I am starting this series to discuss about the Iron condors (IC). This is a strategy that is used by almost every professional option trader. In this part-1, I shall focus on discussing what is an Iron condor, how is it created and why I consider Iron condor for my portfolio. I would like to start with the fundamentals so as to make sure the new readers would be able to follow along. Before we delve into details, let me restate key terms:
- ATM stands for At the Money. This means the strike price of an option is the same as the price of the underlying stock/index. i.e. a 475 GOOG call would be ATM when the value of the GOOG is 475.
- CTM- Close to the money. This means the strike price of an option is closer to ATM and it is not very far from ATM.
- ITM – In the money. For a call this means the strike price is below the value of the underlying, and for a put the strike is above the value of the underlying. i.e. A 810 RUT call would be ITM when the RUT is at 811 or more.
- OTM – Out of the Money. For a call the strike price is above the value of the underlying, and for a put the strike is below the value of the underlying. i.e. a 850 RUT call would be OTM when the RUT is 850 or lower.
- FOTM- same as OTM but with very far from ATM. Generally speaking 1 std dev or more away from the ATM.
Credit spreads are the foundation for Iron condor. For more about credit spread, please click here.
What is an Iron Condor: An Iron condor is made up of two credit spreads i.e. one Bull Put Spread and one Bear Call spread for the same expiry month. Since it is made of credit spreads, we are obtaining credit to open an Iron condor. For an example on Iron Condor (assume RUT is currently at $800):
- A Bear call spread will be any call OTM spread i.e. short 850, long 860 calls Mar expiration
- A Bull Put spread will be any PUT OTM spread i.e. Short 760 and long 750 Put March expiration
- This will create an Iron Condor that is 750/760/850/860
This is how above IC will graphically look like…Click here
Why an Iron Condor: Iron condor makes money primarily via time decay. Because you are a premium seller, time erosion works in your favor and therefore sideways markets are the best friend of IC traders. An IC makes the most money when the underlying remains in between the short strikes (760 and 850 in the above example). Your risk as well reward is known in advance and your Risk/Reward expectation will determine your winning probability. Keep in mind though, this is high probability trade and therefore the risk/reward ratio is not attractive. At the same time its statistical superiority is what makes it loved by almost every professional option trader and many treat this as their bread-n-butter strategy.
End of Part-1