Ever wondered how to make money in any market condition? How about how to profit on a stock that doesn't move? How about how to trade an iron condor?
A stocks movement can be classified into three distinct cycles. The first cycle, and everyone's favorite, accumulation. Accumulation is when the stock is being picked up by buyers, who outweigh the sellers. This creates an uptrend in the stock which is pretty easy to trade. You can buy the stock, buy a call, short a put, etc. to profit from an upswing.
The next cycle is distribution. Distribution is when the sellers finally get the upper hand on the buyers. This will drive the stock lower, and it is also easy to trade. You can short the stock, buy a put, sell a call, etc. to take advantage of the downward momentum.
The last cycle, in no particular order, is consolidation. Consolidation is when buyers and sellers reach the equilibrium price, and the stock begins to move sideways. What makes this a problematic cycle is that the sideways movement will happen over a range. Range bound movement benefits the brokerages not traders. They will eat up the commissions of buyers and sellers moving in and out of the stock trying to churn a profit. All stocks go through these cycles so being able to take advantage and profit from each period is a necessity.
How Do You Make Money On A Range Bound Stock?
One of our favorite ways to profit from a range bound stock is with the use of Iron Condors. Iron Condors are an intermediate option strategy since they are multileg, four legs to be exact, require adjusting, and constant monitoring. However, they are great strategies if you can find a stock that doesn't move or is stuck in a range.
What Is An Iron Condor
An Iron Condor involves buying a put, selling a put, buying a call, and selling a call. This may sound difficult, but it gets more comfortable with a little practice and explaining. Iron Condors generate a credit instead of a debit, so it is going to pay you money up front instead of you having to shell it out. This credit creates a "pad of safety," and if the stock price is on that pad by expiration, you receive the full credit. Since we are receiving a credit time decay is on our side.
How And When To Open An Iron Condor
Strike selection and timing are your two main concerns when opening an Iron Condor. Luckily strike selection is going to be easy since the stock will give it to you. Remember, we are using an Iron Condor because the stock is trading within a range. We are going to want to setup our strikes on the outside of that range. This will make sure our pad of safety is where the stock has been trading, and it will give us a higher probability of success (which we love).
Timing an Iron Condor is going to be a bit more difficult because we are going to introduce a more advanced concept, volatility. First, lets talk about days to expiration. When opening this trade we want to start 50-60 days out. It will not be our intent to hold it that long but it will give us a good starting point. When traders first come into Iron Condors they immediately think of shorter time frames. Most traders are taught that time decay speeds up the closer you get to expiration. If time decay is on our side why not trade on the Weekly Options? Gamma is our answer. Gamma is the measure of how quickly things are going to move. The closer we are to expiration the higher our gamma will be, and we don't want our Iron Condor turning against us at the drop of a hat.
We will be using deep out-of-the-money options when constructing our play. Deep out-of-the-money options carry with them an insurance property that other options don't receive. What this means is that after a while these options will cease or slow down losing their value. Have you ever noticed that when trading a short put the option price will remain almost consistent even though you are getting closer to expiration? This is because large traders will purchase these options and use them as cheap insurance causing them to hold their value.
Deep out-of-the-money options will typically lose the highest percentage of their value between 30 and 50 days. This is why we center our trades to start around 50-60 days. We want to be in the play and ready for its rapid loss in value.
Setting up an Iron Condor with the right type of volatility can make the difference between a great trade and a not so great trade. There are two types of volatility measures: implied volatility (how people think the stock will move in the future) and realized volatility (how the stock has moved in the past). Our whole goal here is to find a stock that is stuck in a range, so little movement is ideal. This will lead us to stay away from stocks with high implied volatility. High implied volatility means that people are predicting the stock is going to move around. It also says that the stock has a high realized volatility. Now, the tricky and more advanced part, the terms low and high when referring to volatility is all relative. High for one stock may be low for another and vice versa. When looking at a volatility chart, it is best to look through the history of the stock and get a feel for what is high, low and average.
For now, lets stay away from stocks with high volatility. Stocks with low volatility can make great trade candidates. These are stocks that are not interested in moving around. Typically these are going to be bigger companies, exchange-traded funds, or indexes. Ideally, you will want to find a stock that has high volatility but it is starting to move back to low volatility. High volatility means the options will be more expensive and thus a bigger credit and return for us. When it moves to low volatility it is going to suck the premium from these options giving us a bigger return quicker. As you can see this is an ideal scenario but harder to find. If you do find an stock where volatility is turning over, wait for it to turn over. Do not try to front run the trade and predict when volatility will begin to fall. The worse thing you can do is enter an Iron Condor and have volatility continue to climb higher. This will increase the cost of all your options and put you underwater from the start.
