In my previous article I presented a way to take advantage of sideways markets by trading a strategy called an Iron Condor. This is one of my favorite strategies for sideways markets. The Iron Condor is a combination of a bull put spread and a bear call spread. The whole trade is done for a credit.
As a reminder, I executed the January Russell 2000 Index (RUT) Iron Condor on December 5, 2011 when RUT was trading at $742:
- Buy RUT January 2012 670 put
- Sell RUT January 2012 680 put
- Sell RUT January 2012 800 call
- Buy RUT January 2012 810 call
The trade exceeded my wildest expectations. It gained a whopping 70.4% in 30 days. The trade was done for $4.60 credit and closed for 80 cents debit. But don't be fooled by those gains - they are far from typical. In fact, this was my largest gain from this strategy ever. My normal profit target for those trades is 30-35%.
The major factor for this gain was sideways market. During the life of the condor, RUT was trading between 705 and 750, never really threatening any of the short strikes. No adjustment was needed.
One of the major considerations of this strategy is the choice of strikes. If you choose strikes close to the money, the trade will provide more credit but reduce the probability of success. Going further OTM (Out of The Money) will reduce the credit but increase the probability of success.
RUT is currently trading at $750. I will be looking to place the following trade:
- Buy RUT February 2012 690 put
- Sell RUT February 2012 700 put
- Sell RUT February 2012 800 call
- Buy RUT February 2012 810 call
This is a delta neutral trade. The deltas of the short strikes are about 25. The credit is around $4.55. You can do the same trade with Russell 2000 Index ETF (IWM), depending on the size of your account and/or your commissions structure.
You can notice that the distance between the strikes is smaller than in the previous trade. This can be explained by reduced IV (Implied Volatility) of the options since the previous trade was done.
I will use the following guidelines to manage the trade:
- Place a $0.20 Buyback GTC (Good Till Cancel) Order for each spread separately.
- Exit the trade if the loss exceeds 15-20% or the profit exceeds 30-35%.
- Adjust the trade if RUT reaches one of the short strikes by rolling the spread in danger further OTM or exiting the trade.
Russell 2000 Index, S&P 500 index (SPX), NASDAQ 100 INDEX (NDX), Russell 2000 Index ETF (IWM) and S&P 500 index ETF (SPY) are among the best candidates for the Iron Condor strategy. You can do it on individual stocks as well. Some ranged bounded individual stocks like Microsoft (MSFT), Johnson & Johnson (JNJ), General Electric (GE) or American Express (AXP) can also be good candidates. I prefer to do those trades on indexes to avoid any stock-specific risk.
Risk management is extremely important for this strategy. Remember Warren Buffet's Two Rules? "Rule No. 1: Never Lose Money. Rule No. 2: Never Forget Rule No. 1." I don't think there is any investor including Buffet who has never lost any money, but the key is to minimize the losses. Iron Condors can be brutal and should be treated with respect.
As I outlined in the My Investment Strategy for 2012 article, I like to use this strategy in combination with pre-earnings strangles. Those strategies have strong negative correlation and can work very well together.
I will probably wait for a down day to place the trade. The reason is to get some spike in Implied Volatility so you can get higher credit. I will update the Comments section when I place the trade.
Additional disclosure: I will be placing the RUT Iron Condor trade within the next few days