where you learn new ways to understand the latest market trends, gain strategy insights, and learn from the experts. My name is Rod Mahnami and I’m grateful that you’ve given me this opportunity to join you on your investment journey.
This edition of Profit talk we’re going to cover one of my personal favorites when it comes to options strategies, especially for those who are just starting out. I’m talking about the option strategy called an Iron Condor. Although, I’ve been trading options for more than a decade now I still love using the Iron Condor. It is low risk and easy to manage, plus it provides a high probability of profit.
Iron Condor Attributes
The Iron Condor strategy has a variety of styles. They can be bought, creating what’s referred to as a “long” Iron Condor which is debit style strategy. Or, they can be sold to create a “short” Iron Condor which is a credit style strategy. The Profit Effect style of trading uses short Iron Condor strategies exclusively. Debit style “long” Iron Condors are avoided because they have a very low probability of profit. The short Iron Condor on the other hand, has a high probability of profit. On average, the probability for profit on an Iron Condor that is not managed is about 68%. If you manage them, meaning take profits and defend losses at predetermined points, the probability of profit can be increased to 80% and higher.
The Iron Condor is a defined risk trade. This means that the maximum amount that can be lost on the trade is limited. This loss limit is decided by the trader based on the strike selection. The short Iron Condor is constructed through the combination of buying and selling options. The short Iron Condor version, which we are covering here, means that the profit is derived from the sold (short) options. The purchased (long) options are used to hedge the position and define the risk.
Selling the Iron Condor results in a credit. This means you get paid for placing the trade. That makes the short Iron Condor a credit style option trade. Specifically, it’s a credit spread, because it utilizes long options to limit (hedge) the risk. The profit driver of the spread are the short options. The money you receive is called a credit and you get that payment no matter what happens.
The tradition style Iron Condor is non-directional or neutral when it comes to the directional bias of the strategy. However, the amount of directional bias can be adjusted by moving strike locations. This will create a directional bias to the position and is referred to as a “skewed” Iron Condor.
Choosing an Iron Condor Candidate
When it comes to choosing a prospective security to use an Iron Condor strategy on, one of the most important factor lies in the current relative state of implied volatility. Matching the correct option strategy with the current state of implied volatility is significant to successful option trading.
Implied volatility is a function of an option’s price. It shows what the market expects in terms of future price movement in the particular security. The security used is referred to as the underlying asset or just “underlying” for short. The current price movement and the expected future price movement of the underlying directly affects the price of the option. A larger expected move will increase the implied volatility. When it comes to using this measure, our concern is what the current level of volatility is compared to its historical range.
The implied volatility level on it’s own does not give us useful information when it comes to aligning the correct option strategy with the given volatility environment. In order to do that we need to compare volatility to itself and give the current state of volatility a relative value when compared to its historical range. This value is often referred as “IV Percentile” or “IV Rank”.
All credit based option strategies, which includes Iron Condors, enjoy better success rates if placed when the IV Percentile (IVP) is high. Ideally, we’re looking for the IVP to be 60% or higher. But, the market can experience long periods of low volatility which makes finding suitable candidates based on this criteria difficult. Under these circumstances, I may choose to employ a few credit strategies at a lower IV Percentile than 60% but rarely when it’s below 50%. There are other strategies that are best utilized under those conditions which you’ll learn in future issues.
Now that we know what to look for in terms of IV Percentile we can use our platform tools to filter prospective candidates.
You can use the scan feature to look for candidates that have an IVP above 50 or work from a known list of candidates that you can sort by IVP using the quote window. (Figure 1) Here I have a list of equities that have good option volume. I can simply sort by IVP in the quote window.
To create a scan query to find candidates with an IVP above 50% go the the Scan page. First select the universe of products in which to search. Use the “Scan in” drop down menu and under category choose “All Optionable”
Then add the standard two filters that we use on every scan, which are the stock price and volume minimums. I set the minimum stock price for $15 per share and the minimum volume to 1,000,000 shares traded daily.
