NEUTRAL (OR RANGE-BASED) INCOME STRATEGY
An Iron Condor is a four-leg options trade where we sell a Credit Call Spread and simultaneously sell a Credit Put Spread. The strategy has defined risk and defined reward.
Since we are selling both Calls and Puts, we are taking a view that a stock will stay within a range (our zone of profitability) at expiration.
It is commonly used as an income generating strategy by investors with a generally neutral view, or who are expecting a significant drop in volatility (such as after an earnings event). The Iron Condor typically offers a probability of profit greater than 50% in return for an investor accepting a higher risk to reward ratio.
The Iron Condor is often compared to another four-leg neutral option strategy – the Iron Butterfly – something that we will look at more closely. It might also be used as an alternative to a short Strangle by investors who are willing to accept somewhat less premium (income) in return for creating a defined risk position with protection against a sharp move higher or lower in the underlying stock.
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To look more closely at the Iron Condor and how it might be as an income generating strategy, we’ll take a hypothetical example using SPY.
Credit Call Spread + Credit Put Spread
We’ve seen how a Credit Call Spread can be seen as a strategy that profits if a stock stays below a certain level and a Credit Put Spread one that profits if a stock stays above a certain level. Therefore, if we combine both spreads and trade them simultaneously, it follows that we have a strategy that profits when a stock stays between two levels, or within a range – the Iron Condor.
Further, by selling two Credit Spreads at once, we benefit from collecting more premium (or income) by selling to both the bulls and the bears. In addition, if we are wrong, we can only lose on one spread, since the stock cannot end up both above and below each of our breakevens. So, by combining spreads into an Iron Condor, we typically generate incremental income and improve our risk to reward ratio relative to a stand-alone Credit Call or Put Spread, in return for accepting a defined zone of profitability.
Taking a hypothetical example using SPY, we start by establishing levels at which we believe the stock will find support in a downward move and resistance in an upwards move. This range or zone of profitability is typically set equidistant from the current underlying stock price.
To inform our decision in this example, we decide to look at the expected move for our timeframe – a move of around 3.5% higher or lower than the current stock price.
With this in mind and with the stock currently trading around $383, we decide to set the short strikes of each our Credit Call and Credit Put Spread legs approximately 3.5% higher and lower – at 396 and 370 respectively.
As we have seen, determining how far to set any spread from the current stock price and how wide to set the spread is a balancing act of risk, reward and probability of profit. As a general rule with Credit Spreads, the closer the strike prices are to the underlying stock’s current price, the more premium (income) will be collected, but probability of profit will be lower (since our zone of profitability is reduced). In addition, the greater the width of the spread (between the short and long option), the more premium will be collected, but maximum risk will also be increased.
Next, we decide to set our Iron Condor ‘wings’ (the Credit Call and Credit Put Spread width) to a one strike width. In this example, we find that this gives us a somewhat balanced risk to reward ratio. It also provides an initial setup with a relatively low maximum risk in dollar terms, giving us the opportunity to size-up by trading more contracts, if desired.
So, we decide to open the 369/370/396/397 Iron Condor at $0.50, collecting $50 in premium.
This visual setup using the Options AI platform shows our (light green) zone – the zone we need the stock to stay within at expiration in order to keep the premium received and realize max gain. Also, note that given the relatively tight spread width (one strike or $1), our zones of diminishing profits (dark green) and increasing loss (red) up to max loss, are themselves relatively narrow – giving us breakeven levels very close to the expected move.
Also noticeable (which we have seen is typical for both the Credit Call and Credit Put Spread) is the relatively high probability of profit . We will look at this in more detail in the summary below.
In this Iron Condor example we have a defined Max Risk of $50. That’s the most that we can lose if the stock closes above our long 397 Call strike or below our long 369 Put strike at expiration. We will see gains if the stock stays within our breakeven levels of 369.50 and 396.50 and a Max Gain of $50 if the stock stays within our short 396 Call and short 370 Put strikes at expiration.
What may become apparent from this visualization and associated metrics is why the Iron Condor is a favored strategy of income seeking investors with either a neutral stock view and/or a view that option prices are currently overstating any potential move.
One example of the latter might be around an earnings even where options prices are elevated due to higher implied volatility, resulting in an outsized expected move. Should an investor believe this move is overstated and choose to fade the earnings move (or indeed fade volatility in general) the Iron Condor provides a potential strategy for collecting increased premium income from both the bulls and the bears.