By Geoffry Wong

Although option traders are often attracted to strategies that offer limited risk and a relatively high probability of success, these approaches are often more difficult to apply than they appear on paper.

The iron condor is a four-option strategy with limited risk that is designed to profit when the underlying market remains in a relatively low-volatility condition during the life of the trade. It is a “credit spread” — that is, the trader collects premium upon establishing an iron condor, and this net credit is the position’s maximum profit.

The components of an iron condor are:

1. Short one out-of-the-money (OTM) put;

2. Long one OTM put with a lower strike price;

3. Short one OTM call;

4. Long one OTM call with a higher strike price.

The trade’s maximum profit occurs when the underlying’s price is between the strike prices of the short put and short call.

Notice options 1 and 2 comprise a bull put spread, while options 3 and 4 represent a bear call spread (see “Option terms” for definitions of these positions). The long call and long put options essentially protect the position against large up or down moves in the underlying instrument.

Although the iron condor seems to represent a fairly straightforward concept  — collect premium and keep it as long as the underlying market does not break the short strikes in either direction and implied volatility remains low — it is easier to profit from these positions in theory than in practice.

The reason goes back to thinking of the iron condor as the combination of a bear call spread and a bull put spread. In short, traders typically collect too little premium on either the bear call spread or the bull put spread portion of the position when entering all legs of the trade simultaneously (and they give away the bid-ask spread, too). This is a result of the differences between call and put options that are equidistant from the underlying price in a given situation.

Let’s look at the mechanics of properly executing an iron condor.

Before the trade

There are a few basic steps for entering any options trade. The first is identifying an appropriate underlying stock or commodity. This is more challenging than it might first seem. Basically, you should be intimately familiar with the underlying market you are interested in trading. It is not in your best interest to apply a strategy unless you have a complete understanding of the underlying stock or futures contract’s historical highs and lows, annual and quarterly reporting dates, average daily true range (volatility), and volume, as well as the open interest (the number of open positions) in the specific option contracts you might trade. All these factors play an important role in price movement.

Selecting an underlying instrument with the appropriate characteristics is an important step in capturing the most premium (credit) possible. Stocks such as Apple (AAPL) will have more premium value simply because their interday volatility is greater than that of many other stocks. For example, if you sold a bear call spread on AAPL a few strikes OTM (i.e. selling an OTM call and buying a higher-strike OTM call with the same expiration date), you would expect to receive more money than if you sold a call spread on, say, Microsoft, which has much lower volatility. Larger underlying price moves translate into higher option premiums.

Another factor that effects the premium value is market perception, or “bias.” Using Apple stock again, the market prices the OTM calls higher, which results in higher premiums and call-spread values. For example, the market bias a few months ago was that it was willing to pay more for OTM calls than OTM puts. As a result, calls were more expensive than puts that were equidistant from the current stock price.

At times, option deltas may explain this anomaly or relationship.

From March 2011 issue of Active Trader Magazine

www.activetradermag.com/index.php/c/Trading_Strategies/d/Execution_and_management_of_iron_condors