Playbook: Spreads: the Short Iron Condor

Short Iron Condor

This strategy can be profitable for stocks that are rangebound (have no direction, go sideways). It is the combination of a bull put spread and a bear call spread.

The higher strike put is lower than the lower strike call in order to create the condor shape.

The combination of two income strategies also makes this an income strategy.

Ideally, the stock will remain between the two short strikes, with the maximum profit achieved if the options expire worthless between these, and you keep the combined net credit you received when opening the iron condor.

You typically buy an iron condor around 45 days before expiration (45 DTE) (like bull and bear credit spreads).

The position benefits most from IV/IVR contraction and/or minimal moves of the underlying price which should remain between the short put and call strikes. So you benefit from volatility going lower once you are in the trade.

Volatility rule: stable or declining market volatility is key to a successful condor!

Considerations

General

For an iron condor, implied volatility does not need to be high but only higher than the underlying’s average true range (ATR). Thus, an iron condor can be traded in just about any volatility condition. It only matters that expectations of implied volatility are higher than ATR. Essentially, you think implied volatility is too high.

Iron condors are most effective in lower volatility. In higher volatility, you are getting a higher premium or setting up the iron condor wider, but often ATR is high. The key to trading iron condors in high volatility is to try to sell when volatility is stable or falling, not when implied volatility is simply “high.

These are the considerations for entering a bull put:

• The expectation that underlying (stock, ETF, index, future) will go sideways (remain ‘rangebound’): the outlook is neutral (or modestly bullish/bearish).
  • If the underlying price is in the range of maximum profit when the position is established, then the forecast must be for unchanged, or neutral, price action.
  • If the underlying price is below the range of maximum profit when the position is established, then the forecast must be for the stock price to rise into the range of maximum profit at expiration (modestly bullish).
  • If the underlying price is above the range of maximum profit when the position is established, then the forecast must be for the stock price to fall into the range of maximum profit at expiration (modestly bearish).
• Selling premium is expensive.
• Implied Volatility (IV)/IVR (IV Rank) is mid-high to high (>30), and expected to decrease in value over time.
• Lessening buying power for larger underlyings
• To widen the area of your breakevens with the combined net credits: the Bull Put credit helps the Bear Call, and vice versa.
• Trade wider condors (look more like short strangles and have netter PoP) instead of more contracts with narrow spreads
• Risk is limited (‘defined’) to the difference between the spreads minus the premium received (‘credit’).
• The maximum reward is capped at the premium received (‘credit’).

* Note: because you’re both buying and selling a credit spread, the potential effect of a decrease in implied volatility will be somewhat neutralized.

Miscellaneous

Skew: If you were simply selling strangles, the skew curve might be the most important part of the trade equation. Skew seems to matter less because you are selling an iron condor, thus selling a short and buying a long against it. Still, it can help the trader recognize red flags.

In low volatility, typically, you would prefer a slightly steeper skew. Below ATM, an elevated skew will push the short slightly further away from ATM. Above ATM, the short call spread will receive slightly more credit. This is not of major significance, but it does matter.

An overly steep curve should be considered a major warning sign. When implied volatility has yet to rally, but the curve has caught a bid, this can indicate an impending volatility spike. Selling an iron condor into rising volatility is a recipe for disaster. Skew tends to be very steep in two instances: rising volatility and falling volatility. If IV is low and skew is steep, either doesn’t enter an iron condor or back up the truck on insurance.

Insuring: The greatest danger to an iron condor is not found when volatility is low. The greatest danger is not when volatility is high. Iron condors can destroy a play during the transition from low to high. The proper implementation of unit puts can save a portfolio.

The transition from low to high can ramp up the value of OTM puts. Thus, if volatility is in the lower 25% of its historical range, you should always spend a few dollars on insuring the value of the open iron condor. Although traders vary in how much they buy, no more than 10% of the credit received on a sale is necessary to ensure that the iron condor is properly insured.

On the other hand, when volatility is at its highest levels and declining, insuring may be unnecessary; it is likely that the trade was entered when you had a full view of the risk associated with the trade. It is also likely that any insurance bought would be ineffective, as the far OTM puts will already have a large portion of risk premium built into their price.

