2 Ways To Use The Great 'Reverse Iron Condor' Option Strategy

Includes: FAS, GLD, GOOG
by: Kevin M. O'Brien

As part of an ongoing series of articles I write for Seeking Alpha on the many different option strategies available to traders, this week I will go into the 'Reverse Iron Condor' spread, which is one of the most fascinating option spread trades you can place.

The 'reverse iron condor' is made with a net debit instead of a net credit. It is a neutral strategy that can profit when the stock moves up or down. This aspect appeals to many traders. Another factor that is great about the 'reverse iron condor' is that since it is placed as a net debit, you do not need a higher level options trading account. Most credit spreads require a Level 4 account, and many traders do not have this level yet. This trade can be placed with most brokers by only having a Level 2 or 3 account.

The 'reverse iron condor' is a strategy that appeals to a lot of people who trade options for several reasons. First, the amount of risk is known from the start. The highest potential of profit on the trade is also known from the start. Therefore, it is a limited risk, limited profit strategy, but also has a higher profit potential than many other spreads. I will show examples of this, as well.

For whatever reason, there is little information available on the 'reverse iron condor' spread. The strategy is widely used by professional traders and it is truly unique from most other option strategies. The relatively small price move needed to profit makes this strategy a great choice under the right circumstances. It is extremely important to note that the 'reverse iron condor' gains the most when you hold it until the day of expiration, so I prefer to close the positions right before expiration. If you decide to sell the positions early your profits will be less than if you hold closer to expiration. Under ideal circumstances, however, it is a wise decision to sell early.

The 'reverse iron condor' is a complex trade that has four (4) "legs" to it, but is placed as a spread to minimize commission costs. However, you can "leg" into the trade individually. Let's take a look at how the trade is placed. For explanation purposes, I will use the one (1) contract for each "leg" to simplify the example for understanding the trade.

  • Buy one (1) out-of-the-money put option
  • Sell one (1) out-of-the-money put option (Lower Strike)
  • Buy one (1) out-of-the-money call option
  • Sell one (1) out of the money call option (Higher Strike)

This trade is best used under the following two (2) scenarios:

  • When a company has weekly options available and is reporting earnings during that particular week. The stock should have a proven track record of making a modest move after earnings. I will provide a list of stocks later in the article that have worked well for me in the past.
  • The other time I like to use this strategy is when there are weekly options available on very volatile stocks or ETF's, such as the Direxion Financial Bull 3X (NYSEARCA:FAS) and the Direxion Financial Bear 3X (NYSEARCA:FAZ), Caterpillar (NYSE:CAT), SPDR Gold Shares (NYSEARCA:GLD), the U.S. Oil Fund (NYSEARCA:USO), along with a few others that I will mention later in the article.

This is a strategy that takes advantage of volatility and modest (not massive) price swings in a short-time period. It is the opposite of the 'long condor' strategy, which benefits from low volatility.

For a list of stocks that currently have weekly options, please see this link here. I find that when buying the weekly options on extremely volatile stocks, such as the Direxion Financial Bull 3X and the Direxion Financial Bear 3X or other volatile ETF's or stocks, this strategy can work very well when you purchase the contracts on the preceeding Friday.

Here are a few examples of hypothetical trades using ten (10) contracts for each "leg" :

Weekly Trade #1: Direxion Financial Bull 3X (FAS)

For example, using (FAS) as a weekly trade, we can set-up the strike prices with this ETF currently trading at $57.82/share. This trade expires on December 9, 2011, but these examples can easily be used as a reference for future trades by simply changing the strike prices according to what the security is trading at. (Note: I will use ten (10) contracts for explanation purposes.)

  • Buy one (10) FAS December Week 2 $60.00 put option
  • Sell one (10) FAS December Week 2 $58.00 put option
  • Buy one (10) FAS December Week 2 $62.00 call option
  • Sell one (10) FAS December Week 2 $64.00 call option

The bid/ask price is to place this trade is currently $1.36 - 1.99. By placing a limit order of $1.66 with 10 contracts for each "leg", the total debit is $1,660.00. This is also the maximum amount you can lose on this trade.

