The IRON CONDOR

[TradingAdmin]

Had a question recently about the IRON CONDOR as a method to reduce the risk in a trade..- thus here goes...

What is an Iron Condor?
It is an options strategy, ideally suited for a level market - please note - level, flat, market going nowhere - NOT for a trending market.  You basically setup two legs for the trade, one each above and below the market.  You then cover the potential loss on the downside of those two legs with additional options to limit the risk.  The strategy really limits the risk in a trade, allowing you a save trade - PROVIDED the market stays flat!!

Let us setup such a strategy and you can see for yourself..

Below is a chart for Gold as of yesterday - Wednesday the 11th of May 2016:



What we are going to do is sell a CALL option above the market, then sell a PUT option below the market.  For both of these options we collect the premiums into our account.  Now Gold can not move up AND down simultaneously - thus one of these two options will always be profitable.  Gold may threaten the one side of this trade, the one leg, but never both legs.  Thus MARGIN-wise, the Exchange will take a favourable view on our position and only charge as the margin for one of the two legs. 

BUT:- this still leaves the market open to drop below (or above) one of our legs and we risk losing money on that side.  Thus enter the second part of the trade.  We now "cover" the potential loss above our CALL and below our PUT with additional options. Thus we move one strike above our CALL and we buy that option. We also move one strike below our put and purchase that option.  It should be clear that since the option we buy (above our original CALL) is further out of the money (same for the put), this option will be cheaper than the first option.  Thus we use some of the money that we collected for our initial two options, to buy the next two (safe-guarding) options.  And that is it - we have an IRON CONDOR:



What do we have:

• We SOLD a 1260 Put option and a 1265 Call option, collected the premiums for them,
• We then used some of that premium and bought a 1255 Put and a 1270 Call, both further out of the money, thus cheaper

Net situation, we collected around $470 in premium.

Risk wise, we can never loose more than $30 on this trade!!  Why?  Well. if the market suddenly starts trending, let's say down, below our Put of 1260, the 1260 Put may get into trouble, but at 1255 our safety option kicks in and protects our position.  Thus when we get exercised, we will have to buy Gold at 1260, but we then sell it at 1255, for a net loss of $500.  But since we collected $470 on the position our loss is limited to ($500 - $470) = $30.  And exactly the same applies on the up-side!

Should Gold stay between our two "legs", then we will keep the $470 as a profit!!

Here is the risk graph for this position:



As long as Gold (green line) stays between our two yellow lines, we profit.  We only loose if Gold goes beyond (outside) of our two yellow lines - and as you can see, provided we have the market correct as a level-trading market, the chances are good that we will profit from this trade. 

The position above is for ONE contract only.  Margin wise the Exchange will charge as next to nothing, as we are not taking any risk.  Thus a trader willing to risk $300, can setup ten contracts like these, for a maximum risk of $300 and a profit potential of $4,500!

[TradingAdmin]

OK, so this is the Iron Condor.  From the look of it a nice, safe trade.. - you have really managed to limit the risk in this trade. 

The problem that I have with this trade, is the RATE at which you make money.  Let me take this trade, keep the price of Gold level and move into this trade by four weeks - 28 days!!



Here you go - 28 days into this trade - look at the left hand graph, the pink line.  You are sitting on a profit of $14.  That is correct, only $14.00 for all your trouble!!  In 28 days!

Thus, although you have managed to limit your risk - you have also managed to limit your money making potential - 28 days into the trade and the maximum money you have been able to make is $14 !?  Is this worth it?  To me, it is not worth the time.

Let me move 45 days into this trade:



This is the situation 45 days into the trade, close of business on the Friday.  The options expires on the next Monday. Even here you are sitting on a MAXIMUM profit of $70 on this trade.  On Monday the options will expire, and the profit line will become the red line on this graph!

For 48 days you have to hold this position.  For 48 days you have to hope that the price of Gold will stay level, between your two price levels.  You have to wait out the full period of time - all 48 days, before you can realise your profit.  A LOT can happen to Gold in 48 days, ANY movement away from our price levels in that period of time...  You will have to sell your position.  Okay, you will not be taking a loss, but is it really worth it tying your money up in this position for 48 days and after 30 days (or whenever Gold moves) having to get out with nothing !?

To me ..- the iron condor is a nice strategy - but it is sort of a theoretical strategy.  It shows that yes, you can really manage the risk in a trade - but for $14.00 in 28 days!?  If I want to make $14 in 28 days, I may just enter one contract on Gold, wait till it moves three pips = $30 and get out.  Just once in 28 days and I have made more than double what I could make with the iron condor!

