So what exactly is an iron condor and why do we focus on that particular kind of trade? This page will answer those questions.
What an iron condor is
An iron condor is a type of options spread trade that involves
simultaneously buying and selling multiple contracts in order to
capture a particular segment of future market movement. Before we get
down to technicals, look at the following chart of price action in the
S&P 500 over the year 2006.
Now, look at the range in which the index moved in August 2006. The SPX
started off the month just above 1275, and went into September a bit
above 1300. Now, what if the index hadn’t had such a good month, and
had actually dropped to 1240? Anybody with a long position would have
taken a serious loss. The unique and powerful ability of iron condors is that they enable you to make money no matter which way the market goes.
Our strategy is a “non-directional” strategy because it works
independently of market movement, meaning we don’t have to be right
about whether the market will go up or down.
In our example, a properly constructed iron condor would have made
money whether the S&P 500 ended August up at 1300 or down at 1250,
because the idea behind this trade is to:
Sell rather than buy; and sell time rather than price.
Let’s explain what that means. If you’ve ever been to a casino or
played a slot machine, you know that the games are mostly rigged in the
casino’s favor. Sure, occasionally some lucky gambler will hit a big
payout or find a hot streak, but the consistent profits that the house
takes on a daily basis more than make up for the occasional lucky
winner. The idea here is the same: by selling options rather than
buying them, we take on the role of the casino rather than the
individual gambler. And by selling time instead of selling price, we’re choosing the game that will put the odds most in our favor.
The trade itself is made up of four pieces:
- +1 put at the lowest strike in our range
- -1 put at the next lowest strike
- -1 call at the next highest strike
- +1 call at the highest strike in our range
Each leg of the trade is for the same underlying security or index,
with the same expiration month. There should always be an even number
of contracts traded, in multiples of four, so that the trade is always
weighted equally with no downside or upside bias. That just means that
for one Iron Condor, we’ll buy/sell 4 contracts, as shown above; to put
on 2 Iron Condors, we’ll buy/sell 8 contracts, etc.
Until next time-