In a nutshell, there are 3 basic things you can do with options:
1. Leverage a market (direction) opinion
2. Generate income
3. Profit from sideways price movement
This piece will focus on #3. Please note that as always, the example detailed in just that – an example – and not a recommendation.
Strategy: Iron Condor
An iron condor is an option trading strategy that attempts to make money when the price of the underlying security remains within a particular price range.
If the price of the underlying security remains within the particular price range then the trade makes money. If it moves outside of that range the trade must either be exited or adjusted or else a loss that is (typically) in excess of the potential profit on the trade may occur.
There are many factors that a trader may consider when looking for an opportunity to use the condor strategy, but two of the key ingredients are:
1. Price action within an objectively identifiable range: This establishes a high and low for a price range and also helps to identify key price levels where action may need to be taken.
2. Above average implied option volatility: The condor strategy involves “selling premium” and the maximum profit potential is established at the time the trade is entered. The higher the implied volatility for the options the more premium that the trader takes in by selling options, i.e., the greater the profit potential.
Ticker: EWZ
In Figure 1 we see that iShares MSCI Brazil Capped (N:EWZ) is presently trading within a price range roughly bounded by $26.14 on the upside and $20.06 on the downside. So we will look for a potential condor that can profit if EWZ stays with that price range.
Figure 1 – EWZ in a trading range? (Source : www.ProfitSource.com)
In Figure 2 we see that implied option volatility (the black line superimposed over the daily bar chart) is just coming off of an extremely high level. Remember, the higher implied volatility, the more time premium is built in to the price of the EWZ options. This chart tells us that this may be a good time to sell premium using EWZ options.
Figure 2 – EWZ option implied volatility at the high end of the range (Source: www.OptionsAnalysis.com)
The Iron Condor Spread
I used www.OptionsAnalysis.com to find the condor spread trade displayed in Figures 3 and 4. I simply sold the call option closest to the range high (26) and bought the next $1 higher strike (27). I also sold the put option closest to the range low (20) and ought the next $1 lower strike (19).
I assumed willingness to assume a maximum risk of $2,500.
This position involves:
*Buying 30 November 27 calls @ $0.12
*Selling 30 November 26 calls @ $0.22
*Selling 30 November 20 puts @ $0.18
*Buying 30 November 19 puts @ $0.11
The particulars appear in Figure 3.
Figure 3 – EWZ Iron condor details (Source: www.OptionsAnalysis.com)
A few key things to note:
*The breakeven prices (assuming the trade is held until November option expiration) are $19.83 and $26.17.
*The maximum profit potential is $510 and will occur if EWZ is between $20 and $26 at November option expiration.
*The maximum loss on this trade is -$2,490 and would occur if the position was still held at November option expiration and EWZ was above $27 or below $19.
*The maximum profit % is 20.5% ($510/$2,490).
The risk curves for this trade appears in Figure 4. The breakeven prices are highlighted.
Figure 4 – EWZ Iron condor risk curves (Source: www.OptionsAnalysis.com)
What to Do Once the Trade is Entered
*In a perfect world, we would simply sit and wait for our profit to accrue while EWZ trades sideways within our upper and lower breakeven prices. And this often can be the case. The problem is that occasionally trouble intrudes as price decides to make a significant move in one direction or the other.
*If price moves far enough the risk curves begin to slope downward enough to start incurring a significant open loss. As a result, a condor spread IS NOT a “set it and forget it” type of trade.
*The key is to have in advance some idea as to what you will do price approaches or exceeds one of the short strikes and/or if a loss begins to accrue. Whether to “adjust” or “cut bait” is a personal choice based on a lot of factors. Adjusting an existing position is something of an “art form”, but doing so can keep you from getting stopped out just before price reverses back towards the middle of the target price range.
*For sake of example, in our EWZ trade a trader might decide to simply exit the trade if either of the short strikes ($26 or $19 are reached). Another alternative might be to target those areas where the risk curves “meet” just beyond the breakeven levels (roughly $26.60 on the upside and $19.50 on the downside). The net result of this approach would be that the trader risks roughly $1,000 in order to make $510, with the knowledge that the ETF price must move roughly 15% in either direction over the next 24 days in order to trigger this stop-loss.
Summary
Once more, I am not “predicting” that EWZ will in fact remain between $20.06 and $26.14 for the next 24 days nor that this trade will ultimately make money. This is simply an example of a trade that exhibits some of the key ingredients that option traders should look for when considering an iron condor (i.e., an objectively identifiable price range and high implied volatility).
For traders who know what to look for and are willing to act if need be after the trader is entered, the condor spread offers the opportunity to make money even as the price of a given security drifts sideways and/or remains locked within a particular price range.
For individuals looking to expand their realm of money-making opportunities, it might be worth a closer look.