Unlike most investors, we have the ability to structure our positions in a way that generates profits regardless of the direction of the underlying stock or ETF.
Take for instance, the iron condor: an options strategy that thrives when the market goes nowhere. It generates above-average profits when the underlying security remains range-bound for the duration of the trade, which in our case is typically 45 to 60 days.
The best part is that we have the ability to choose our return. Just keep in mind, the higher your expected return, the higher the risk.
Here’s my step-by-step approach to iron condors.
OK, let’s get started.
First, a disclaimer of sorts. If you don’t understand the terminology, don’t be discouraged. Focus on the concept. Pay attention to the numbers; you’ll learn the terms with repetition. Best of all, if you need some help, just email me at firstname.lastname@example.org and I will gladly attempt to answer your question.
The first requirement when trading iron condors is making sure you are using a highly liquid security, in most cases an ETF. Highly liquid, in the options world, just means that the bid-ask spread is tight, say within $0.01 to $0.10, at least in most of the ETFs I trade.
For instance, take the heavily traded Russell 2000 ETF (NYSE: IWM).
The ETF is currently trading for $141.56.
IWM is just one of 20 to 30 ETFs that I consider “highly liquid.” I focus my attention on only those ETFs.
I then move on to my mean-reversion indicator, otherwise known as RSI.
RSI can be seen below the IWM chart above. You’ll notice peaks (overbought) in green and valleys (oversold) in red. But that’s often not enough to warrant a trade.
An appropriate implied volatility rank and implied volatility percentile is also needed.
Without going into detail, the IV rank and IV percentile simply tells us if the implied volatility is high or low in the highly liquid stock or ETF that we want to trade.
If it’s normal to high . . . we want to trade it. Of course, there are a few exceptions, but I’m not going into the details here. I’ll save that for another time.
A normal-to-high IV rank and percentile just means we can sell options for fair to inflated prices, and as anyone who sells anything for a living, your preference is to always sell your product for inflated prices. Options are no different.
Typically, this type of set-up occurs when a security moves from an oversold state back into a neutral state. When a security is oversold, it has trended lower, and as a result, fear has increased. The increase in fear inflates the price of the option, because more investors are buying options for protection. And that’s the reason why prices are skewed slightly higher for put options.
So, assuming IWM’s implied volatility is at least slightly above historic volatility, we can proceed to the next step . . . choosing your return.
Again, IWM is trading for roughly $141.50.
I typically like to start with a trade that has a probability of success around 80%, if not higher. But I use 80% as my starting point.
First, I look at the call side of the iron condor, also known as a bear call spread. I want to find the short strike with an 80% probability of success.
The September 147 calls fit the bill, as it has an 81.91% probability of success.
Next, I look at the put side with the same goal in mind, a probability of success of 80% or higher. At 82.99%, the September 132 puts work.
So, right now I have my starting range established. Obviously, I can alter it as needed, but first I want a good base for my iron condor trade.
By selling the 147/150 bear call spread and the 132/129 bull put spread simultaneously – thereby forming an iron condor – you can make $0.65, or 27.7%, over the next 49 days.
With IWM trading at $141.56, the underlying price in IWM would have to breach the breakeven levels of $147.65 or $131.35 by September expiration before the trade begins to take a loss.
Best of all, the probability of success on the trade is a staggering 81.91% on the upside and over 82.99% on the downside. I like those odds.
I typically manage the trade by taking a loss if the spread increases to around roughly double the premium sold. I want to keep my losses small, knowing that I can make up for the loss if all goes well in the next trade.
Remember, we are trading math here. It’s all about allowing the probabilities to work themselves out amidst the iron condor options strategy, so we want to try to keep losses to a minimum, knowing that if the statistics play out, our wins should far outweigh our losses.