The Iron Condor – Part I

THE IRON CONDOR

By Mike Parnos

The most popular strategy, and the foundation and the source of most of our profits. is the Iron Condor.

The Iron Condor often has a wide wingspan, but an intentionally short life span. We’re trying to establish a position, using credit spreads, that will allow an index (or stock) to vacillate (no, it’s not a lubricant) up and down within a trading range without violating the integrity of the position.

The Iron Condor consists of establishing a bear call spread on top of a trading range and a bull put spread at the bottom of the trading range. We normally use the front month for both spread positions.

The Iron Condor is a credit strategy. That means the maximum we can make on the trade will be the credits we take in at the inception of the position. We will take in a credit from both spreads and, if the option Gods smile upon us, we’ll keep all the money. All the options will expire worthless and ascend to option heaven — where all good expired options go to when they die.

Criteria for Creating an Iron Condor

Here’s a quick review of the concepts used to create an Iron Condor, in this case we’ll use our favorite underlying, the SPX (S&P 500) index. Keep in mind that the points below are not hard and fast rules. They are simply guidelines. They will vary from person to person, based on risk tolerance and account size. Basically, we’re just trying to position ourselves to have the greatest probability of success.

a) With over four weeks left until expiration, we want to establish a maximum profit trading range of about 100 points. There’s a little flexibility here, depending on your risk tolerance. The wider the range, the safer the trade.

b) We want to limit our exposure to about $10,000 – $18,000 per position (this will vary depending on your account size). That means 10 contracts on a 10-point spread or 12 contracts on a 15-point spread. We used to trade wider spreads (20 & 25 points), but learned some expensive lessons and that we should limit ourselves to the smaller spread sizes.

c) Try to make the spread as close to equidistant from where the stock is trading as possible. If the SPX is at 1190, we would initially look at the 1240/1250 bear call spread and the 1140/1130 bull put spread. This isn’t always possible because there always seems to be more premium available on the put side than the call side.

d) Take in a reasonable amount of premium. What is reasonable? Well, it has to be worth the risk. Again, that can vary based on the spread size, time left to expiration, number of contracts you’re trading, etc. Ideally, I like to get about 10% of the spread size, $1.00 on a 10-point spread, $1.50 on a 15-point spread. It’s not always possible, especially with the low premium environment we have now, but it’s a place to start.

Choosing the Underlying (Index or Stock)

We want to find a relatively volatile index that is trading within a range. The volatility will hopefully provide us with some decent premium. If we place the spreads properly, the support and resistance levels will hold the underlying within its range and we all live happily ever after. If not, there are ways to deal with a trade that isn’t working.

Iron Condor Example

Let’s use our old favorite – SPX (S&P 500 Index) – closed Friday at 1195.90. It’s had a history of trading within the $35-$45 range. It has good volatility and should be good for this hypothetical example.

The Bull Put Spread:

Sell 10 contracts of SPX Nov. 1135 puts       

Buy 10 contracts of SPX Nov. 1125 puts                   

Credit for Bear Call spread of about $.90 ($900)

The Bear Call Spread:

Sell 10 contracts of SPX Nov. 1260 calls       

Buy 10 contracts of SPX Nov. 1270 calls                   

Credit for Bull Put spread of about $.80 ($800)

From the two spreads, we have taken in a total of $1.70 ($1,700). If you’re a shrewd trader, you might be able to get another dime, but let’s go with the $1,700 for our calculations. How do you get to be a skilled trader? For starters, attend a CPTI advanced seminar. Then, experience putting what you learn to work.

Target Profit

This is the fun part. This part is truly exciting. It causes heart palpitations, eyebrows and various other body parts to rise just at the thought of these returns. Based on what you read in the paragraph above, you can see that we took in $1.70. Our actual risk is only $8.30 ($10 – $8.70). If the SPX behaves and finishes inside the predetermined range, both spreads will expire worthless and our return on our risk is 20.5% — for about six weeks!! Sure beats the Hell out of a Treasury Note!!

Stay Tuned To This Station

Next, we’ll continue our discussion of the Iron Condor strategy. We’ll look at maintenance requirements, risk calculations, possible position adjustments, etc.