Legging into an iron condor: A Good Idea?


Can you please provide some in depth info on what would the preferable steps to leg into an IC – by spread – would be?

Example. if I open the put side today and next week index moves higher I sell the call side, that's great. But what if next week index moves lower? Roll-down the puts? Take losses and wait for another opportunity? Sell the calls at current prices?

My second question is: from your experience, would an IC constructed around 1 standard deviation OTM be really ~68% probability of keeping all the premium (given we do not make adjustments, in plain theory)? Thanks.



In depth discussions are not always possible.  That's the stuff of which lessons and book chapters are made.  However, I'll offer the major points in enough detail, that it should satisfy your needs.

As it turns out, you do not need a lot of information about legging into iron condor trades. 


Legging into iron condors

1) Here are the major points – everything else on this topic is far less meaningful.

I do not like the idea of legging into iron condor trades by selling puts first.  It simply doesn't work as well as it should – when considering the risk involved. I know that's not good news for the trader who usually has a bullish bias, but there are good reasons.

When the market rallies, IV tends to shrink.  When IV shrinks, the value of the call spread that you are planning to sell also shrinks.  By that I mean it increases in value by less than you anticipate.  Often much less because it is an OTM spread.  I'm assuming that the iron condor trader is not looking to sell options that are CTM (close to the money).

It takes a significant upward move for that OTM call spread to increase in value by enough to compensate the trader for taking the leg. If you do sell the put spread first, and the market cooperates, it's often better to buy back that put spread, take the profit, and forget about getting a little better price on the call spread.

It's different with calls. If you correctly (i.e., you are correctly short-term bearish) sell the call spread first, then you have the opposite effect.  If the market declines, the put spread widens faster than expected and you have an iron condor trade at a good price.

Thus, unless bearish, I suggest not legging into iron condor trades.

Managing the single leg

2) If you don't get an opportunity to sell the second leg of the iron condor, I suggest forgetting about it and managing risk for the one credit spread that you did sell. 

Let me point out something that seems 'obvious,' but may not be obvious to everyone.  More than that, a significant number of traders may have never considered this simple idea: Once you own the full iron condor position, my experience tells me that it is far more efficient to forget that it is an iron condor and manage risk as if it were two separate trades:  one call spread and one put spread.

Thus, I recommend trading the situation described above as a put spread.  The fact that you did not collect any option premium by selling the call spread no longer matters. 

[If you had sold the call spread, and the market declines, the only important consideration is knowing when to buy back that call spread by paying a small price .  Waiting for it to expire worthless is far too risky.  Sure, it expires most of the time, but on those occasions when you get the big bounce (and that's what you (Dmitry) are in the market to find, isn't it?) there is no point in taking a good-sized loss on the call spread when it could have been covered by paying $0.20 – or another low price that suits you.

That's why I suggest managing the put spread as you would normally manage such a spread.  I understand that you are primarily a stock trader and have not traded a bunch of these, but there is no single best way to manage the risk.  My advice is DO NOT allow the fact that the call spread was not sold influence your decisions.

Yes, you can roll it down; yes you may be uncomfortable with the trade and exit at a loss.  Yes you may sell a call spread now – but that is my least favorite adjustment method and I strongly recommend that you not do that.  I base that on your bullish personality, and for you, losing money in a rising market would make you very unhappy.  Much more so than losing in a falling market.  These pshychological factors may not be a legitimate of scientific trading, however I truly believe that a successful trader does not place him/herself in a situation that can result is a very unhappy outcome.  My strong guess is that if you were to lose a given sum, you would be far unahppier losing on the upsdie than the downside.

Standard Deviation

No.  The chances of keeping the entire premium are nowhere near that 68%.

If you sell an option that is one standard deviation (SD) OTM, then yes, it will be out of the money approximately 68% of the time when expiration arrives.  But don't ignore the fact that it may be ITM far earlier than expiration (and then finish OTM), and you would probably elect to adjust or exit, rather than clsoe your eyes and wait for expiration.