The setup: Once you have determined that volatility is “too high,” you should look to sell a 10–11 delta call and buy the next call strike. However, this is not set in stone. A smart trader examines strikes around the 10–11 deltas to see whether any strikes are mispriced. I have seen situations where an SPX 1350–1360 call spread netted more than an SPX 1340–1350 call spread. This is generally due to a “public order” in the “book.” Then you should look to sell the 10–12 delta put against the call spread.

Description

Set-Up

1. ‘Sell to open’ (‘STO’) an OTM bear call credit spread with the short strike at <= 0.30.
2. ‘Sell to open’ (‘STO’) an OTM bull put call credit spread with the short strikes so <= 0.30 (so higher than the bull put spread)

• Sell the same number of strikes with same spread width, at the same expiry date, and in principle at same equidistance (see later for dynamic/skewed iron condors) with the underlying price between the two short strikes.
• Arrange both spreads to collect a credit of at least 1/3 the width of the spread (while taking into account the deltas/cushions).
• Go for 67% PoP or at least 70% P50 (=probability of achieving 50% profit target).
• For higher the IV/IVR, widen the strikes for greater PoP.
• Look at taking advantage of volatility skew to determine spread widths, and distance to underlying price for dynamic iron condors with non-equidistant spreads.
• Wider spreads are better then adding more contracts (for same credit).

Traders often will leg into the short iron condor, first trading a bull put spread just below support and then as the stock rebounds off resistance adding a bear call spread, thereby creating the short iron condor.

Related Options Strategies

The short iron condor is very similar to the iron butterfly. The difference is that the short put and call strikes of the iron butterfly are at the same strike.

The Greeks

Entry Rules

Profitable iron condors require correctly selecting neutral underlyings AND good timing.

Criteria

• Acknowledge whether market sentiment allows trade.
• Check whether trade fits in portfolio allocation rules.
• Ensure stock meets all of your selection criteria (volume, open interest, ask-bid range, etc.).
• IV/IVR above 30% or higher than the historical volatility (HV)*.
• Ensure the trend is neutral (rangebound/sideways).
• Ensure at least three of the technical momentum indicators are positive.
• Identify the clear areas of support and resistance.
• Make sure there are no major events (dividends, earnings) within 30 days of the expiry date.
• Profitability of Profit at selected strike: around 67%.
• Backtest (since 2006 and last 200 trades): at least $1.00 (average and mean) profit/day.

* Note: For an iron condor, implied volatility does not need to be high, but only higher than the historical volatility of the underlying. Thus, an iron condor can be traded in just about any type of low to high-volatility condition. It only matters that expectations of implied volatility are higher than HV. Essentially, you think implied volatility is too high. Iron condors are actually most effective in lower volatility. In higher volatility, you are getting a higher premium or setting up the iron condor wider, but often risk is higher. The key to trading iron condors in high volatility is to try to sell when volatility is stable or falling, not when implied volatility is simply “high”.

Technical Indicators Used

1. Trend = neutral
2. Support & Resistance = the underlying has just experienced a decrease to a clear support level
3. RSI = check overbought and oversold conditions to position the spreads
4. Bollinger Bands in combination with Keltner Squeeze: check top/bottom to position the spreads
5. ADX/DMI: increasing up and above 20
6. ATR high

P/L and Risk Profile

Net Position

Net credit, because you receive a premium for selling the put option.

Theoretical Profit

Iron condors have a negative vega. The net premium (to be paid at exit) will fall when IV decreases (so profits).

As long as the underlying price stays in between the lowest and short strikes, an iron condor could profit fro time decay (theta). So it has positive theta.

The maximum reward is the net credit, realized when the price of the underlying is between the short strike of the bull put and the short strike of the bear call at expiration.

Both puts will expire worthless, and you keep the net credit.

Theoretical Risk/Risk Profile

See above: Iron condors have a negative vega. The net premium (to be paid at exit) will rise when IV increases (so losses).

See above: if the underlying price moves below the lowest long strike, or above the highest long strike, the theta becomes negative, and the position loses more as expiration comes closer.

The maximum risk is the difference between the strikes (spread width) of the widest spread -/- the net credit received for selling the iron condor, realized when the underlying price is above the highest strike or below the lowest strike at expiration.

Breakeven

• Upside: short call strike + net call premium/credit
• Downside: short put strike -/- net put premium/credit.

