“80% Winning Record Guaranteed!”
How many times have you seen an ad like the one above? How many times have you thought to yourself “Can that really be true?” or "What’s the catch?” The surprising thing is those headlines can often be absolutely true – it is possible to win 8 times out of 10! HOWEVER, that does not necessarily mean you will make money! And that’s the catch…
Most experienced traders have encountered examples in reading financial journals where one is told that by making money on 1 trade in every 2, cutting losers short and letting winners run that profits can be consistently generated. With those examples in mind, it seems that if we could generate 8 winners of 10, instead of simply 1 out of every 2, that we should generate phenomenal returns in our account. Yet, what the headline fails to reveal is that while you could potentially produce 8 winners out of every 10 trades, those 2 losers could be sufficiently large to offset the gains of the other 8 trades!
One strategy that has the potential of generating such a phenomenal win-loss record is the iron condor. However, it also has the potential of exposing the trader to significant losses. As a result it is paramount to enter such trades judiciously as will be outlined below. The risk of jumping in with abandon is the risk of making say $1.50 per share on 8 trades of the 10 (i.e. $12 per share) but losing $8.50 per share on the remaining 2 trades (i.e. $17 per share) producing a net loss of $5 per share – even with an 80% winning record,
Iron Condor Basics
The bull put comprises a short put placed out-of-the-money (below the stock price) in conjunction with a long put placed even further out-of-the-money (usually a strike below the short put).
The bear call comprises a short call placed out-of-the-money (above the stock price) in conjunction with a long call placed even further out-of-the-money (usually a strike above the short call).
Iron condors are entered when the expectation is for the stock to remain within a certain range. If the stock does indeed remain constrained between the short call and short put strikes then all options expire worthless and the net credit received upfront is banked as profit.
Unlike debit spreads where commissions are paid at trade entry to open positions and at trade exit to close positions, commissions are only paid once at trade entry for iron condors – provided the stock does indeed remain within the expected range. Indeed one could consider that the net credit received from the bull and bear credit spreads is used to pay for commissions so no money is actually taken out of the trader’s pocket.
Iron Condor Example
An example of a conventional iron condor might look like the following trade:
Trader Jack (but not Phil) believes that BIDU is likely to consolidate over the next month following its big bull run from earnings. He evaluates the current option chain and decides that a 120/115 bull put and a 140/145 bear call produces sufficiently attractive premium to warrant trade entry and meets his expectations that the stock is unlikely to move down below $120 or above $140 (note: current stock price $131.05). He is betting that the stock does not move more than about 7% up or 8% down from its current level.
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120/115 Bull Put: Credit = $0.50. Risk = $4.50
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140/145 Bear Call: Credit = $0.75, Risk = $4.25
The Net Credit for the iron condor is simply the sum of the credits from the bull put and bear call:
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Net Credit = $1.25
However, the Total Risk in the iron condor trade is NOT the sum of the individual risks!
In fact the Total Risk is calculated as follows: Total Risk = Maximum Difference in Strike Prices – Net Credit.
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Total Risk = $5 – $1.25 = $3.75
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Return on Risk = $1.25 / $3.75 = 33% in 26 days (at time of writing!)
The trade works out perfectly IF the stock remains between $120 and $140 by June expiration. This would yield the 33% return on risk. If the stock moves beyond short option strikes at 120 or 140 then the trade starts running into trouble. In fact, theoretically the breakeven points for the trade are as follows:
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Breakeven (if stock moves up) = Short Call Strike + Net Credit = $141.25
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Breakeven (if stock moves down) = Short Put Strike – Net Credit = $118.75
Technically this means that if the stock remains in the range from $118.75 and $141.25 by expiration then the trade will not lose money. Anywhere between those prices and the trade is profiting. And, if it moves beyond the long option strikes at $115 or $145 a maximum loss will result at expiration.
Just in case you were wondering why it is that the credits of the two credit spreads are summed to produce the Net Credit while the risk of the two credit spreads are not summed, keep in mind that the stock cannot be both above $140 and below $120 at the same time.
