Short Iron Condor
Direction: Volatility in Either Direction
Strategy Description
Short Iron Condor is one of the volatility strategies employed in a highly volatile stock. It is usually a four-legged spread option strategy using a combination of both puts and calls options with the same expiration date but different strike prices. Typically the distance between the strike prices for the various options are equal for this strategy.
Unlike the regular butterfly spread, shorting (selling) an Iron Condor is created by using a combination of puts and calls options instead of all calls or all puts options.
Short Iron Condor =
- 1 lower strike OTM Short Put + 1 lower middle strike Long Put + 1 higher middle strike Long Call + 1 higher strike OTM Short Call OR
- 1 Bear Put Spread + 1 Bull Call Spread OR
- 1 Narrow Long Strangle (Long middle strike puts and calls) + 1 Wide Short Strangle (Short OTM puts and calls).
Outlook: With this stock option trading strategy, your outlook is directional neutral.
You are expecting an increase in volatility of the underlying stock price.
However you are not concern on whether the stock will move in which direction.
Risk and Reward
Maximum Risk:
- Limited to the amount of Net Premium Paid for the various options entered. (May loss 100% of amount invested in this option trading strategy).
Maximum Reward :
- Limited to the different in adjacent strikes less net premium paid when the stock is between the two middle strike price (at expiration).
Breakeven :
- Upside Breakeven = Middle Long Call Strike plus Net Premium Paid
- Downside Breakeven = Middle Long Put Strike less Net Premium Paid.
Net Position:
- This is typically a net debit trade as you are combining two debit spread: Bear Put Spread and Bull Call Spread at the same time.
Advantages and Disadvantages
Advantages:
- Make profit from extremely volatile stocks, without having to determine the direction.
- Limited risk exposure when the underlying stock is between the two middle strike prices on expiration date.
- Typically lower net premium paid compare to Short Iron Butterfly strategy
Disadvantages:
- Usually offer smaller return compare to straddle or strangle strategies with only slightly lower risk exposure.
- Pay double (or near double) premium to a stock that is expanding in volatility.
- Significant movement of the stock and options prices is required for this strategy to be profitable.
- Bid/Ask spread from the various option legs may adversely affect the profit potential of the strategy.
Exiting the Trade
- Offset the position by buying back the options that you sold and selling the options that you have bought in the first place.
- As the underlying stock fluctuate up and down, advance option traders may choose to unravel the spread leg by leg. In this way, the trader will leave one leg of the spread exposed while he profit from the closure of the other legs.
- Remembering that Short Iron Condor is a combination of other strategies, you can also unravel the spread in two legs. In this way, advance traders can create bullish, bearish, sideway or volatility strategies based on the underlying stock’s movement.
Short Iron Condor Example
Assumption: XYZ is trading at $37.10 a share on Mar 20X1. The verdict of a legal law suit against the company is expected to be made soon. You are expecting share price of XYZ to soar up or plummet down once the verdict is out. You would like to profit from the volatility of this stock with limited risk exposure and lesser cost outlay than a Short Iron Butterfly strategy.
In this case, you may consider to sell one Jun 20X1 $30 strike put at $0.30, buy one Jun 20X1 $35 strike Put at $1.40, buy one Jun 20X1 $40 strike call at $1.00 and sell one Jun 20X1 $45 strike call at $0.40 to profit from the volatile outlook of the stock. Note: commissions are NOT taken into account in the calculation.
Analysis of Short Iron Condor Example
Maximum Risk
= Limited to the amount of Net Premium Paid
= ($1.40 - $0.30 + $1.00 - $0.40) * 100 = $170
Maximum Reward
= Limited to the different in adjacent strikes less net premium paid
= ($5.00 - $1.70) * 100 = $330
Upside Breakeven
= Middle Long Call Strike Price plus Net Premium Paid
= $40 + $1.70 = $41.70
Downside Breakeven
= Middle Long Put Strike Price less Net Premium Paid
= $35 - $1.70 = $33.30
A Short Iron Condor is a strategy whereby you combine 2 debit vertical spread strategies: Bear Put Spread and Bull Call Spread to profit in the event of a big move by the underlying stock. It is a four –legged spread option strategy consisting of puts and calls options and is the opposite of Long Iron Condor, which is a sideway strategy
Typically the strike prices between the options legs are equal. However if you have a stronger view in one of the direction, you do not need to space them equally apart. You can weight more toward calls versus puts, or vice versa, by tailoring the position according to your view of the underlying stock and the risk-reward parameters.
Before you executed a Short Iron Condor strategy, you must first determine at which price the underlying stock will most probably NOT be trading at the expiration date. This is the price that will be in between the two middle strike where you purchase the puts and calls options. Next sell a lower strike put option and a higher strike call option of the same expiration date. These two short options help to reduce the cost of the two long options.
A Short Iron Condor is typically a bet on the volatility
expansion. Verdict of law suit, product announcement, earning or
economic reports do have a tendency to move the stock price sharply up
or down.
The maximum profit will be earned, at the expiration
date, when the underlying stock moves beyond one of the breakeven points
in either direction.
The maximum loss will occur when the underlying stock close in between the two middle strike prices at expiration day.
This is a net debit trade as you are paying the premium for both the puts and calls spreads. The risk is that the stock is trading range bound or the move is not big enough to push the stock price beyond the breakeven point during the trading time frame, forcing both the puts and calls debit spread to decay in value. Therefore it is preferably to use this option trading strategy with at least 3 months left to expiration so as to give yourself more time to be right.
An Iron Condor strategy is a good strategy to deploy in
your arsenal of trading strategies. You should pick the strike price and
time frame of the Short Iron Condor according to your risk/reward tolerance and forecast outlook of the underlying stock. Having the patient to wait, knowledge to apply and discipline to follow through the option trading strategies with appropriate risk-reward parameters is important to your long term success in option trading.
Related Strategies
|
|
|
Short Call Condor
|
Long Strangle
|
Long Iron Condor
|
