The dramatic falls in the past few weeks in global stock markets has caused option implied volatility [IV] to increase. This increase in IV coupled with stock directional uncertainty set up an environment for high implied volatility sideways strategies. This week's article will explore the Iron Condor strategy.
An Iron Condor is a strategy that involves buying one Out-Of-The-Money Call (usually at the stock's resistance level), selling one At-The-Money Call (usually the midpoint of the trading range), selling one At-The-Money Put (usually the midpoint of the trading range) and buying 1 Out-Of-The-Money Put (usually at the stock's support level). The term "iron" comes from the fact that two OTM credit spreads (a Bear Call spread and a Bull Put spread), are used to construct the trade. The expected outcome of the trade is to have the stock expire within the strike of the two options sold and thus the entire trade expires worthless and you keep the credit. These trades are typically placed with 45 days or less to expiration.
Chart 1 shows an example of an Iron Condor trade on MGM Mirage Inc (MGM). Following the criteria above, the Apr07 options with 33 days to expiry are used. The call options used are buying the 75 and selling the 70 strikes and the put options are selling the 65 and buying the 60 strikes. The trade takes in a 2.20 (3.40 â 1.20 = 2.20) credit calculated by taking the difference between the option premiums sold (1.90 + 1.50 = 3.40) and the option premiums bought (0.70 + 0.50 = 1.20). The maximum risk of the trade is calculated by taking the difference between the option strikes sold minus the net credit for the trade ((70 â 65) â 2.20 = 2.80). Thus the trade has a potential reward of 79% (2.20 / 2.80) profit over a 33 day holding period.
Chart 1 â MGM Iron Condor
Another important factor to consider is the Implied Volatility [IV] of the options. The IV for an Iron Condor is the "edge" a trader should put on their side. Typically, high IV with a down trending curve is the ideal scenario. This means the sold options were filled at an inflated price and dropping in value. This is perfect for selling. Chart 2 shows the 30 to 60 day IV for MGM. The 30 to 60 day IV is chosen because the holding period of the trade is 33 days. The IV curve to be analyzed is a function of the number of days to expiration.
Chart 2 â MGM 30-60 Day Implied Volatility Chart
Iron Condors are a great trade to take when IV is high and the market's direction is uncertain. This scenario usually occurs after big unexpected falls in global markets that have recently been witnessed. The important criteria for any sideways trade is for the trade to expire within the breakeven points of the trade. In the case of an Iron Condor, if the trade expires within the strikes of the options sold the entire trade finishes worthless and nothing else needs to be done.
Manage Your Risk!