Profit from Low Volatility Using Options

The stock market's lack of volatility has made headlines in 2017

Nov 9, 2017 at 2:52 PM
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    The stock market's lack of volatility in 2017 has made headlines lately, with the S&P 500 Index (SPX) enjoying a slow, steady grind to record highs. In fact, the last time the SPX dropped 3% or more was June 24, 2016, during the Brexit panic. Against this backdrop, we decided to break down a four-legged options strategy that allows you to capitalize on a period of muted, low-volatility price action in an underlying stock: the iron condor.

    What is an Iron Condor?  

    The iron condor is essentially the combination of a short call spread and short put spread, and -- like both of those strategies -- the maximum potential profit is limited to an initial net credit. Alternately, the iron condor can be thought of as a more conservative version of the short strangle.

    The two sold options at the inner strikes form the "body" of the condor, while two purchased options at the outer strikes represent the "wings." The trader's goal is for the underlying stock to remain between the two sold strikes through options expiration, in which case all four options can be left to expire worthless.

    An Example of the Iron Condor

    Stock XYZ has spent the past few weeks range-bound between the $25 and $27 levels. You expect this sideways channel to hold firm during the near term, especially with the next earnings release a long way off, so you decide to implement an iron condor using these two price points as your "body" strikes.

    Simultaneously, you sell to open the 25-strike put, bid at $0.15, and buy to open a 24-strike put, asked at $0.06. For the other half of the condor, you simultaneously sell to open a 27-strike call, bid at $0.13, and buy to open the 28-strike call, asked at $0.03. You collected $0.28 ($0.15 + $0.13) on the pair of sold options, and spent $0.09 ($0.06 + $0.03) on the purchased options, for a net credit of $0.19 ($0.28 - $0.09). Multiplying your upfront credit by 100 shares per contract, you've netted $19 upon entering the spread.

    Iron Condor Profit Potential and Breakeven Rails

    The goal is for XYZ shares to remain between the sold 25 and 27 strikes through the options' lifetime, at which point you can retain the entire $19 credit. But as long as the stock remains between two breakeven rails -- the sold call strike plus the net credit ($27.19), and the sold put strike minus the net credit ($24.81) -- your iron condor will be profitable.

    iron condor profit loss

    Iron Condor Risk is Capped, But Could Be Substantial

    Because each of your sold options is hedged by a purchased option at a nearby strike, potential losses on an iron condor are limited. If XYZ should rally above $28 -- the strike price of the purchased call -- the most you can lose is limited to the difference between the bought and sold call strikes, less the net credit -- or [(28 - 27) - $0.19] = $0.81, or $81 (x 100 shares).

    Similarly, if XYZ falls below $24 -- the purchased put strike -- the most you can lose is limited to the difference between the bought and sold put strikes, less the net credit -- again, [(25 - 24) - $0.19) = $0.81, or $81.

    However, if one of your sold options moves into the money prior to expiration, you may want to buy to close the contract to avoid assignment -- thereby incurring an additional transaction fee.

    3 Things to Remember Before Implementing an Iron Condor

    1. Focus on stocks you expect to stay in a tight range, and select your options strikes accordingly. Equities with low Schaeffer's Volatility Scorecard (SVS) readings have tended to make undersized moves on the chart during the past year, relative to what the options market has priced in.
    2. Focus on shorter-term options, so the underlying stock has less time to move against you. And make sure there aren't any potential stock-moving catalysts before expiration, like an earnings date or notable presentation.
    3. Additionally, be aware that the iron condor requires four opening transactions, which translates into much higher brokerage expenses than a two-legged credit spread. Weigh the cost of entry against your potential reward.




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