The Option Coach: Iron Condor

              

Welcome to another in a series of articles that examines the thought process behind a variety of option strategies using stock, index, and/or exchange-traded fund (ETF) options. This column will examine a potential iron condor, the pros and cons of putting on an iron condor, and the profit and loss potential of this position. So, let's jump into this interesting strategy.

First off, I should define exactly what an iron condor position is. The simplest way of looking at an iron condor is by imagining a stock sandwiched between a bearish call credit spread and a bullish put credit spread. The goal is for these options to expire worthless, allowing the trader to retain the entire credit received at the initiation of the position.

A credit spread is the sale of an out-of-the-money call (or put) and the purchase of a deeper out-of-the-money call (or put). The options player wants the sold option to remain out of the money.

An iron condor strategy is generally reserved for veteran options traders, since this is a bet that a stock, ETF, or index will remain within a narrow trading range during a specific period of time. This is not a position that a trader wants to initiate during a period of high volatility, as he could be quickly whipped out of the trade due to extreme market moves.

Stock and Option Selection

In an iron condor, the stock is surrounded by sold strikes. As a result, the goal is for those options to expire out of the money, requiring the security to remain in a narrow trading range. This strategy is ideal for stocks, ETFs, or indices that are currently trapped within a tight trading range, with specific areas of both support and resistance keeping the shares bound.

In fact, veteran traders often use index options with this strategy, since indices tend to see less volatility than specific stocks.

When choosing the options for this position, the sold strikes should mark the outer rail of a stock's current trading range. If a stock is locked in a range between 16 and 21, a trader may consider selling a 15 put and a 22.50 call if those strikes are available.

At the same time, the purchased strikes should be an equal distance out of the money from the corresponding sold strike. Using the example above, a trader may consider buying a 12.50 put to match with the sold 15 put and a 25 call to match with the sold 22.50 call.

Let's Look at an Example

One stock that has caught the attention of our hypothetical trader is AT&T (T). The security has been range-bound for the past several months. From mid-March through mid-May, the equity was locked between 27 and 25. After breaking below support at the 25 level, the stock quickly became trapped in yet another trading range between support at the 23 level and resistance at the 25 level. From a longer-term perspective, the security is consolidating sideways into resistance at its 10-month moving average – a trendline it has not closed a month above since May 2008.

From a sentiment perspective, Wall Street remains smitten with the shares. The stock has earned 12 "buy" ratings and seven "hold" ratings, according to Zacks, leaving ample room for potential downgrades. What's more, the average 12-month price target for T stands at $29.58, according to Thomson Reuters. This estimate is more than 21% above the equity's closing price of $24.42 on Monday.

Options players are also growing more optimistic toward the shares. The International Securities Exchange (ISE) has reported an uptick in call trading, as 1.8 calls have been purchased to open for every one put purchased to open during the past 10 days. This ratio of calls to puts is higher than 57% of all those taken during the past year, pointing to a growing optimism.

In this example, let's assume that the trader expects the shares of T to remain in their trading range during the near term. In an iron condor, a trader is typically looking for a relatively short time frame, as this will allow time decay to have the strongest impact on the premium of the options. It also reduces the time the stock has to move out of the set trading range that has been created by the sold options.

However, one concern with this position is that AT&T is slated to report earnings on July 23. Analysts are expecting a profit of 51 cents per share, which is down from the firm's profit of 76 cents per share for the same period a year ago. Historically, the company has missed the consensus estimate twice, matched once, and surpassed once during the past four quarters. With this event sitting on the horizon, the trader may be better served by waiting to see if the stock remains in its trading range following the earnings report.

For today's example, we will look at the stock's options as if the trader were opening a front-month position today. With the shares trading at $24.70 and taking into consideration the stock's trading range, let's go with selling the out-of-the-money August 25 call at $0.52 and buying the August 27 call at $0.06. The result is a net credit of $0.46 per pair of contracts. At the same time, the bullish end of this condor needs to be opened, so a trader should sell the August 23 put at $0.19 and buy the August 21 put at $0.04, for a net credit of $0.15. The total credit on the entire position is $0.61, or $61 ($0.46 + $0.15 x 100).

If the stock remains between 25 and 23 (the two sold strikes) through August expiration, which is on Aug. 21, the trader will be able to keep the entire premium of $0.61.

Margin Requirement

As with a regular credit spread, the margin requirement represents the most that an investor could lose on an iron condor. Since the stock can only move against one side of the trade at any given moment, the margin requirement is the larger of the potential losses for either the call spread or the put spread.

First, let's calculate the maximum loss for each side of this trade.

For the call side, the maximum loss is the difference between the two strikes minus the total credit received on the position. So, the most that can be lost on the bearish call credit spread is $139 ([27 - 25] - 0.61 x 100).

For the put side, the maximum loss is the difference between the two strikes minus the total credit received on the position. So, the most that can be lost on the bullish put credit spread is $139 ([23 - 21] - 0.61 x 100).

The margin requirement is the larger of the two losses. In this case, they are the same. So the margin requirement for this iron condor position will be $139.

Implied Volatility

After the position is initiated, increasing implied volatility is the enemy of this iron condor, as it will raise the price of the options when the trader really needs to see these options decrease in value, particularly the sold options.

Profit and Loss

The maximum profit achieved on this position is the total credit received for both credit spread positions. In this example, the total premium received was $0.61, or $61. To achieve this profit, the stock must close between the two sold strikes by the time these options expire so that all the contracts close worthless.

The maximum loss was calculated in the margin requirement section, where we found that the most that the trader could lose to the upside was $139, since the purchased contract acts as a hedge against the sold contract. On the downside, the largest loss the trader could incur is $139, since the purchased out-of-the-money option acts as a hedge against the short put.

There are two breakevens for this position. On the upside, the net credit is added to the sold call to find the breakeven. In this instance, the stock can rally to $25.61 (25 + 0.61) before the position starts to incur a loss.

On the downside, the net credit is subtracted from the sold put to find the breakeven. In this instance, the stock can fall to $22.39 (23 – 0.61) before the position starts to incur a loss.

Overview

With the broad market suffering volatile swings on a regular basis, this could be a very risky position to open at this juncture. A trader may be more inclined to wait until the market falls into a more predictable sideways consolidation before entering an iron condor position.

One drawback of an iron condor is that the trader incurs four commissions for initiating this position. However, one positive it that there should be no commission if the position ends in a profit, since all four options should expire worthless.

If you missed some of the other strategies that have been covered by this column, please click here to see a complete list and read more.