How To Adjust An Open Position
Adjusting options is always a complicated process because there are a lot of different adjustments that can be made. We will go through setting up a plan and several adjustment options that we can run for a failing Iron Condor. We first need to know when we are going to adjust a position. One of the rules we follow is the "one-third rule". For an Iron Condor we want to set a max loss that is half of the overall credit. We are not interested in losing more than that. Our first adjustment will happen when we are down one-third of the max loss. The next adjustment will occur when we are down two-thirds of the max loss. When we are down the entire max loss of the position simply close the position, take the loss, and live to trade another day.
There are two types of adjustments that need to be made, upside and downside. Both of these adjustments will be made with the goal of cutting our overall position deltas in half.
If we are feeling pressure on the upside, we want to buy a call that is under the call spread. Buy enough calls that will cut the delta of the Iron Condor in half. If you have reached the second adjustment on the upside, buy more calls to reduce the delta in half again.
On the bottom half, when we are feeling pressure to the downside, we want to buy put spreads. We will want to set these up with the long strike of the put spread inside our spread. Again, buy enough of these to cut our deltas in half and in the second adjustment buy more to do it again.
These adjustments are going to reinforce our Iron Condor on the side that is feeling the most pressure. This will help slow the losses because we are dropping the deltas on that side.
How We Adjusted This Iron Condor Position
The best way to demonstrate an adjustment is through an example. Here is our trade, an Iron Condor on the Russell 2000 (sym: RUT). On the call side, we were short the 1300 strike and long the 1310 strike. On the put side, we were short the 1230 strike and long the 1220 strike. We placed 6 of these condors for an individual credit of $3.48 or a total credit of $2088. Unfortunately, the Russell 2000 moved against us and started to drop near our put side strikes. As our deltas began to climb, we needed to adjust to the downside to protect our condor.
We had a couple of different adjustments that we could have taken, but the one we chose was to open a vertical put spread around our lower strikes. We went long the 1235 strike and short the 1220 strike which gave us a nice bump up on the lower side and cut our deltas in half. We only opened two of these because it was enough to reduce the deltas and it cost us $6.45 or a total debit of $1290. As you can see this gave our downside a bump cutting our potential losses in half and also raising the profit potential if the Russell 2000 was to stay on the lower side.
One other adjustment we could have made was taking a vertical spread and going long the 1235 strike and short the 1225 strike. The strikes on this spread were closer we would have had to take 3 contracts instead of 2 to cut our deltas in half. We could have done this for $4.75 or a total debit of $1425. The reason we did not go with this adjustment is that it achieves the same goal (cut our deltas) but does it at a higher cost ($1425 vs. $1290).
When Is It Time To Close Your Position Out
As we mentioned before we are not interested in holding these babies until expiration. It would be difficult to find a stock to sit in one range for two months. Focus on taking the position off when there are thirty days left until expiration. Remember, we are going to hold this position when it loses most of its value through time, so there is no point in keeping it after that to get a few more percentage points. Of course, it doesn't always work so cleanly, so we also like to shoot for half of the overall credit. If the whole trade would give us a 10% return, we are happy taking a 5% return and calling it a day. Don't get greedy trying to trade an Iron Condor. The last thing you want is to hit a profit target and then watch as the stock moves outside of the range.
|Iron Condor Greek Cheat Sheet|
This may look like a neutral trade, but you will short delta due to volatility skew. Short delta indicates an inverse relationship to the stock movement. If the stock prices move lower, you will profit and vice-versa. You don't want a lot of movement in the stock, so it is short gamma. Remember we talked about wanting volatility to come in to make a more substantial return? Well, that is because you are short vega. You are, however, long theta so the passing of time will cause the position to profit.
Iron Condors make ideal setups when you find a range bound stock with falling or low volatility. They are not a set it and forget it trade, however, as they must constantly be monitored and possibly adjusted. Before entering the trade figure out your profit target (half the overall credit), max loss (half the overall credit), and adjustment points (remember the one-third rule).
What option strategies do you use to profit from a range bound stock? Let us know in the comments...