Managing and Closing Position

Halfway to/Near Expiration

• If the underlying is between the short strikes: both spreads expire worthless, and the profit is the net credit.
• ‘On the dance floor’ is when the short strike is ATM/slightly ITM, and the long strike is still OTM, and is generally the point to adjust/roll.
• Roll until both strikes are at the same strike, creating an iron butterfly (which is a straddle with long strikes as protection)
• If the underlying decreases below the long put (lower strike): ITM long put exercise risk, ITM short put assignment risk and OTM calls expire worthless.
• If the underlying increases below the long call (higher strike): ITM long call exercise risk, ITM short call assignment risk and OTM puts expire worthless (theoretical risk is then also having no stock).

Rules for Managing/Adjusting Position

• If the PoP is <33%
• If the short strike of one of the two spreads is challenged, adjust the strikes of the untested (profitable) spread for a credit of around 50% of the initial credit and/or roll the position (spread) out in time.
• Thus, you should try to collect about 55% of the value of the iron condor you sold. The intent is to be out of the condor by 14 – 30 days until expiration.
• Roll out in time when short strike = ATM/slightly ITM, and long strike OTM, to extend the duration, and to continue the original position/strategy.
• Do not close the challenged spread since this may cause more losses than rolling/allowing the probabilities to play out or closing the entire position.
• Defensive roll: extend the duration of the existing position for an additional credit to increase profit potential and extend the breakevens.
• If this is not workable: allow the limited risk probabilities to play out, or close the entire position.
• Set alerts on breakeven/predetermined targets.

Rules for Closing Position/Exiting the Trade

• Close for a 50% profit. If the trade picks up 25% of the credit sold in under five trading days, you caught “edge” in the sale. You should exit the trade, stop, reevaluate- ate current conditions, and then decide to enter a new trade if you are so inclined. Profit made quickly means there was an edge in the trade, and edge should always be captured promptly.
• Unravel the iron condor by buying back the spreads you sold.
• Close before the final month before expirations (to avoid volatility going up), so not later than around 21 DTE.
• You can also decide to either close spread-by-spread or leave one spread open if you expect to profit from that.
• Close if the underlying is close to ex-dividend; assignment risk
  • short shares: short ITM call with corresponding put value < dividend
  • long shares: short ITM put strike > underlying price.

Mitigating a loss

• Unravel the trade as described above.
• Work with a (mental) stop loss based on an underlying asset of either 50% or 100% (whatever your exit rule is) of the premium paid.
• See also this video on when (or whether) iron condors hit max loss.

Additional Notes

Advantages

• A short-term income strategy not necessarily requiring any movement of the stock.
• Profit from a rangebound stock for no cost and low downside risk.
• Capped and low risk compared with potential reward.
• Comparatively high-profit potential if the stock remains rangebound.

Disadvantages

• Bid/ask spread can adversely affect the quality of the trade.
• Higher profit potential only comes when nearer to expiration and if the range between wing strikes is narrower.

Exercise/Assignment

If assigned on the short put resulting in (unwanted) long stock: close the 100 long shares and long put as a single covered stock.

If assigned on the short call resulting in (unwanted) short stock: close the 100 short shares and long call as a single covered stock.

The short put can be assigned in the event it is ITM. This results in (probably unwanted) stock.

The risk of early assignment is a real risk that must be considered when entering into positions involving short options.

While the long put (lower strike) in a bull put spread has no risk of early assignment, the short put (higher strike) does have such risk. Early assignment of stock options is generally related to dividends, and short puts that are assigned early are generally assigned on the ex-dividend date. In-the-money puts whose time value is less than the dividend have a high likelihood of being assigned. Therefore, if the stock price is below the strike price of the short put in a bull put spread (the higher strike), an assessment must be made if an early assignment is likely. If the assignment is deemed likely and if a long stock position is not wanted, then appropriate action must be taken. Before an assignment occurs, the risk of assignment can be eliminated in two ways.

1. The entire spread can be closed by buying the short put to close and selling the long put to close as a single Covered Stock order.
2. The short put can be purchased to close, and the long put open can be kept open.

If early assignment of a short put does occur, stock is purchased. If a long stock position is not wanted, the stock can be sold either by selling it in the marketplace or by exercising the long put.

Note, however, that whichever method is chosen, the date of the stock sale will be one day later than the date of the stock purchase. This difference will result in additional fees, including interest charges and commissions. Assignment of a short put might also trigger a margin call if there is not sufficient account equity to support the stock position.

Source: Fidelity Learning Centre

The long put can be ‘exercised’. For this, you need to contact your broker.