Here is the profit/loss chart:

(FAS) Current Price: $60.89

Price Profit / Loss
43.50 $340.00
50.51 $340.00
57.88 $340.00
58.00 $340.00
58.34 $0.00
60.00 ($1,660.00)
62.00 ($1,660.00)
63.66 $0.00
64.00 $340.00
65.25 $340.00
80.00 $340.00

With a total risk of $1,600.00, the maximum profit is $340.00, or a 20.4% gain. Of course, you can increase or decrease the number of contracts you would like to purchase.

Weekly Trade #2: SPDR Gold Trust (GLD)

Buy 10 GLD December Week 2 $167.00 Puts

Sell 10 GLD December Week 2 $166.00 Puts

Buy 10 GLD December Week 2 $170.00 Calls

Sell 10 GLD December Week 2 $171.00Calls

The bid/ask spread is $0.61-$0.73, so you should be able to get the order filled at $0.68 or less. Here is the profit/loss chart:

Current Price: $169.76

Price Profit / Loss
124.50 $320.00
141.63 $320.00
159.66 $320.00
166.00 $320.00
166.32 $0.00
167.00 ($680.00)
170.00 ($680.00)
170.68 $0.00
171.00 $320.00
177.69 $320.00
213.75 $320.00

The total risk on this trade is $680.00, and that is the most you can lose. This specific trade also offers a nice ROI, as you can see from the profit/loss chart.

With the 'reverse iron condor spread, you can always move around the strike prices on a trade calculator and decide how you would like to set-up the trade.

Trade #3: Earnings Trade Example- Google, Inc. (NASDAQ:GOOG)

Here, I want to show you a hypothetical earnings trade you can use this strategy for around the time when a company is set to report earnings (the best time to buy is the day before the event.) While Google doesn't report their next earnings until mid-January 2012, this example can be used whenever a stock with weekly options has earnings due that particular week. For this trade, I will use the weekly options with a December Week 2 expiration. Google is currently trading at $613.77/share. (Note: this is only an example of how I would trade Google before earnings).

  • Buy 10 December Week 2 $610 put options
  • Sell 10 December Week 2 $605 put options
  • Buy 10 December Week 2 $615 call options
  • Sell 10 December Week 2 $620 call options

With the bid/ask spread at $3.30- $5.00, this trade should be placed with a limit order of $4.20 or less, and this should get the order filled. Since this example has 10 contracts for each leg, the total debit to place the trade is $4,200.00, which is also the most you can lose on the trade. Here is the profit/loss chart for the trade:

Current Price: $613.77

Price Profit / Loss
453.75 $800.00
515.40 $800.00
580.30 $800.00
605.00 $800.00
605.50 $0.00
610.00 ($4,200.00)
615.00 ($4,200.00)
619.50 $0.00
620.00 $800.00
645.20 $800.00
775.00 $800.00

While you limit your upside gain if a company reports blow-out earnings and estimates and the stock soars or if the stock seriously tumbles after earnings, the 'reverse iron condor' has one thing a 'straddle' or 'strangle' option trade doesn't have: peace of mind. This reason, along with a 19% overall return on investment hardly makes this trade without merit. In fact, this can be an extremely safe trade to make around earnings when the options are close to expiration.

Let us see what past history tells us with Google's past five earnings with actual numbers. This would be if we purchased the Google "reverse iron condor' a day in advance of their earnings release and held until expiration at the end of the week:

On October 13, 2011 Google reported third-quarter earnings. Here is how the stock moved:

Date Open High Low Close Volume
Oct 14, 2011 599.47 599.60 587.57 591.68 8,532,242
Oct 13, 2011 550.03 559.00 548.02 558.99 5,687,512
Oct 12, 2011 548.13 555.23 544.63 548.50 3,178,044

On July 14, 2011 Google reported second-quarter earnings. Here is how the stock moved:

Date Open High Low Close Volume
Jul 15, 2011 597.50 600.25 588.16 597.62 13,735,983
Jul 14, 2011 539.12 542.00 526.73 528.94 6,649,410
Jul 13, 2011 537.00 544.00 536.48 538.26 2,790,771

On April 14, 2011 Google reported first-quarter earnings. Here is how the stock moved:

Date Open High Low Close Volume
Apr 15, 2011 545.29 545.75 530.06 530.70 14,050,013
Apr 14, 2011 575.19 579.45 572.10 578.51 5,456,289
Apr 13, 2011 575.51 577.60 571.75 576.28 2,071,646

On January 20, 2011 Google reported fourth-quarter earnings. Here is how the stock moved:

Date Open High Low Close Volume
Jan 21, 2011 639.58 641.73 611.36 611.83 8,904,357
Jan 20, 2011 632.21 634.08 623.29 626.77 5,485,733
Jan 19, 2011 642.12 642.96 629.66 631.75 3,412,573

On October 14, 2010 Google reported third-quarter earnings. Here is how the stock moved:

Date Open High Low Close Volume
Oct 15, 2010 599.27 601.64 591.60 601.45 14,824,722
Oct 14, 2010 544.18 545.25 537.11 540.93 6,634,018
Oct 13, 2010 547.00 547.49 542.33 543.30 3,060,836

As you can see, the 'reverse iron condor' would have been successful for the last five trades. Each one had the required move in the underlying stock price to profit, as the chart above showed and the past results proved.

You do have to be very selective in what stocks you choose to use the 'reverse iron condor' trade with. For example, you do not want to use this strategy with AT&T (NYSE:T), Microsoft (NASDAQ:MSFT), or any other stock that has such little movement. Remember, the stock must have weekly options available as time/theta is an enemy to this trade more often than not. Another thing to remember is that this opportunity (because we are using the earnings as one example) only comes around once every three (3) months for a stock, as earnings are reported every three months, four times a year. The following stocks have consistent movement after earnings (and weekly options) which can make this trade successful:

  • Google (GOOG)
  • Apple (NASDAQ:AAPL)
  • Amazon (NASDAQ:AMZN)
  • Baidu (NASDAQ:BIDU)
  • Salesforce (NYSE:CRM)
  • F5 Networks (F5)
  • First Solar (NASDAQ:FSLR)
  • Green Mountain Coffee Roasters (NASDAQ:GMCR)
  • International Business Machines (NYSE:IBM)
  • LinkedIn (LNKD)
  • Mastercard (NYSE:MA)
  • Molycorp (MCP)
  • MGM Resorts (NYSE:MGM)
  • Priceline (PCLN)
  • Sina Corporation (NASDAQ:SINA)
  • SanDisk (SNDK)
  • Wynn Resorts (NASDAQ:WYNN)
  • Research In Motion (RIMM)
  • Netflix (NASDAQ:NFLX)

I plan to write future articles and trade scenarios when these stocks are reporting earnings. I will list the strike prices I am choosing and a profit/loss chart for each trade using the 'reverse iron condor' spread.

You may ask yourself why you should avoid using long-term options with this strategy? The answer is because the more time the stock has, the better chance it may retrace to the middle strike, which is exactly what we do not want to happen. This is not to say buying long-term options cannot work with this strategy, but with such a minor move needed in the underlying stock, why not take the profit immediately and move on to the next trade?

As I mentioned earlier in the article, I will use the leveraged Direxion ETF's (FAS) and (FAZ) for just a weekly trade from time to time. These are separate from the earnings trade I use. With all that is going on in Europe and the financial mess their dealing with, the Direxion 3X ETF's are even more volatile than usual. It is generally a good idea not to use extremely low-priced stocks or ETF's with this strategy. Sprint (NYSE:S), for example, is a stock that should be avoided even though they have weekly options available. Other securities that I have used this strategy with, as only a weekly trade, are the following:

  • United States Oil Fund (USO)
  • SPDR Gold Trust (GLD)
  • Citigroup (NYSE:C)
  • InterDigital (NASDAQ:IDCC)
  • Netflix (NFLX) - always large weekly moves
  • Google (GOOG) - more expensive stocks tend to do well with this strategy because of the large price moves

To summarize, the 'reverse iron condor' spread is a great strategy if you want to know ahead of time what your maximum profit and loss is on a specific trade. If you are looking to capitalize on an extremely large move in the stock price where profits are unlimited, the 'reverse iron condor' may not be what you are looking for.

I hope you found this article interesting and will try the 'reverse iron condor' as a trade. If you have never used it before, I recommend trying it out via "virtual trade" or paper trade. This will give you a head-start when the time comes to place the trade with real money.

I plan to write future articles on this strategy for both the weekly trades and when earnings season is back with the stocks listed above.

If you have any questions, please leave them in the comment section or send me an e-mail. I try my best to respond as soon as possible.

Good Luck.

Disclosure: I am long AAPL.

Additional disclosure: I am currently long AAPL calls and I trade options daily with several of the above listed stocks.