Every option strategy comes with the possibility of earning a profit. There is also the possibility of losing money—and that represents the risk of trading. Whenever you initiate a trade, you should have some expectation of the likelihood of incurring a loss when seeking the potential reward.
Most traders have a market bias—they initiate a trade when expecting that the overall stock market (or at least the price of the individual stock being traded) will move higher or lower. Such traders adopt a bullish or bearish strategy.
Other traders have no specific bias. They look at the market in one of two ways:
- They have no opinion on market direction and by default, adopt market-neutral strategies.
- They expect a non-volatile, non-directional market and elect to adopt market-neutral strategies.
The iron condor is one such strategy.
- The iron condor is a market-neutral strategy, meaning that it earns a profit when the market trades in a relatively narrow range.
- Market-neutral traders earn money from the passage of time—but only when rallies and declines do not generate a loss that is larger than the positive time decay.
- When the stock moves too near the strike price of one of the options that you sold, its price increases rapidly, and the iron condor loses money.
- Bullish Strategy: Earns a profit for the trader when the market moves higher.
- Bearish Strategy: Earns a profit when the market declines.
- Market-neutral Strategy: Earns a profit when the market trades in a relatively narrow range, and all rallies and declines are small (i.e., when volatility is low).
There is one other important consideration for traders:
Bullish and bearish traders earn money from market movement; i.e., they correctly predict whether the market rises or falls.
Market-neutral traders earn money from the passage of time—but only when rallies and declines are small enough that they do not generate a loss that is larger then the positive time decay. Ideally, the trader waits for Theta to work its magic.
How Does a Trader Make Money from the Passage of Time?
Options are wasting assets, and (all else being equal) lose value every day. Theta measures the decay rate.
Traders who buy options must have their market opinions come true—sooner rather than later—or else the options bought will lose too much of their value while the trader holds onto the position and waits for his/her prediction to come true.
Option sellers don't have that problem. They make money every day—unless the underlying asset (stock, ETF, index) moves too far in the wrong direction. [Call sellers do not want the stock price to rally and put sellers do not want the stock price to fall.]
Iron Condors: Risk and Reward
Let's examine a typical iron condor.
- Buy 1 INDX Jan 16 '15 1240 call
- Sell 1 INDX Jan 16 '15 1230 call (These two options form the call spread; premium $0.95)
- Buy 1 NDX Jan 16 '15 1110 put
- Sell 1 INDX Jan 16 '15 1120 put (These two options form the put spread; premium $1.05)
Let's assume that the premium collected is $2.00 per share or $200 for one iron condor.
The Iron Condor Trade
The losing situation: When the stock moves too near the strike price of one of the options that you sold, its price increases rapidly, and the iron condor loses money. Sometimes there is a good offset: If enough time has passed, and if the time decay is large enough to offset the entire increase in value, you may still have a profitable position.
When the Trade Is Not Working
If the index (INDX) price nears 1230 (the short call option) or 1120 (the short put option), the corresponding spread gains significant value, and the whole iron condor position would cost more to exit than the $200 collected when the trade was originated. As a result, the position is losing money or is "underwater."
There are three ways to handle the situation. Two are acceptable actions that traders can take when faced with this money-losing situation. One is unacceptable.
- Adjust the risk when the position is no longer in your personal comfort zone. In other words, your worries about losing even more money leave you queasy. There are a number of good strategies that you can use when adjusting risk.
- Close the position and accept a loss. This choice is difficult for the inexperienced trader because no one likes the idea of giving up on an open position and locking in the loss. However, knowing when a position is too risky for you, and especially when it comes with a high probability of incurring that loss, being able to take defensive action is a mandatory skill for traders. When a trader is uncertain of how to proceed—but is unhappy with owning the current position—then making a clean exit is often the very best choice.
- What is unacceptable—because it will eventually lead to ruin—is ignoring risk and holding a bad position with the eternal hope that all will work out in the end.
When the Trade Is Working
The profitable situation: Time passes. The options remain far out of the money.
The options that you sold (1230 call and 1120 put) are always worth more than the options that you bought (1240 call and 1120 put). That means they gain or lose value more rapidly. Thus, as time passes, the call spread, and the put spread each lose value, and eventually, you can buy both spreads to exit the iron condor with a profit. Important note: Iron condor traders do not rush to the exits with a small profit. Nor should you seek the maximum possible profit. Learning when to exit is a skill unto itself and is just one more part of managing risk for an iron condor position.