Recommended Option Strategies: Decisions to Make Before Trading an Iron Condor. Part III

This is an important post because it contains
information seldom discussed elsewhere – information that is essential if you
want to understand how adopting the iron condor strategy results in gains and
losses.

Strike Prices and Premium Collected

Choosing the strike prices
for your iron condor position – and deciding how much cash credit you are
willing to accept for taking on the risk involved – are irrevocably linked. Thus, I’ll discuss them together.

Assume the call spread and
put spread are each 10-points wide.

For
example:
(RUT is the (Russell
2000 index)

Sell
10 RUT Sep 620 put

Buy
10 RUT Sep 610 put

Sell
10 RUT Sep 760 call

Buy
10 RUT Sep 770 call

  • Market bias

Most
of the time that you open an iron condor, you have a neutral opinion, i.e., you
have no expectation that the stock is going to move in one direction as opposed
to the other. As a result, you tend to choose a call spread and a put
spread that are equally out of the money. To put it simply – the call and put you sell will each be approximately
the same number of points away from the price of the underlying security. In
our example above, If RUT is trading near 690, the 620 put and the 760 call are
each 70 points out of the money, and the position is ‘distance neutral.’

There
are other methods you can use to have a position that is ‘neutral.’ Instead of equally far out of the money, you
may choose to sell spreads that bring in the same amount of cash. This is ‘dollar neutral,’ a method seldom
used.

If
you understand the term delta (we’ll get to it eventually) you may choose to
sell spreads with equal delta. I don’t
recommend this method for iron condors, although ‘delta neutral’ trading has a
great deal to recommend it under different circumstances.

If you are
bullish, you can choose to sell put spreads that bring in more cash, attempting
to profit if the stock or index does move higher, per your expectation.

If you are
bearish, you can choose to sell call spreads that bring in more cash,
attempting to profit if the stock or index does move lower, per your
expectation.

 

  • How far out of the money

Most
investors believe that the further out of the money the options they sell, the
‘safer’ their position and the less risk they have. That's one way to look at ‘safety.’

Probability
vs. Maximum loss
. If you sell the RUT 580/590 put spread
instead of the 610/620 put spread, there is a higher probability that the options
you sell will expire worthless, allowing you to earn the maximum profit that trading this iron condor allows.

I
believe that is intuitively obvious, but for those who don’t see it, consider
this (and for the purposes of this discussion, assume you hold this position
until the options expire): Most of the time the options expire worthless, but
part of the time, RUT moves far enough below 620, resulting in a loss. Part of the time that RUT is below 620 at
expiration, it is also below 590. But,
the probability that it’s below 590 must be less than the probability that it’s
below 620 because part of the time RUT is going to be between 590 and 620. Thus, you lose money less often, when you sell options that are further out of the
money. That fits the first definition of
‘safer’.

But,
you can also look at it this way. When
you sell the 580/590 put spread, you collect less cash than when you sell the 610/620
put spread. This is always true: the more distant the options are from the market price of the underlying stock or
index, the less premium you collect when selling single options or option
spreads.

This
is why it’s so important to find your comfort zone when choosing the options
that make up your iron condor.

o You can trade
options that are very far out of the money. 

§ These positions have a very small chance of losing
money. You can easily find iron condors with
a 90% (or even higher) probability of being winners.

§ However, the cash you collect may be too little to
make the trade worthwhile. Some
investors are willing to sell iron condors and collect between $0.25 and $0.50
for each spread, netting them $50 to $100 per iron condor. If that makes you comfortable, then it’s okay
for you to trade this way. For my taste,
the monetary reward is too small. NOTE:
Selling a spread for $0.40 translates into $40 cash, and the possibility of losing $960.

§ Remember that the maximum loss is very high, and one
giant loss can wipe out years of gains. The maximum loss is $950 per iron condor, when you only collect $50 to
initiate the trade.

o You can trade
options that are far out of the money, but not so far that the premium you
collect is too small.

§ You still have a high probability of owning a winning
position.

§ You have the potential to earn more money because you
collected more cash upfront.

§ The maximum loss is reduced, and some consider this position ‘safer.’  That fits the second definition
of safety.

o You can sell options
that are closer to the money

§ This reduces your chances of having a comfortable ride
through expiration, and increases the chances of losing money.

§ In return for that reduced probability of success, potential
profits are significantly higher. You
may decide to collect $400 or $500 per iron condor.

§ The maximum loss is much smaller, and again, that fits
the second definition of owning a safer position.

How
do you decide? There is no ‘best’
choice. You goal should be to find iron
condors that places you well within your comfort zone. And if you are unsure of how your comfort
zone is defined, use a paper trading account to practice trading iron condors (or any other strategy). I know that real money is not at risk, but if
take the positions seriously, you can determine which iron condors
leave you a bit uneasy and which ‘feel’ ok. Advice: Don’t make the decisions about
comfort based on which trades are profitable. Base the decision on which iron condors make you nervous about potential
losses both when you open the position and as the risk changes over time.

It’s
easy to randomly open positions and hope they work. But it’s better to open positions that fall
within your comfort zone.

20

One Response to Recommended Option Strategies: Decisions to Make Before Trading an Iron Condor. Part III

  1. PeteD 07/24/2008 at 9:39 PM #

    Hi Mark,
    above, when talking about which strikes to choose, you seem to compare “distance neutral” with “delta neutral” – wouldn’t they be basically the same thing? ie, if a call has a delta of 7, and a put has a delta of 7, can you not basically assume they will be a similar distance out of the money?
    Also, you say in the post that “…you may choose to sell spreads with equal delta. I don’t recommend this method for iron condors…” – yet you don’t mention why you wouldn’t recommend this method? In light of your answer to my first question, I am interested in some reasons for this comment…
    Cheers,
    Peter
    (my blog is at options.freeblogit.com)
    Peter,
    Good question and I placed your question and my reply in a separate blog:
    https://blog.mdwoptions.com/options_for_rookies/q-a-choosing-st/