Selection Criteria
A pure options strategist might view the iron condor above from the perspective of probabilities. He might see that the option deltas build in a 72% chance of the stock remaining below $140 while they effectively build in an 83% chance of the stock remaining above $120. From this the strategist might do some quick conservative calculations….
If the trade makes money 7 times out of 10 then the trader would profit $1.25 * 7 = $8.75 while the 3 losses (if they were maximum losses) would produce a total loss of $3.75 * 3 = $11.25!
Obviously this would not be attractive so the strategist might decide to increase the bear call from 140/145 strikes to 145/150 strikes thereby producing more symmetry from the probability standpoint. The deltas in the higher strike bear call build in an 81% probability of the stock remaining below 145. However, the trader must then accept lower reward, $0.45 instead of $0.75 for the bear call. The combined net credit would then be $0.95 for the new iron condor with bull put (120/115) and bear call (145/150).
Making $0.95 8 times out of 10 produces $7.60 while losing the maximum risk (now $4.05) 2 times out of 10 produces a loss of $8.10!
The conclusion is that randomly entering iron condors based on probability/net credit tradeoffs will not yield numerous attractive iron condor candidates and so additional factors must be considered before an arbitrary trade entry.
From a technical perspective, iron condors can be more strongly considered when firm resistance and support levels can be established and attractive reward/risk ratios are on offer by placing the bull put at or below support and the bear call at or above resistance. If firm resistance and support levels have held in the past, the trader will have increased confidence that those same levels will hold in the future to repel the stock.
Phil does not like this particular trade on BIDU (or Iron Condors in general – "too dull") as he does not feel that $120 is an established floor and additionally feels that $140 is not beyond the realm of possibility on a breakout as BIDU has consolidated around $120 for 6 months and may break out again if the Asian markets take off. ANYTHING that makes you feel that a position may not have a 95% chance of success is a good reason not to attempt an Iron Condor. That is what will make this a fun trade to watch!
While firm technical levels are often a necessary aspect of due diligence when identifying iron condor prospects, never forget the potential volatility that can arise from events such as earnings announcements. As such, it is generally worth avoiding iron condors going into earnings unless the implied volatility on the options was so high that the reward/risk ratio became compelling.
In fact, often an excellent approach to entering these trades is to wait for an event that causes a strong directional movement and then leg into the trade! For example, I mentioned to Phil following the bearish move on TSO a couple of weeks ago that I was entering a bear call at the 120/125 strikes. I waited until the stock got rejected on heavy volume before considering the trade – my expectation was that continued bearish sentiment would translate into pushing the stock lower and that while consolidation was possible the chances of a huge reversal were slim.
As the stock fell to $112 intra-day this past week I closed out my short call and took most of my profits. I wasn’t quite as confident in support levels to enter the bull put side of the trade, however, in practice there is no reason why it couldn’t be considered when there is higher confidence that a short-term support level will hold.
I’ve played other stocks like SHLD in the exact same way recently with great success because I tend not to fight the trend when it’s going against me. The real test in fact is patience; waiting for the sell-off and then pouncing with a bear call or indeed waiting for a big pop and then pouncing with a bull put. The key then is to wait for the stock to run before entering the second part of the trade when it is repelled off key technical levels. This can produce even more attractive reward/risk ratios than could be received by entering both positions simultaneously – though admittedly it does require slightly better timing of the market and a more active role spotting such opportunities.
Cheat Sheet
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Factor in fundamentals (events, earnings) & technicals (resistance/support) when starting iron condors.
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Evaluate risk/reward ratio & determine what ratio best suits your risk tolerance.
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In general, avoid evaluating iron condors purely based on mathematical probabilities
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Once your timing has improved, consider legging into iron condors to maximize reward and minimize risk.
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Set clear triggers whereby you will exit trade.
Trade Safely & Have A Great Week!
OptionSage
