Iron Condors: Reduce Volatility Risk

For the individual investor who is trading options without taking the time to learn many of the finer points of options theory, the major risk for the owner of an iron condor position is that the underlying stock or index will be too volatile, or even worse, be uni-directionally volatile (several big moves, all up or all down) resulting in one of the options sold moving (or threatening to move) into the money.

The iron condor is a position in which one call spread and one put spread are sold: same underlying, same expiration date.  Profits are earned when time passes and you can buy both spreads for less than you collected when you sold them.

What can be done to reduce risk?

1) To reduce or eliminate the loss that results when the stock moves too far, you can buy extra puts and calls (strangles).  I've already covered this idea more than once.  Naked long options go a long way towards offsetting losses (and sometimes can turn the entire position profitable) – when you own the right strike prices.

2) Certain risk characteristics of options are described by Greek letters, and are collectively known as 'the greeks.'  Trading and keeping things simple is acceptable, but it's not a good idea to trade options by ignoring your exposure to risk.  Four of these risk factors are worth your time to understand: delta, gamma, theta, vega.

The numbered statements below assume a 'normal' iron condor.  That means that the underlying has not moved so far that prudence would have convinced you to exit the trade.

3) Iron condor positions always have positive theta.  That means the theoretical value of the position increases every day.  Theta is your friend.

4) Gamma is negative.  Because gamma measures the rate at which delta changes, that negative gamma is your enemy.  It makes you longer in a falling market and shorter in a rising market.

5) Delta is a measure of how 'long' or 'short' the position is.  When delta is -30, you can expect to lose $30 for the first point that the underlying moves higher.  Because of negative gamma, the next, and each subsequent one point move, results is slightly larger losses.  Similarly, you earn that $30 when the underlying makes a favorable move (down is favorable when you have negative delta).  But each subsequent one point move earns less and less (negative gamma reduces positive deltas quickly), until delta turns positive.  Then you begin to lose money as the underlying declines.

Thus, it's important to pay attention to delta and not allow it to reach an uncomfortable level.  I cannot define that level for you.  At some point, I recommend that you consider making a Stage I adjustment.  And then a Stage II adjustment, if necessary.  If the market continues to move against you, at some point (Stage III or IV), it's time to concede defeat on this spread and take the loss.  Why?  To be certain you incur no large losses.  If you avoid big hits, you will make money with iron condors.

6) Vega is always negative for an iron condor position, and that means volatility risk.  When implied volatility increases, the iron condor trades at higher prices, resulting in a loss. 

But this is one risk you don't have to take.  There are methods for making these positions vega neutral, or at least, less vega negative.

One such idea is to buy calendar spreads.  These spreads have positive vega.  You have a couple of reasonable choices:

a) Instead of opening iron condor positions, open some double diagonal spreads (combination of iron condor + calendar) and some iron condors.  Choose an appropriate number of each to make the combination vega neutral.

b) Choose a different calendar spread, but choose strike prices that are in an area where the iron condors will be losing money.  Calendar profits can offset some of those losses (that happens when the calendar strike price becomes an ATM option).


3 Responses to Iron Condors: Reduce Volatility Risk

  1. Blue cat 05/03/2009 at 12:26 PM #

    Hi Mark,
    I know you tend to be uncomfortable with some of my suggestions. I hope you don’t mind my continuing.
    Since you tend to be very cautious and conservative when protecting positions by making adjustments, why would it not be a better strategy for you to be naked instead of spread? That is, you tend to make adjustments significantly before the underlying reaches the short leg. Since you do that, it doesn’t provide much safety for the short leg to be protected by a long leg. You will get out of the short leg before it is breached in any case. And if you don’t have the long leg, the profit from the short leg is significantly larger. Further since the short leg profit is so much larger, one need not take as large a position, further limiting the potential damage.
    It seems to me that the only thing the long side of each spread does is protect against extreme sudden moves. Of course that’s not unimportant. But I wonder what a historical analysis would yield if one compared the profit from naked positions to those of spread positions. Would one really do better in spreads?
    Also, it seems to me that the primary danger of extreme moves is downward. Upward extreme moves are almost always manageable, even if they produce a loss. The real danger is a panic such as the response to 9/11. If one agrees to that, then it might make sense to do iron condor strangle mixes: spreads on the put side and naked on the call side.
    What do you think?

