The title of “worst” may be a bit harsh, but it is well deserved.
A lot of option traders see the iron condor as the holy grail of option strategies.
I mean, who could blame them?
How many option strategies offer twice the return for low margin, give you limited risk, and allow you to profit over a broad range of prices?
Few strategies fit that bill.
Spiderman said it best, “With great power comes great responsibility.”
It is true that the iron condor wields a lot of power, but it is the lack of responsibility in the options trader that makes it such a dangerous weapon.
Too many options traders get into an iron condor thinking it is the key to riches, but too often they get into the position at the wrong time, manage it poorly, and then take on significant losses.
This must come to an end. We must return the iron condor to its place at the top.
How To Properly Enter An Iron Condor
We can look at “how to enter” in several different ways. First, we can talk about timing, both from a volatility and price perspective. Then we can look at entering from an order type standpoint. Both will be keys to success, but timing is the most important.
Most options traders enter iron condors because they think the stock price will remain in a range, or, even worse, that the stock has run up, is overbought, and needs to come down.
This is the worst possible thing you can do.
What you will soon learn, if you haven’t already, is that a stock can stay up longer than you can stay sane.
You don’t want to base your decision to enter an iron condor solely on the stock’s price. Instead, you want to focus mainly on implied volatility.
An iron condor’s structure is made up of two near money options that are short, and two deeper out-of-the-money options that are long.
We don’t care about the long options. They are there to limit our risk in the position. In the end, we hope that they expire worthless.
The short options are the key. All options are going to be affected by the changes in implied volatility. As implied volatility rises, our option prices will increase; as volatility drops, so does the option price.
You want volatility to drop when you have an iron condor on. This is vital to your success.
This means you don’t want to open a new iron condor when volatility is at a low. Follow me down this rabbit hole.
Low volatility means your option prices will be smaller. With low option prices, you are going to have to bring your options closer to being at-the-money to generate any real return.
When you do that, the range your stock must remain in becomes very small. Once your position is that close to being at-the-money, it only takes a small move in the underlying to put your position at a loss.
This is the number one killer of iron condors, and portfolios, for that matter.
Most traders will place an iron condor without giving a second thought to volatility. This is especially true when you place an iron condor after the stock has run up to new highs. A stock that is running higher also has dropping or extremely low volatility.
Low volatility is not suitable for you, and neither is rising volatility. As we stated above, rising volatility increases option prices. If you already have a position on, your short option prices will go up, and it will result in a loss.
Ideally, you want high volatility that is falling. This is going to give you the best of both worlds. The high volatility will generate high option prices and allow you to get a position that is deep out-of-the-money. This will give you a wide range for your stock to finish in and increase your probability of success.
High volatility isn’t always enough. High volatility can continue to rise, or worse, it can bring on a lot of movement in the underlying. Volatility that is falling is a good sign that the stock is not moving. This is the perfect scenario for your iron condor.
When you have finally found falling volatility, it is time to place your trade. There are several ways you can do this.
First, you can place the iron condor as one big position, that is, all four legs at once. The pros of this method are that it is easy and can be cheaper on commissions. If you are placing one big trade, you set one price and execute the trade. From there, you sit back and wait to see if your order gets filled.
The other way to place an iron condor involves trading two spreads. Iron condors are made up of either a long strangle and short strangle or a bull put spread and bear call spread.
You don’t want to trade the iron condor as a long straddle and short straddle. Even though they make up an iron condor, straddles offer a very different trade than you originally intended. An iron condor is placed so you can make money if the stock doesn’t move.
A long straddle, on the other hand, needs a lot of movement in the underlying to be profitable. A short straddle requires only a little movement like the iron condor, but it remains unhedged and therefore it has unlimited risk.
It is best to trade iron condors as a bull put spread and bear call spread. If you were to place a bull put spread, but no the bear call spread, you still need the stock to remain above your strike prices. Your position is hedged and even though not an iron condor, it still has the same properties.
The Truth About The Calls
Most the time you are going to lose money on the call side of your iron condor. This happens for several reasons.
First, the call spread will be closer to at-the-money than your put spread. This deals with volatility skew and the natural behavior of humans and their desire to protect their portfolios. Majority of investors carry long portfolios (they are long stock versus
Majority of investors carry long portfolios (they are long stock versus short stock), and they need a way to protect these portfolios from a market or stock crash. People will defend their portfolio with the purchase of put options. Put options gain value when the stock declines, so naturally, this makes sense. The purchase of options or stock will drive the price higher. This is the basis for skew and why you can trade put options further out-of-the-money versus call options.
This is the basis for skew and why you can trade put options further out-of-the-money versus call options.
Because the call spread will be closer to at-the-money you will have a negative delta when you open an iron condor. A negative delta means your position will lose money when the stock rises. Even though the stock price may still be within your range of prices or strikes, you will have unrealized losses on your hands. These losses will continue to add up as the stock, continues to rise.
This is terrible news for you because now the loses are climbing, and the stock price is getting closer to your strikes, which puts the whole position in jeopardy.
Second, and we alluded to this before, most traders place iron condors when a stock has risen for an extended period. They think, foolishly, that the stock has gone up too far too quickly and it needs to come down. If only that were true.
What usually happens is that a stock will continue on its current trend, giving no thought to how fast it has risen, or about your iron condor.
What can you do?
Don’t be afraid to place an iron condor when the stock has dropped. This will give volatility a gentle little push and allow you to trade call spreads further out-of-the-money.
Leg into your position. Remember, if you don’t want to enter a full position at once, trade the put spreads and then wait for a chance to trade the call spreads. If you never get that opportunity, you can still make money on the put side.
Trading Earnings With Iron Condors
It’s okay, they said.
The position is protected, they said.
Most traders prefer to trade earnings with iron condors. Volatility is exceptionally high during these times so you can get a position that is deep out-of-the-money, and once an earnings report has been released volatility will drop like a rock, and you can laugh all the way to the bank.
Simple? Yes. Effective? No.
If this strategy were as easy as everyone seems to think, it would be traded exclusively. The problem with trading earnings is that it is a binary event. Binary events are either a yes or no, right or wrong, bank or broke.
When you trade iron condors during normal market situations, you are given plenty of time to reevaluate and adjust your position. Earnings trades don’t offer that luxury. When you wake up the next morning, you will either be a winner or a loser.
The secret to iron condors is that they allow you to sacrifice return versus risk for a higher probability trade. You will not have a good risk-reward scenario, but you will win more than you lose.
Earnings trades are going to lower that probability of success even more. You will still win more than you lose, but take the trade enough times and your loss will take away all your wins.
When you do place an earnings trade, and we know you will, trade them lightly and sparsely. Portfolios are not made during earnings; they are lost.
We love trading iron condors, but we don’t love the people trading them. The strategy is useful for gaining more premium at less margin, which is a win-win.
The problem is too many traders place iron condors at the drop of a hat. An iron condor needs to be timed and nurtured to flourish. Placing iron condors when the stock has just made a big run or when volatility is at a low is a great way to set yourself up for failure.
When you can time your trade so that implied volatility is falling instead of rising, you are going to increase your odds of success.