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Know Your Options

Whether you trade options regularly or not, you've probably heard of the strategy called an 'Iron Condor'.

Although, I'll bet the majority aren't quite sure what it is. It almost seems like it's the Big Foot of options strategies; something talked about but never seen.

But I can assure you it's real. And that's what we're going to be talking about today.

Definition

The iron condor is classified as a neutral strategy.

For instance, a bullish strategy, of course, means you're expecting the market to go up. A bearish strategy has you expecting the market to go down. But with this strategy, instead of picking a direction, you're defining a range. In other words, the price can go up by a certain amount, or down by a certain amount, or trade sideways. And any one of those three scenarios would result in the same exact maximum profitability.

This is considered a low risk, high probability trade.

The iron condor is usually put on as a credit, meaning you'll be a net collector of premium. And there are four parts to this trade.

Set up

The best way to explain it is to go over an actual trade I just put on. The one I'm going to illustrate was done on Interoil Corp. (IOC) yesterday.

Given the recent pullback and the sudden uncertainty in the market, these neutral, non-directional strategies are perfect for this kind of environment.

So here's what I did on June 26th when IOC was trading at $70:

  • Bought to open 1 August 2013 85.00 call at 2.47 (or $247 debit)
  • Sold to open 1 August 2013 80.00 call at 3.46 (or $346 credit)

And...

  • Sold to open 1 August 2013 60.00 put at 3.12 (or $312 credit)
  • Bought to open 1 August 2013 55.00 put at 1.91 (or $191 debit)

Essentially, an Iron Condor is comprised of two credit spreads (one on the call side and one on the put side). We received a net credit of $99 on the call side, and we received a net credit of $121 on the put side, for a combined net credit of $220.

So the maximum profit on this kind of trade will always be your credit. And in this example, it's $220. And we'll see that as long as Interoil, at expiration, stays between $80 on the upside and $60 on the downside. With IOC trading at $70 when we put this on, that gave us a $10 cushion both above and below the market. So that means IOC can go up approximately 14%, it can go sideways, or it can go down 14%, and we'd still make the same maximum profit.

Pretty cool.

The maximum loss would be $280. That would be seen if IOC closes above $85 or below $55.

Show Me

For a winning example, let's say, at expiration, IOC closes up at $80. That means:

  • The 85 call that I paid $247 for would expire at $0 for a loss of -$247
  • The 80 call that I collected $346 for would also expire at $0, meaning I kept the entire $346

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  • So that's a net gain of $99

On the put side:

  • The 60 put that I collected $312 for would expire at $0, meaning I kept the entire $312
  • The 55 put that I paid $191 for would also expire at $0, for a loss of -$191

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  • So that's a net gain of $121

  • Add both sides up, and that's a $220 gain.

Whether it closed at the high end of that range, the low end of the range, or in the middle of the range, as long as it was within that range (between $60 and $80), the outcome would be the same.

But once you closed beyond the farther out strikes that you bought, then you've generated your maximum loss, which is the difference between the largest spread you have on and your maximum credit.

For this trade, the largest spread we have on either side is a $5 spread. (80 to 85 and 60 to 55). One $5 spread is equivalent to a $500 risk.

For a losing example, let's say at expiration, IOC closed lower at $54; just outside of the out range. That means:

  • The 85 call that I paid $247 for would expire at $0 for a loss of -$247
  • The 80 call that I collected $346 for would also expire at $0, meaning I kept the entire $346

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  • So that's a net gain of $99

On the put side:

  • The 60 put that I collected $312 for is now in-the-money, and would be worth 6.00, meaning I lost -$288.
  • The 55 put that I paid $191 for is also in-the-money, but is only worth 1.00, which means I lost -$91.

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  • So that's a net loss on this side of -$379

  • Total loss = -$280 ($99 gain less -$379 loss = -$280 net).

IOC could go to zero, or infinity, and the loss would still be the same.

So with this trade, you can place non-directional bets on a stock, and make money as long as it stays within your determined range.

To increase your probability of success, you want to establish a wide enough range. And since your profit is limited to the credit you collect, you want to put this on for as large of a credit as possible.

Here's a chart showing the range I want IOC to stay within by August 16th, which is the last trading day for August options. This is what it looked like yesterday (June 26th), when I put it on.



Take note, in this example, the gain is $220 while the loss is $280. That's just under a 1 for 1 reward to risk ratio.

Typically, when placing a directional trade, I'd like my potential reward to be 3 to 1 or better. But there's only one way to win on those kinds of trades.

In this instance, since there are 3 ways to profit (up, down, or sideways), the lower reward to risk ratio is made up for the higher probability of winning.

You can learn more about different types of option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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