More importantly, you are selling a call and a put.  The probability that the put finishes OTM is that 68%.  The probability that the calls finishes OTM is also 68%.  However, you have both positions and the probability of finishing ITM is 32% for either option.  these probabilities are additive. 

Conclusion:  The probability that either the put or call will finish ITM is ~64% and the chance that the iron condor will expire worthless is only 34%.  That is nothing near the 68% that you mentioned.

It gets worse.  If you decide to determine (see yesterday's blog post) the probability that the underlying stock or index will move to touch either the put or call strike price during the lifetime of the options, you will discover that the probability of touching is much higher than the probability of finishing ITM.  Assuming you would make an adjustment, the probability of keeping the entire sum is now far less than 34%

Iron condors are riskier than they may appear at first. That's why risk management is so important.



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15 Responses to Legging into an iron condor: A Good Idea?

  1. Dmitry 01/25/2011 at 4:36 AM #

    Thanks alot for the comments, i would actualy be more happy losing money on the upside (beacause my iron condors represent only a small % of the total portfolio). That is why i ve concluded that IC best suits my needs in all aspects – enhancing the profits on a limited upside moves and lowering losses on a market fall (as i mentioned earlier i initiated some negative delta ICs). So the upside risk doesnt scare me TO much, and for the lowside im long 1 VIX vert. (better than nothing).
    The idea behind legging in is either collecting a better premium on a condor that i would otherwise buy as a spread, or either to collect same prem. for a wider IC. The second option is more tempting to obtain to me. That is why im thinking of waiting for a market pullback, sell puts (expensive cause of IV and delta), than if lucky and in coming days the market reverses sell some higher strike calls than initialy planned, collecting same ~3+ / IC. If market falls further before i sold any calls, the rise in VIX will probably offset the losses on closing/rolling puts.
    And for the SD question – im still thinking about whether SD can be based on IV or not. The only way to find it out is the trade statistics for some 20+ years. It is possible to calculate the chances of NOT touching either strike and compare them to real trading experience, but i do not have that experience. Backtesting could solve my question but i doubt i can find any reliable info on daily option prices for the last say 20 years.

  2. Dmitry 01/25/2011 at 6:10 AM #

    Isnt using IV for statistics the same as using Beta as a measure of risk for stocks? I.e. if the stock dropped sharply and it`s beta increases, but not the risk, it`s actualy a better price now. Same here – if the market declines today does it really mean that tomorrow will be an even risky day, as told by IV? If not it elliminates the need to trade fewer contracts on high IV times.

  3. Mark Wolfinger 01/25/2011 at 8:24 AM #

    1) Yes – the goal when legging is to own a position at a better price. When you leg by selling puts first, the potential extra gain is LESS than when selling calls first.
    2) If you sell puts first and market falls further, there is NO offset. The rising IV (VIX as you refer to it) INCREASES losses.
    If the market rises, it take a big rise to sell call spreads with higher strikes to achieve the same premium. First, the move must be 10 points or more – just to make the calls as far OTM as the call spread you wanted to sell earlier. Second, some time has passed, another negative. Third, IV has decreased, a third negative. The move must be > 10 points to get the same premium.
    It takes a good move to get what you want to get.
    3) Yes, SD is valid. Why? Because the IV is the best available estimate for future volatility. It’s not going to be accurate because estimates are seldom accurate. But, you must choose a value for future volatility before you can calculate SD.
    Choose whatever value for volatility that suits. If it is possible to do those calculations, I have no idea how to do that. Besides, each time you made the test, the option choices would be random. It takes many many examples to learn anything from the data.
    You can find the option data needed from OptionVue. I don’t know how much they cost and I don’t know how far back the data goes, but you can ask.

  4. Mark Wolfinger 01/25/2011 at 9:00 AM #

    I do not believe they are the same or even similar.
    More on this topic as soon as I can get to it. A day or two.
    Thanks for the excellent questions.

  5. Gus 01/25/2011 at 2:14 PM #

    What do you think about low probability ICs? with about 30% probability of expiring OTM and around .65 credit per 1k margin, with very low initial size expecting to increase size with almost certain adjustments.

