With the market providing a lot of volatile action and implied volatility elevated, it might be a good time to talk about iron condors again. In Group Coaching, we have modeled out several iron condors recently. An iron condor is a market-neutral strategy that combines two credit spreads. A call credit spread is implemented above the current stock price, and a put credit spread is implemented below. The objective of any credit spread is to profit from the short options' time decay while protecting the position with further out-of-the-money long options.

The iron condor is simply combining both the call and put credit spreads as one trade. The trade is based on the possibility of the stock trading between both credit spreads by expiration. Let’s use XYZ stock as an example. If you have noticed that the stock has been trading between a range of $75 and $80 over a period of time, an iron condor might be an option with an expiration of a week or two.

A call credit spread with the short strike call at 80 or higher would profit if the stock stayed below $80 at expiration. A short strike put at 75 or lower would profit if the stock stayed at $75 or higher at expiration. Both short options would need to be protected by further out-of-the-money long options. Both spreads would expire worthless and both premiums are the trader’s to keep if ABC closes at or between the short strikes. The total risk on the trade is also reduced because of both premiums received.

Max profit is both credits from each credit spread. Max risk is the difference in one set of strike prices minus both premiums received. Maximum loss would occur if the stock is at or below $75 or at or above $80 at expiration. No matter what happens, one of the credit spreads will always expire worthless. This, of course, does not guarantee a profit.

We recently looked at Alibaba Group Holdings Ltd. (BABA). Taking a look at the chart below, you can clearly see the stock had been trading in a range from about $182.50 to $190.

A call credit spread was implemented by selling a 190 call and buying a 192.50 call with about a week left until expiration. At the same time, a 182.50 put was sold and a 180 put was bought to complete the put credit spread side of the iron condor. A $0.95 credit was received, which meant the total risk was $1.55 (2.50 – 0.95).

Iron condors are a great way to take advantage of time decay when it looks like the stock will be traveling in a range for a certain amount of time. The key is to have your management plan in place before entering the iron condor.

John Kmiecik, Market Taker Mentoring