  2. Mark Wolfinger 05/03/2009 at 2:43 PM #

    Hi Russ,
    This gets a bit incoherent, but please bear with me.
    The extreme downward move may be more more likley than an extreme upwards move – over a day or two, but don’t you think the recent >30% rally was quick enough to demonstrate that big moves can occur to the upside as well? I suffered through such moves in 1978, 1982 and 1984. I’m not making any money during this 2009 rally either, and would never be willing to face such possibilities with naked short options.
    Let me be clear that I’m not saying it’s a bad idea for everyone. But, it’s not for me and I would discourage anyone from adopting it. It’s just too risky with so little (if anything) to gain.
    I will not risk an overnight marekt gap – such as a successful terrorist attack or assassination might bring. I will not forfeit my account to a black swan event. That’s reason enough. Sure, owning insurance guards against that, but I don’t always own insurance and have no idea whether you do.
    But you must take a good look at option prices and then think about what realities you may be forced to face. What will you do if the option you sold naked at $5 is now $25? IV can do that, even if delta doesn’t. And how would like to suffer a nice loss on the short naked call when the market tumbles and IV soars?
    Here’s one problem that I confront frequently: Newcomers to the option world are eager to learn and always have lots of ideas. When I get a question such as this, I don’t know how much data crunching I’m expected to do to try to convince you that this idea is not viable. That’s too kind – I’ve reconsidered my earlier statement: it’s risky beyond belief and I take back what I said earlier. It’s a terrible idea. I base that on my experience and what I have seen. And don’t ignore the margin requirement on a naked short option: it increases as the market moves against you. Decreasing account + increasing margin requirement can easily = disaster and forced buy-ins.
    I would have thought that 2008 demonstrates this better than I can expalin it to you.
    Why not crunch some numbers instead of sending me this idea. You will learn far more by doing this study than you will from my opinion – which is after all, just an opinion.
    Take such a position: The iron condor sans purchase of the long call. Assume you sell options with a 10 delta. Take a look at what happens when the index moves ?? percent.
    When will you cover? What delta does the call have to reach before you buy in it? Or how much must you lose in dollars before covering. Assume ?? days have past and calculate option values. How much did you lose? What happens if IV moves higher – say 20% higher. How much is the loss then? Don’t forget the put side.
    If you owned the full iron condor, would you be covering at that point, or be comfortable enough to hold longer?
    If you trade fewer of these than you would trade normal iron condors, how many fewer would you trade? How much cash would you collect, for the 4-way vs. the 3-way? Is is worth the risk to make that extra cash – or is there no extra cash because you traded fewer 3-legged spreads?
    When I trade an IC for $3, my max loss tends to be about $3 (say I cover one spread @ 5.50 or less and the other @ 50 cents). How much would you lose on the naked call at the point at whch you clsoe it? I know it’s more than my $3, but to offset that, you would not always have to close and thus, could earn more than my $3 maximum.
    All in all, is it a good idea? Does it still work for you? If yes, you must feel more comfortable having crunched some numbers.
    1) Please continue. One thing I know for certain is that I do no have all the answers, so discussion is always welcome.
    2) I am not as cautious as my persona suggests. I wish I were.
    3) My usualy practice has been not to adjust until the short strike has been breached, but over the past year have evolved into adjusting sooner – in stages.
    But answering this question is too much work for me. Please do the study and report back. If you have a lot to say, perhaps we can turn it into a guest blog.

  3. Russell H 05/07/2015 at 6:10 PM #

    Hi, you’ve said that “3) Iron condor positions always have positive theta. That means the theoretical value of the position increases every day. Theta is your friend.” But it’s not simply right ’cause then no one would ever loose any money in Iron Condor. Please correct your statement. Thank you.

    The statement is correct.
    Iron condors earn money every day from the passage of time.

    However, other factors are in play. When implied volatility increases, it can cause the loss of more money than is gained from the passage of time.

    When the stock price changes, especially by a significant amount, it will definitely result in the loss of more money than is gained from the passage of time.

    When several factors determine the daily profit/loss for any option position, there is no such thing as an iron condor that always earns a profit. Nevertheless, it is true that an iron condor earns a profit from the passage of time.

    Look at it this way: You are paid the time decay as compensation for the risk being taken. And that risk is primarily that the underlying stock price will change. So if the stock price behaves, the time decay becomes the profit. When the stock price misbehaves, the the time decay offsets part of the loss.