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, and an understanding of why you would want to own 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.
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.