[TradingAdmin]

Why did the Iron Condor FAIL?

Because you took all your profit that you gained from selling the Call and selling the Put and you used that to purchase two more options, to try to reduce your risk.  In the process you destroyed the trade - yes, you did manage to reduce the risk, but also your money making potential.

Allow me to handle this trade slightly differently:

• I am going to move far away from the current price action (which is around $1267).  For the CALL option I am going to move far away, to the $1,300 price level - in other words above the price action that formed this trading range.  For the PUT I am going to move an equal distance away, down to $1,230
• I am not going to purchase the additional two "safeguarding" options, in other words I am prepared to take more risk
• This strategy is no longer called an Iron Condor - we call it a SHORT STRANGLE - it is basically the two legs of the iron condor, but without the two additional options that ate our profit
• Thus I SHORT a 1300 CALL and I  SHORT a 1230 PUT.  For these two options together I collect a total of $3,300 in premium (credited to our account)

Red line will be my profit 48 days from today.  Blue line is my profit today - the day that I enter the trade.  YES, my "potential loss" is unlimited..- but let's be fair here - take another look at the Gold chart of earlier and tell me by how much does the price change on a daily basis?

Here's your risk chart:



Profit BETWEEN our two yellow lines!  The feint yellow lines are at $300 loss.  Look at the wide range in which we are trapping Gold.  If this level market continues it will well and truly move into that bowl formed by our break even lines (the strangle hold of our strategy - from there the term - short strangle)!

And the risk - well it is there yes, but we are not blind!  We can every single day follow what Gold does, plot it on our graph and make the decision to stay in or get out - there is enough time for us to act and manage our trade!

What happens to out money-making potential?  Let's again, like before, keep the price of Gold at the current level.  I am going to move forward fourteen days (two weeks) in time:



There you have it - the pink line shows us that Gold finding itself anywhere between 1220 and 1300, two weeks from today, and we will be into a profit.  Max profit at this point in time is already $864!  Now we are making money..!

What did we do differently?  We were willing to take more risk - and with the risk comes reward!

[TradingAdmin]

And the risk - well it is there yes, but we are not blind!  We can every single day follow what Gold does, plot it on our graph and make the decision to stay in or get out - there is enough time for us to act and manage our trade!

What did I mean by this statement..?  Here is Gold 6 days into the trade, at the close yesterday:



We currently sit on about $260 of profit.  Reading off the left hand graph, where the vertical indicator line crosses our pink line (current profit/loss line - I have circled for you in red).  On the right we can see that Gold has moved into our funnel, which gets wider over time.  On the upper side, should Gold cross above $1290, we will be at breakeven - this is confirmed on the left where the pink line crosses zero.  A drop in Gold price will be very favourable for us, bringing us into the centre of the funnel (highest profit area).

However, the point to notice here is this:  There is enough time for you to monitor the position carefully, every day, and decide what you want to do.  Do you take profit and run, or do you stay in another day and wait.  Thus although the "risk" with this trade is much higher (well "unlimited") than the risk with the iron condor trade, that "unlimited risk" statement is a bit over-rated.  We have to take into account the speed (average daily move size) at which Gold changes in price.  And that is small, relative; thus there is a lot of time in the trade to decide on whether it is worth taking the risk or not

[TradingAdmin]

And here is Gold 13 days into our trade, as it stands today, 23 May 2016:



Image courtesy of barchart...

Let's look at how the trade is doing:



Gold has moved nicely down into our funnel.  Profit at the moment sitting at $758 on the trade - do you stay in or do you take profit?  That is up to you.  You can see where Gold has to move to before you will loose.  You can also see that there are lots of potential over the coming days for a lot more profit.

However the big thing to note is that you have TIME.  You are not pressurised to take a decision as to whether you close the position, get out, or take profit and run..!  Things happens slowly..  It took 13 days to get here.  Only on the first day of those 13 were you at a loss; since then you've been into profit which is slowly accumulating.  You can easily wait another day and see what happens.. Or if you are happy with $758 = R11,750 profit in your account in 2 weeks (out of an investment of $9,000 in margin = R140,000 ... - thus a return on your investment of 8.4% in 13 days, or 236.5% annualised) then get out!

Iron Condor???
You cannot do this with an Iron Condor because with the Iron Condor you kill your profit making capability in favour of killing the risk in the trade.  You can only do this if you are willing to take the risk in the strangle - but as clearly shown here with a live trade, you are able to carefully manage that risk!