Credit Spread and the Iron Condor

The Credit Spread and The Iron Condor

The use of “out-of-the-money” credit spreads that take advantage of a trending market has become a popular, "high probablity" trading method. The idea is to place a bullish option spread behind an area of technical support when the market is trending higher or a bearish option spread above an area of technical market resistance when market prices are trending lower.

Of course, this strategy presumes that the market is either trending higher or lower. However, experienced market watchers know that more often than not the stock market find itself range bound.

Evaluating Market Trends for Credit Spread Trading

The markets tend to move in waves. In bull market rallies investors are busy buying stock. That buying pressure causes the stock’s price to increase. New investors see the rising stock price and jump on board what they see as a bull market trend for the ride, pushing the price higher still.

Eventually, those early bulls who are holding appreciated shares of stock decide to capture some, or all, of their profits. They begin selling their stock. This profit taking creates an increase in selling pressure and more supply in the marketplace, and the price of the stock falls back from its highs.

This "pull back" in price is seen by those investors and traders who missed the initial opportunity take advantage of the lower price and get in on this rising stock. As profit taking subsides, these new buyers cause the price to again rise.

As this tug-of-war continues, areas of technical price support and resistance are created. Technical support exists where investors perceive the stock to be a good value. When prices reach that “value level” investors start buying. Conversely, technical resistance is established where investors become less sure about the stock’s value and are inclined to take profits.

During a market consolidation, these areas of support and resistance can become well defined on a chart, giving the option trader an opportunity to profit.

Stock Option Trading in Consolidating Markets

In a consolidating or “trendless” market, the choice of selling a bullish credit spread versus a bearish credit spread becomes more difficult. So, why not simply do both?

An Iron Condor is a combination of two credit spreads, i.e., a bull put spread and a bear call spread. As such, you are selling puts beneath market support and selling calls above market resistance.

Long calls and puts are purchased as protection and to limit the risk of the trade. The iron condor does not require any movement from the underlying stock or security. In fact, it is a "delta neutral" trade that will be most profitable with little or no movement at all.

Anatomy and Application of the Iron Condor

In March of 2004, when this article was originally written, the major averages had entered a consolidation phase. Focusing on one such average, the NASDAQ 100, we noted that it had seen a magnificent bullish run since March of 2003. Now, the NASDAQ 100 appeared to be cooling off.

We were able to pick out likely areas of market support and resistance on this broad market index and also saw rather light market volume. Large institutional investors are not buying stocks in quantity, but they were also not dumping their holdings. The QQQ reflected this in its sideways trade.

To promote our monthly credit strategies for monthly revenue generation, and to exploit this trading range, we considered expanding beyond a simple vertical credit spread to a more complex, but more profitable trade; the "iron condor."

A neutral to bullish credit spread trade could have been entered at the beginning of March ’04 at the support level, as follows:

  • Sell the March ’04 36 Put for .40 and Buy the March ’04 35 Put for .20
  • Net Credit = .20
  • Maximum Risk = $1.00 - .20 = .80
  • Maximum Return = .20 / .80 = 25%

A neutral to bearish credit spread trade could have been entered at the beginning of March ’04 at the resistance level, as follows:

  • Sell the March ’04 38 Call for .15 and Buy the March ’04 39 Call for .05
  • Net Credit = .10
  • Maximum Risk = $1.00 - .10 = .90
  • Maximum Return = .10 / .90 = 11.1%

Either spread could be placed by itself. Something rather brilliant occurs when the spreads are placed together as set forth below:

  • Sell the March ’04 36 Put for .40 and Buy the March ’04 35 Put for .20
  • Sell the March ’04 38 Call for .15 and Buy the March ’04 39 Call for .05
  • Net Credit .30
  • Maximum Risk = $1.00 - .30 = .70
  • Maximum Return = .30 / .70 = 42.3%

By selling both the bull put and the bear call spread, the net credit was increased while the risk on the combined trade was reduced which in turn increased the overall yield. This is accomplished by the fact that at any given time, only one side of the trade can be “in-the-money.” As such, by expiration, at least one side of the trade will be profitable. The maximum risk, therefore, is limited to the widest distance between the strikes of either wing, less the total net credit.

The total risk is reduced because the furthest distance between strikes on the Iron Condor is $1.00, the same as either the bull put or bear call spread, but the total credit is equal to the combine credit of the directionally biased trades. As such, the larger credit serves to increase return and decrease risk.

The trade is placed for a net credit. Profit is generated by allowing the a positive theta to erode the value of your short options. So long as the stock continues to trade within the boundaries marked by our short call and put, those previously identified areas of support and resistance, the trade will generate a maximum profit.

Iron Condor Trade Management

The most egregious mistake to be made in this trade is to close out one side of the trade prior to expiration for a loss, then allow the market to change direction and create a loss on the other side of the trade. If you allow this to happen, your loss will exceed the theoretical “maximum” loss.

Guiding principles in designing an exit for the trade must revolve around the stock’s behavior within the defined areas of support and resistance. As long as the stock stays within these boundaries, it is generally best to leave the trade in place and allow the lapse of time and positive theta to create profit. If the stock violates either support or resistance, the question of whether the stock is resuming a directional trend is then raised and an exit plan or trade adjustment must be executed to limit losses.

Incorporating the Iron Condor Into a Credit Spread Strategy

Once you are familiar with how the iron condor functions, it can be incorporated into a credit spread strategy. During a trending market, you will probably want to place the high probability, directionally biased spread, i.e., a bull put or bear call spread. However, during period of consolidation when there is no prevailing trend, the Iron Condor offers a method of placing a short-term credit spread with a reduced risk profile and higher return characteristics.

About The Author

Christopher Smith

http://www.linkedin.com/in/theoptionclub