To search for IV Percentile, click on Add study filter. Use the drop down menu and under the “Volatility” category, select “IV Percentile”. (Figure 2) Change the setting of the filter to look for IV Percentile between 50 and 100.
In addition, since at the time of the recording we are in the middle of earning release season, add a filter to eliminate company stocks that have a pending earnings announcement. Stock prices can have dramatic moves when earnings are released. It’s okay to trade the releases but that strategy uses slightly different rules and is covered in other Profit Talk issues. For today's’ strategy, we avoid earnings.
To add a filter to eliminate those companies that have earnings soon, click the “Add study filter” button. Use the drop down menu and under “Corporate actions” choose “Earnings”. Adjust the filter to look for prospects that “do not have” earnings in the next 45 days. (Figure 3)
This scan query will look for optionable stocks that have a minimum share price of $15 per share and minimum volume of shares traded of 1,000,000 per day. In addition, we are filtering for companies with an IVP of 60% or higher that do not have earnings in the next 45 days.
Press scan to see if there are any prospects. As I expected, most of the list consists of ETFs. This is because, the majority of individual companies with IVP over 50% right now will have an imminent earnings release. Save the list by clicking in the upper right corner of the list and choose “save as watchlist” . Then pull up the list in the quote window. You’ll find it under the “Personal” category. (Figure 4)
You can then go to the chart page and take a look at the candidates. Sort the list by IVP or any other criteria. You see the highest here, you’ve got the French stock market ETF peg at 100 IVP. That’s because they have an election going on. Then you’ve got some US Treasury bond ETFs and other regional ETFs here.
The vetting process consists of simulating an Iron Condor trade on the prospective markets and using the risk graph to determine the best choice. But prior to doing that, the option chain of each prospect should be inspected to see how the markets are in the options.The main thing we look for is a reasonably tight bid/ask spread. This term simply refers to the distance between the bid price and the ask price of the options.
The allowance varies based on the price of the stock, but as a guideline The largest bid/ask spread tolerated is:
.10 to .15 cents for an option priced at $1 or less
.20 cents for an option priced at $1 to $3
.30 cents for an option priced $3 or more
The most important factor in determining whether to trade a particular option contract regardless of the strategy is the bid/ask spread. Don’t trade wide markets, or low volume markets!
In addition, never use market orders to enter the trade. Don’t pay what is called the “natural” price to enter the trade. Always use limit type orders and start at what is referred to as the “mid price”. The “mid price” is the price between the bids and asks. Start there wait for a little bit to see if you get filled. If no fill, then move the price a penny closer to natural. Keep “working the bid or the ask” as they say, until you get filled at a price you are okay with.
Iron Condor Candidate
I’ve gone through the list of prospects from the scan query and selected the top pick based on the quality of the option pricing and volume.
The top candidate based on our criteria is the US Retail Sector ETF symbol XRT. Let’s look at creating a non-directional style Iron Condor for this market.
This first step in constructing an option position is to choose which expiration contracts to use.
The expiration of the options used for all credit style strategies should be within 60 days or less. The sweet spot is around 45 days until expiration, but anything less than 60 days is good.
You can see, at this time, the monthly expirations available on XRT that have less than 60 days to expire and are closest to 45 days are either 39 or 53 days away. Let’s go with the 53 day expiration because it is the regular monthly as denoted by the white colored text. The regular monthly expiration typically has the best volume.
In order to analyze the trade we need to simulate it in action and view it on the risk graph. Construction of a non-directional style, short Iron Condor consists of selling 1 Put option at the bottom of the bottom of the range and buying 1 Put further out and selling 1 Call option at the top of the range and buying 1 Call further out. This creates a credit spread with 4 “legs” which includes both a long and short Put option. Plus, a long and short Call option. These 4 legs equal 1 spread.
The strike choices can be determined with technical analysis (chart reading) or by using the option greeks. The process involves selling the closer in options and buying the further out options. When using the greeks for strike selection for a non-directional Iron Condor, I like to start with selling options closest to the 16 delta value.
