By Josip Causic, Online Trading Academy Options Instructor
The article on Credit Spreads versus Debit Spreads has been out less than a day and my mailbox is filled with e-mails asking me to do more of my real trade explanations in my subsequent newsletters. One particular Online Trading Academy student commented that reading the newsletter helps her to get into my mindset when selecting a strategy and placing a trade. Moreover, she requested that I explain an Iron Condor. Over the next couple of articles, I will oblige this request and explain both Iron Condors as well as Condor Spreads.
In this week's article, I will go over one of my Iron Condors that I did awhile ago. Honestly, in my humble opinion, the last part of 2008 was not the correct environment for the Iron Condor strategy. The I.C. is a strategy that works well in sideways markets. In the last half of 2008, we had a "trending" market, and every owner of a 401K or an IRA account knows which direction the equity market was trending: a way South – deep South.
Anyhow, let us define an I.C. as a complex spread trade used in the directionless market environment. More specifically, an I.C. is an option strategy composed of two vertical credit spreads, namely a Bear Call and a Bull Put. Both of these two verticals are credit strategies I have addressed in greater detail at least once before. For those who wish to review the basic concept of a Bull Put, you can go back to last week's newsletter (Credit Spreads versus Debit Spreads); to review a Bear Call, you could re-read Bear (Call) at Work.
Explanation of the Entry
When searching for an I.C. candidate, one should look for the chart that shows prices fluctuation within a certain range over a period of time. Professional "Condor-ians" do them explicitly on the indices, mostly due to the tax advantage. In my case, I selected the ETF that tracks the Russell 2000 as the best-suited at the time of the entry.
Figure 1 shows the chart of IWM that I was looking at 06-03-2008, the time of entry. I noticed that the 75 area had acted in the past as a resistance level; while as a possible short-term support I noticed the 70 area.
Figure 1
I marked on the IWM chart in yellow a channel and one can observe that the price action did not penetrate either the support (70) or resistance (75) for the previous six weeks. This brings us to the point of month selection. The strike prices that I intended to sell were: 71 strike price for the put side of the trade, and 75 strike price for the call side. On the put side, the IWM had to close above 71 at the time of expiry, whereas on the call side, the IWM had to close below 75. The room that this trade had for fluctuation was only 4 pointswide; so at the time 06-03-2008, I did have a choice of selecting June expiry, or going even further out to July or even August, but I ended up selecting June expiry. From 06-03-2008 to 06-20-2008, which was the third Friday in June, there were only 17 calendar days left. At that time, I was teaching an option class and we needed an I. C. example, so for educational purposes I placed the I.C. on the IWM with a single contract. Most of the time, I would like to go into an I.C. five to seven weeks prior to expiry. The reason for taking on this trade was that the time decay (theta) is the greatest during the last two weeks of the option lifespan.
Figure 2
Figure 2 shows the date, time, and the quantity size at the point of my entry. Also, one can observe from Figure 2 that the I.C. has a position that is short two inner option strikes (75call & 71put) and long two outer strikes (76call & 70put). Thus, as long as the price action of the IWM stays within those two sold (shorted inner) strike prices, our I.C. would be profiting from the time "bleed" (decay). No exiting is needed as long as the price of the underlying stays within the spread/width of the two short strike prices.
A final note on the entry; each of the two spreads (Bear Call or Bull Put) could be placed separately as verticals. In such a case of "legging in", one must ensure that the broker does not require the maintenance on both sides. The price can close only at one or another extreme. We as traders could be wrong only on one end, so the broker should hold the maintenance only for the larger side.
Exit Explained
When I sold an Iron Condor on the IWM, I had a net positive theta (theta measures the rate of decay in the time value of options), and at the same time, a neutral to negative delta. A net positive theta means that the time was on my side, as The Rolling Stones would say. For every passing day while the price was going sideways, I was profiting.
A neutral to negative delta came from the fact that I had traded the options that were OTM (out of the money). I had sold approximately the delta of 10 on each leg (71put and 75call). Inside of delta is also the probability of expiring. Thus, if I sold a delta of 10, then I have a 90% of chance of seeing my sold strike price (71put and 75call) expiring worthless, which is exactly what we want. However, keep in mind that holding on to an I.C. to expiry is equal to taking on a higher risk. In my case, the I.C. had to close below 75 and above 71. As you can observe from Figure 3, the IWM's closing price was 72.55, thus no action was required and all four options have expired worthless. I was able to keep the maximum profit.
Figure 3
In conclusion, an I.C. is a short Bear Call and at the same time a short Bull Put on the very same underlying. Just like any other strategy discussed in these option newsletters, an Iron Condor involves a net premium selling. In the case at point, the I.C. worked as good as any textbook example.
- Josip Causic
jcausic@tradingacademy.com |
