when you have an iron condor position.
2. Iron condors
consist of two separate spread positions, but you must have both spreads or you
are not trading an iron condor.
a. A spread is a
position consisting of two (sometimes more, but not in this case) individual
options: both puts, or both calls.
i. A call spread is
(as you may have assumed) a position with two calls
ii. A put spread is a
position with two puts.
b. Sell a call
spread and sell a put spread. Collect a
cash premium for each spread. Typically, all four options are out of the money.
i. Sell a call
spread: Sell one call option and buy another. The option sold has a lower
strike price and has a higher price (premium) than the call you buy.
ii. Sell a put
spread: Sell one put option and buy another. The option sold has a higher strike price and has a higher price (premium) than
the put you buy.
c. All four options
expire in the same month.
3. How do you make
money?
As
time passes, the value of each option deceases. But, the options you sold were higher priced than the options you bought
and they will lose time value faster. Thus,
the passage of time makes the position worth less and less. When it reaches a price that is low enough
(no hard and fast rule; you must decide for yourself), you close out the
position by selling out the options you own and buying back the options you
sold. As an alternative, you may hold
the position longer (risky) and perhaps each of the options will expire
worthless.
4. How do you
lose money?
If
the underlying stock or index moves too far in either direction, one of the
options you sold increases in value much faster than the option you bought. Thus, either the call spread (if the market is
higher) or the put spread (if the market is lower) is worth much more than the
price for which you sold it. That means
you have a loss. You may hold this
position, hoping that the stock reverses direction, but that is very risky
because a continued move in the same direction rapidly increases your
losses.
5. Your main goal as
an option trader is to manage risk. That
means preventing large losses. Thus, it’s
not smart to simply hold a losing position and hope. It’s better to take your loss and find
another trade.
This is a very abbreviated description of an iron condor. If you believe that this is a strategy you want to learn, you can read about the strategy or begin by practice trading in a paper trading account. Please don’t jump in using real money if this is your first introduction to iron condors. You have much more to learn first.