Then, start with buying options around $2 to $3 further away or more on high priced stocks.Start there and see if you can get a minimum of 50 cents credit per spread. This will typically create a well balanced Iron Condor. In addition, by selling the 16 delta options, the short strikes should fall just outside the range that price is expected to close in on the option expiration.
The first consideration when analyzing an Iron Condor is total the credit received for the trade. Since this is a spread with 4 legs involved it’s a bit commision intensive. So, it’s important to collect enough credit to make the trade worthwhile. In general, make sure you receive at least 50 cents for the trade spread at the minimum. That’s the first hurdle to cross.
The amount of credit received can be adjusted by moving the strike locations. The long options can be moved further away to increase the credit. The credit increase because the cost of the long options are cheaper the further away they are from current price, which leaves you more credit. However, the distance between the short strikes and the long strikes is what determines the maximum risk in the trade. This is because the loss amount is capped at location of the long strikes.
The most that can be lost on the trade is determined by the distance between the short and long strikes. This means that although moving the long strike location further away increases the credit received, which is positive for our reward to risk ratio, doing this also increases the the risk in the trade which is negative for our reward to risk ratio. It’s a tradeoff that must be analyzed to determine how best to construct the Iron Condor and ultimately, whether or not to place the trade at all.
In a perfect world, we are able to collect a credit that is around ⅓ the width of the strikes. But, in real, everyday trading it is rare to find set ups that work out that well. Instead, we get as close as we can, say a credit ¼ the size of the strike widths and then manage the risk accordingly. The wider the strike ratio is to the credit received, the more aggressively the risk needs to be managed.
As a side note here, the extraordinary move up in the markets today caused a significant drop in volatility this Monday morning compared to Friday. This means much of the opportunity I saw when I planned this lesson has slipped away. The result is a larger distance is necessary between the short and long strikes in order to receive at least 50 cents in credit. This makes for a less than desireable set-up for the Iron Condor at this time.
The Risk Profile
The risk graph allows you to simulate the profit and loss scenario of the option position based on the price movement of the underlying security you are analyzing. The light blue line represents the P&L of the position based on the underlying price on the day of expiration. The magenta line represents the P&L of the option position based on the price of the underlying today. Magenta is the option position P&L in real time, light blue is the option position P&L on the day of expiration. The difference between the two price comes from the time value contained in the option which will be gone on the day of expiration.
The lighter gray area displays the range that the underlying price is expected to close within on this date here. To analyze the position, set the date to the expiration date of the position you are analyzing. (Figure 5)
The red hash marks represent the breakeven point of the position at expiration. The flat horizontal portion of the blue line, representing the P&L at the time of expiration, extends between the two short strike prices. (Figure 6) This is the maximum profit line. It shows that, in this particular case, if the underlying closes at any price from $40 per share up to $46 the full credit is received.
But, each penny below or above either short strike, eats into the credit received until all the credit is gone, which is our break-even point. Again, as shown by the red hash marks. Subtracting the total credit received from the short Put strike or adding it to the short Call strike gives you the break-even stock price point for the position on the day of expiration. That number is what’s represented by the red marks.
This is the essence of a non-directional Iron Condor. See how you can profit with a fair amount of price movement in either direction. This setup is the ultimate range trade with limited risk.
The horizontal “X” axis represents the underlying price. The real time P&L and the expiration day P&L are shown here in this box and colored accordingly. There are a few key attributes we’re looking for here.
As mentioned, it’s best to meet or exceed a minimum of 50 cents total credit for the spread.
In addition, the break-even point must reside outside of the expected price range as depicted by the light grey area. It would not make sense to put on a trade that has a loss price point that falls within the expected price range. Finally, a risk defense point with a loss amount equal to or less than the total credit received that falls outside of the expected price range must be established, along with an appropriate loss containment strategy. In other words, you must be able to limit the risk to be no larger than the reward, so a 1:1 reward risk minimum, at a point that is outside of the expected range.
