As the U.S. economy continues to flash mixed signals, investors are becoming more skeptical of a near-term recovery. Every positive economic report seems to be followed by two or three negative reports. If this roller coaster ride continues (which we believe it will), income investors would be wise to consider implementing some conservative market neutral strategies to complement their dividend stock and fixed income portfolios. One of our favorite market neutral strategies is the Iron Condor option strategy.
Similar to the cash-secured put selling strategy that we highlighted in Part I of this series, the Iron Condor strategy is a conservative option selling strategy that generates income in a market neutral environment. However, unlike the put selling strategy, an investor is not forced to purchase the underlying stock with an Iron Condor.
What is an Iron Condor?
The Iron Condor is a limited profit, limited risk, non-directional option strategy that is designed to have a large probability of earning a small limited profit when the underlying security is perceived to have low volatility. The Iron Condor strategy is essentially a combination of a bull put spread and a bear call spread. Using options expiring on the same expiration month, the option trader creates an Iron Condor by selling a lower strike out-of-the-money put, buying an even lower strike out-of-the-money put, selling a higher strike out-of-the-money call and buying another even higher strike out-of-the-money call. This results in a net credit to the investor. Note: The number of call spreads will be equal to the number of put spreads.
Limit Profit - Maximum gain for the iron condor strategy is equal to the net credit received when entering the trade. Maximum profit is attained when the underlying stock price at expiration is between the strikes of the call and put sold. At this price, all the options expire worthless.
Limited Risk - Maximum loss for the iron condor spread is also limited but significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rises above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.
Breakeven Point(s) - There are 2 break-even points for the iron condor position. The breakeven points can be calculated using the following formulas.
- Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Buying Iron Condors are popular with investors who seek regular income from their capital. An Iron Condor buyer will attempt to construct the trade so that the short strikes are close enough that the position will earn a desirable net credit, but wide enough apart so that it is likely that the spot price of the underlying will remain between the short strikes for the duration of the option contracts.
With this summary as a backdrop, below is a deeper look into how to implement this strategy.
Finding the Right Candidates for an Iron Condor Strategy
The best candidates for the Iron Condor strategy are stocks with historically low volatility that have recently exhibited (or expected to have) higher than normal volatility (i.e., low volatility stocks that have had a recent spike in implied option volatility). The Iron Condor is an effective strategy for capturing any perceived excessive volatility risk premium (through selling options), which is the difference between the realized volatility of the underlying and the volatility implied by options prices.
That said, below is a sample list of stocks that meet that criteria.
Choosing the Right Strikes
When an investor is choosing strike prices for an Iron Condor, they should take into account their aversion to risk as well as how strong they feel about the near-term direction of the stock price. The closer the short strikes, the higher the probability that the position will experience a loss (and the higher the maximum gain). The further the short strikes, the lower the probability that the position will experience a loss (and the lower the maximum gain). Said another way, risk can be controlled by setting your spreads further out-of-the-money
Putting It All Together
Below are some specific Iron Condors that we would recommend from the list of candidates above.
Other Things to Consider
- The Iron Condor strategy is considered an intermediate option strategy and it may not be suitable for novice option traders. We suggest that you fully educate yourself on the strategy before adding it to your income-generating repertoire.
- Commission costs to open the position are higher since there are four trades, it might be cost prohibitive to trade iron condors that are low net credits.
- The credit you receive for the trade is generally much smaller than the max risk of the trade, therefore it is prudent to close the short option before the position is at max loss. Many traders do this when the short option is near-the-money.
- If you have closed the short option half of the trade you may want to consider holding the long option to possibly profit from continued directional momentum in the underlying. However, the danger is that the underlying will correct and whipsaw in the other direction.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.