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 30 to 45 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 in basic terms.
A Bearish Iron Condor
OK, let’s get started.
An iron condor strategy is a non-directional options strategy that profits when the option on the underlying stock or exchange-traded fund of your choice expires within your chosen range at expiration.
The basic premise of the iron condor strategy is easy. You choose the price range of the trade. Increasing the range will decrease your potential profits but will increase your likelihood of success.
The first requirement when trading iron condors is to make 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 SPDR S&P 500 ETF (NYSEArca: SPY).
The ETF is trading for $416.13.
I typically like to start with a trade that has a probability of success around 80%, if not higher.
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 June 18th 432 calls fit the bill, as it has an 81.16% probability of success.
Next, I take a look at the put side with the same goal in mind: a probability of success of around 80% or higher. However, since I am bearish on the market over the short term, I want to increase my probability of success slightly. I’ll have to forego some of my potential return to do so, but it’s a reasonable approach given my view on the market.
At 87.01%, the June 18th 374 puts work. If I were to go with my typical 80% probability of success, I would need to sell the 387 strike. But again, in this example I want to take a more conservative approach, so adding a $13 margin of error to increase my probability of success by roughly 7% is worth foregoing an additional $0.15 to $0.25 in total premium on the iron condor trade.
So, right now I have my starting range of $374 and $432 established. Obviously, I can alter it as needed, but first I want a good base for my iron condor trade.
What’s the Return?
By selling the 432/437 bear call spread and the 374/369 bull put spread simultaneously – thereby forming an iron condor – you can make $1.22, or 32.3%, over the next 43 days.
With SPY trading at $416, the breakeven levels are $433.22 or $373.78.
The probability of success on the trade is a staggering 81% on the upside and over 87% on the downside. I like those odds.
I typically manage the trade by taking a loss if the spread increases to 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, so we want to try and keep losses to a minimum, knowing that if the statistics play out, our wins should far outweigh our losses.