IRON CONDOR - The Credit Spread Spreads its Wings

I like credit spreads. Specifically, I like “out of the money” credit spreads that take advantage of a trending market. If the market is trending upward, I like placing a bullish stock option spread behind an area of technical support. A bearish stock option spread can be placed behind market resistance when market prices are trending lower.

The trouble is that the market is not always trending.

Evaluating Market Trends For Credit Spread Trading

The markets tend to move in waves. In bullish markets, investors may start buying a stock. That buying pressure causes the stock’s price to increase. New investors seeing the rising stock price jump on board for the ride, pushing the price higher still.

Eventually, those holding the stock decide to capture some, or all, of their profit and begin selling the stock. The increase in selling creates more supply in the marketplace, easing the buying pressure and the price of the stock falls back from its highs. At that point, those who missed the opportunity get in on this rising stock see their chance to buy it cheap, thereby causing the price to again rise on their buying.

As this tug-of-war continues, areas of technical 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 in volume. Conversely, technical resistance is established where investors become less sure about the stock’s value and are less eager to buy it. 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 where to put a credit spread, behind resistance or support, 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. This trade 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 no movement at all.

Anatomy And Application Of The Iron Condor

As this article is being written, the major averages have entered a consolidation phase. Focusing on one such average, the NASDAQ 100, we will note that it has had a magnificent bullish run since March of 2003. Now, the NASDAQ 100 is cooling off and deservedly so.

Coupled with the identification of these areas of support and resistance in early March 2004 is the observance of very light market volume. Large, institutional investors are not buying stocks in quantity but they are also not dumping their holdings. The QQQ reflects this in its sideways trade.

To promote our monthly credit strategies for monthly revenue generation, and to exploit this trading range, we might consider 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 March ’04 36 Put .40
Buy March ’04 35 Put .20
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 March ’04 38 Call .15
Buy March ’04 39 Call .05
Credit .10

Maximum Risk = $1.00 - .10 = .90
Maximum Return = .10 / .90 = 11.1%

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

Sell March ’04 36 Put .40
Buy March ’04 35 Put .20
Sell March ’04 38 Call .15
Buy March ’04 39 Call .05
Credit .30

Maximum Risk = $1.00 - .30 = .70
Maximum Return = .30 / .70 = 42.3%

By placing both the bull put and the bear call spread, the net credit is increased, risk on the trade is reduced, and return on risk is improved. This is accomplished by the fact that at any given time, only one side of the trade can move “into 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 as displayed below:

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 of the Iron Condor.

Guiding principles in designing an exit for the Iron Condor 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 returning to a trend is then raised and an exit plan or trade adjustment must be considered 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 easily incorporated into a credit spread strategy such as that outlined in a prior article. 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.

Additional Option Trading Resources

The Options Mastery Course
By Options University and Ron Ianieri
reveals the details of how to profitably
trade equity options.

Reliably Identify Market Trends
and Consolidations with Smart Scan
technology by MarketClub.