Analyze the profit & loss of the prospective trade by moving the cursor along the X axis. You can see the resulting P&L information in the box here. Again, the magenta color is the P&L information real time and the light blue represents the P&L on the day of expiration. For our purpose here, use the day of expiration information. The purpose is to determine what the loss amount is within the expected price range. In order to maintain the 1:1 reward to risk ratio, the loss amount reached within the expected price range must not exceed the total credit received.
Both the long and short strikes can be moved to adjust the credit received. Just make sure the breakeven point does not fall within the expected price range. Again, that is the light grey area. I always start with moving the long strikes first to see if I can acheive the correct ratio. Again, the farther away the strikes are from current price the lower the cost of the option. This means, moving the long strikes farther away lowers their cost and therefore increased the total credit. But, this widens the distance between the short and long strikes which increases the total risk in the trade and directly affects the P&L scenario. It’s a tradeoff that must be analyzed.
If within the expected range, the loss amount at expiration does not exceed the total credit received, the prospective trade passes the test and is okay to take.
The maximum loss we are willing to accept on the particular trade is established as the “risk defense point”. The price of underlying at this point is to be noted and if the trade is taken, risk defense actions must be applied if this price is breached. Doing so will help to maintain the risk to reward ratio. This give us the best chance of being profitable.
When it comes to risk defense there are a few options available for this type of position which includes, closing the trade outright or rolling the trade to a further out expiration date. There is really no right or wrong method. It comes down to personal preferences and/or the particular circumstances involved. The most important point is to limit the total loss amount in order to maintain a proper reward to risk ratio.
Another enormously important factor in managing risk comes in the form of profit taking. Taking profit at a predetermined point increases the probability for success exponentially. It is best to take at least some of the profits once 50% of the maximum profit, which is the credit, has been reached. This practice will increase your probability of profit from 68% to over 80%.
The funds should be re-deployed as soon as possible once the profitable trade has been closed. If multiple spreads are being used, and the trader wishes to keep part of the trade on, then a portion of the position, at least ½, should be removed once the 50% profit point has been reached. The rest can remain until the 75% point is reached.
It is not recommended to leave trades on trying to get the last little bit of credit out of a short option. The capital is best used by re-deploying it in a new Iron Condor trade.
So, there you have a great foundation for using short Iron Condors to provide opportunity for profit. This strategy is great for beginners and seasoned investors alike. It offers a way to capture profit from price trading in a range. The Iron Condors is one of the great ways that options allow you to generate profits without having to be 100% right on market direction.
The top takeaways this week are:
First, an Iron Condor is best used in high IVP situations. As in all credit spreads, Iron Condors have the best success when placed during high IV. 60% or higher is best. 50% IVP is the minimum.
Second, use in high volume markets with tight bid/ask spread on options. This is a 4-leg spread which makes this even more important.
Third, you can increase success by managing winners and losers. Determine a risk defense point and implement a risk defense procedure when triggered. In addition, take profits at the 50% point and immediately redeploy the capital in a new trade to get the best results.
This past week in the broad US Markets we did see some two sided price action, however the net result was a fairly tight range.
Today Monday April 24th, we’ve a reasonably significant move in the US markets which have followed the exuberant world market action following the French election round 1. Apparently the financial markets liked the result.
The high impact reports due out this week include:
Tuesday 4/25 - Consumer Confidence report at 10:10 am eastern
Wednesday 4/26 - Crude Oil Inventories will be released at 10:30 am eastern
Thursday 4/27 - Unemployment claims and the Core Durable Goods numbers will be released at 8:30 am
Friday 4/28 - Advance GDP q/q at 8:30 am eastern
As always these reports have the ability to move markets and create opportunity for the trader who is prepared.
I hope this has been helpful for you. If you have any questions or comments, please leave them below or reach out on social media. You can also email me directly with any questions or comments at firstname.lastname@example.org.
Thank you so much for being a Profit Talk subscriber. I look forward to joining you for next week’s edition of Profit Talk. Until next time keep trading and investing the Profit Effect way proven, consistent and stress free, just the way trading is supposed to be.