  6. Mark Wolfinger 01/25/2011 at 2:37 PM #

    $0.65 credit is not sufficient information. Thus, I’ll assume that $1.00 is the maximum value for the spread.
    That would make the margin $100. You write of $1k margin. Are you referring to doing 10 of those spreads? I’ll assume that because if you collect 65 cents for a 10-point spread, it is not a low-probability iron condor.
    1) I’m not a big fan of low probability iron condor (LPIC). But that’s honestly because of my personal preferences and comfort zone.
    Traders I respect believe that LPIC are statistically ‘better’ and produce a higher income over the longer term. I can neither affirm nor dispute that claim. But I believe the is nothing wrong with that trade.
    2) The adjustment strategy for LPIC is different. After all, it’s highly likely that the position will be in the money (soon), and I’ve not considered the best adjustment under those circumstances.
    I suggest a trade plan – pre-trade- to give you a chance to think about the choices before you encounter them

  7. Patrick 01/25/2011 at 5:29 PM #

    Hi Mark,
    I have an option question not related to this topic. I would like to know when one should put on a long naked option versus a backspread (like a 1×2). I’ve heard some people talk about using backspreads in preference of a long option. How does one decide which one to use? Thanks. Patrick

  8. Mark Wolfinger 01/25/2011 at 7:35 PM #

    In general, for a retail investor, the back spread is a terrible idea. Many times the stock will move as you anticipate, and you wind up a loser. It’s one thing to lose when your prediction fails, but to lose when you are correct is a big bummer.
    The back spread is very sensitive to time decay. If you don’t get your move quickly, you can get hurt (as your shorts increase in value and your longs move towards zero).
    If you expect a gigantic move, then the back spread has appeal because you want to own as many extra long options as possible. Barring that specific – gigantic – move, the back spread is best handled by professional traders who hedge the deltas in a way that is too costly and inconvenient for the retail trader.
    Go naked.
    Good question.

  9. Patrick 01/25/2011 at 8:23 PM #

    Thanks for your answer. I think I will just go with the long option. Regards – Patrick.

  10. Dmitry 01/26/2011 at 7:52 AM #

    “2) If you sell puts first and market falls further, there is NO offset. The rising IV (VIX as you refer to it) INCREASES losses.”
    I guess i didnt make myself clear. I am already long VIX call vertical, the bullish one. So i guess it will offset the loses from the rising IV.
    Also my initial planned call verticals have a higher -delta than puts, -12 vs 7 in ex. Doesnt it make any difference?

  11. Mark Wolfinger 01/26/2011 at 8:09 AM #

    OK. The VIX call spread SHOULD offset PART of the loss from the put spread that you sold.
    But – and this is crucial – if you own VIX options that expire in the WRONG month, the gain that you anticipate can be almost zero.
    When VIX rises, VIX call options do not always increase in value. The VIX index is not the underlying asset for VIX options. Many novice traders have been BURNED by trading VIX options – a product that is not easy to understand.

  12. Dmitry 01/26/2011 at 8:29 AM #

    I understand that. What i dont understand is how those VIX options will work at expiration. The debit ive paid is my max loss in this example, i also have a fixed profit. Is it possible that VIX expires above my short call and i dont receive full profit?

  13. Mark Wolfinger 01/26/2011 at 8:35 AM #

    These options are cash settled. There is ZERO chance that you will not collect the maximum, if both options finish ITM.
    Note: VIX options do not expire at the same time as the other options that you trade.

  14. Dmitry 01/26/2011 at 8:46 AM #

    Yes, ive read CBOE specifications.
    Thanks alot!

  15. Anthony Alfidi 03/23/2013 at 1:17 AM #

    The OIC’s options seminars are very informative introductions to iron condors:
    [URL removed by MDW]

    Thanx for comment. However, if you (per your blog) truly believe a newbie van learn enough to begin trading options in one day, then you are doing more harm than good.