Change text size

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Last week we started a new Real-World Trading series discussing the iron condor strategy. This strategy is akin to the butterfly and condor trades, meaning that it is a neutral trading strategy. In review, an iron condor is the combination of a bull put spread and bear call spread. All options have the same expiration month and different strikes, normally spaced out evenly. An iron condor brings in a credit, which is also the max profit for this particular strategy. This week we will enter a mock trade using an iron butterfly so we can track see how the strategy works.

An iron butterfly is normally set up using four different strikes, meaning that commissions are important, especially for smaller accounts. The fact that an iron condor wants a stock to stay within a certain range usually means we want to use front month options. An iron condor also benefits from theta decay, or time erosion. Therefore, we want to take advantage of the accelerated time decay during the last 30-45 days of the trade's life.

Generally speaking, much like a butterfly trade, we want to use options that are showing high IV, but that we expect to move sideways. The reason is that the higher the IV for the ATM options, the better reward to risk ratio we will receive. The fact that index options tend to show less day to day volatility is a major reason why these types of options are used by many traders when trading an iron condor. The other reason for using index options is that they are highly liquid, making it easier to get good pricing.

The Optionetics platinum site has many search engines that will help traders find sideways moving stocks. One search technique is to create or use a list of high IV stock options. These can be used in an iron condor search or traders could eyeball the charts and news to see which stocks seem ready to consolidate. There is a fine line between using high IV stocks that could move sharply and low IV stocks that won't provide a good enough credit.

We are going to use the S&P 500 ($SPX) as our security in our iron condor mock trade. The SPX broke through a key resistance level at 1,100 this week and many analysts feel sideways trading is in store for the major market indices heading into 2010. IV on SPX options is actually on the low side of its recent range, but this lack of implied volatility is offset by the expected sideways movement in the security and its liquidity.

Choosing the strikes for a condor can be a difficult decision because the distance between strikes changes the reward-to-risk ration dramatically. Traders need to figure where they feel the underlying security will trade during the life of the iron condor and set the appropriate strikes. The larger the spread between strikes, the higher the odds of success. However, this also raises the max risk and evens out the reward-to-risk ratio.

The SPX closed Wednesday's session at 1,109.80. We expect the SPX to trade near the 1,100 range for the rest of the 2009. Therefore, we need to use options that put this key point in the middle. Let's look at a comparison of different set ups so we can see how various strike prices impact the trade.

The downside and upside percentage move is showing the distance the SPX would have to move in each direction to move out of the profit range. Looking at this table, I like the middle iron condor best. This is because it allows some movement in the SPX, but doesn't have near the risk of the wider strike trade. Therefore, let's use this as our mock trade that will expire in December. Remember, this series of articles is not intended to provide readers with a trade to enter, but is used to show how a particular strategy works. When we paper trade like this, we can learn from the good and the bad, helping us when we put real capital to work.

SPX @ 1109.80
Buy 1040 Dec Put @ 6.85 (IV-24.6)
Sell 1080 Dec Put @ 14.75 (IV-22.3)
Sell 1120 Dec Put @19.10 (IV-18.7)
Buy 1160 Dec Put @ 5.55 (IV-17.2)
Credit = $2,145
Max Risk = $1,855
Downside Breakeven = 1058.55
Upside Breakeven = 1141.45

Here is the risk graph and data for this trade created in Platinum:

Figure 1: Risk Data for SPX Iron Condor

Figure 2: Risk Graph of SPX Iron Condor

One thing we notice by looking at the charts is the volatility of the SPX. However, we expect the market to consolidate after seeing such huge declines, followed by a significant comeback since March.

We will continue to discuss this mock trade each week through December expiration. We need to discuss exit strategies and go over the different greeks and how they impact the trade. If you have any questions or comments about this strategy, please post them on my forum, which you may access through "Ask the Traders" from the Discussion board on the homepage of Optionetics.com. so we can go over them.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

• Email This Article
• Print This Article
• Digg This
• Delicious
• Subscribe

Recent Articles by Jody Osborne, Optionetics.com

• March 19, 2010
  Closing Wrap-Up, March 19
• March 18, 2010
  Closing Wrap-Up, March 18
• March 18, 2010
  Economic Watchdog, March 18
• March 18, 2010
  Morning Watch, March 18
• March 17, 2010
  Closing Wrap-Up, March 17