How to Use an Iron Condor to Profit
What if you want to take a position in a stock, but instead of profiting if the stock price moves higher or lower, you want to earn a return if the stock stays in a specific range. This can be done by using an options strategy called an iron condor. The iron condor combines two separate options strategies to form one powerful trading technique.
An iron condor combines two vertical spreads. A vertical spread is an options spread strategy whereby you purchase options and simultaneously sell an equal number of options with the same underlying security and expiration date, but at different strike prices.
A credit vertical spread is an options position where the investor sells the option with a strike price that is closer to the underlying price of the stock and buys the options with a strike price that is further away from the price of the stock. This transaction will produce a net credit.
The iron condor combines a bear call credit spread and bull put credit spread on the same stock or index with the same expiration for all options. This is a neutral strategy, as you are neither bullish nor bearish on the price of the stock. For example, if a stock price stays in the range demarked by the red arrows through the expiration date of the options, you will keep your premium. If the price of the underlying stock moves above the short call or below the short put, you could lose money.
The maximum risk is equal to the differences in strike prices on one side of the spread minus the net credit. For example, if the difference between the call strikes is $3 and the put strikes is $3 (for a total of $6) and you received $1 as a net premium, then the most you could lose on the trade is $2 = $3 – $1.
Most investors who are entering into new debit or credit spreads will avoid stocks that have an upcoming earnings event. This mitigates the chances of any surprises that can cause losses for the leveraged positions.
Most investors trade iron condor strategies on the indexes, as there is lower chance of a sudden change in price. The stocks that generate the largest returns for an iron condor options strategy are stocks that have high levels of volatility. Stocks that have high levels of volatility often garner robust options premiums, which increase the performance of the strategy.
One of the best ways to find a stock or ETF that is a good candidate for an iron condor is to look for stocks that have defined ranges.
The Direxion Daily Gold Miners Bull 3X Shares (NYSE: NUGT) is trading in the middle of a $40 to $60 range so setting strike prices at $40 and $60 seems like a sensible range to establish an iron condor. You can:
Sell Direxion Daily Gold Miners Bull September 20, 2014, $40 puts at $1.27.
Buy Direxion Daily Gold Miners Bull September 20, 2014, $35 puts at $0.52.
Net Credit from Puts = $0.75
Sell Direxion Daily Gold Miners Bull September 20, 2014, $60 calls at $1.85.
Buy Direxion Daily Gold Miners Bull September 20, 2014, $65 calls at $1.20.
Net Credit from Calls = $0.65
Total Net Credit = $1.40
Max Loss (difference in strike prices) $5 – $1.40 (net premium) = $3.60.
Return = 28% = $1.40 / $5
Break Even levels on calls = $61.40
Break Even level on puts = $38.60