By: staff of Investopedia.com

Most traders are familiar with winged option strategies. Here, the staff of Investopedia.com detail a variation on the iron condor that can put the odds more firmly in a trader’s favor.

There are many reasons to consider trading options. One use is to obtain leverage when making a directional play. Another is to hedge an existing position. One other use is to take advantage of opportunities that are simply not available to those who only trade the underlying stock, index, or futures security. This last possibility typically involves the use of option spreads whereby one option or set of options is sold while another option or set of options is bought. One approach to above-average probability spread trading that is relatively new to the mainstream is known as the modidor, which is a modified version of a popular strategy typically know as the iron condor.

The Starting Point: The Iron Condor

As a quick review, an iron condor involves selling an out-of-the-money call and an out-of-the-money put option while simultaneously buying a further out-of-the-money call and put. In a classic iron condor, the options sold are a roughly equal distance from the underlying price. Likewise, the difference in the strike prices between the two call options is the same as the difference between the strike prices for the two put options. Ideally, an iron condor will be entered when the implied volatility of the options is high. High implied volatility indicates that there is an above-average time premium built into the price of the options, allowing a trader to maximize his or her profit potential by taking in as much premium as possible.

By putting on this position, a trader establishes a range of profitability as long as the underlying security stays within a particular range prior to option expiration. While profit potential is limited to the net credit received when entering the trade, the trader’s maximum risk is also limited. Figure 1 displays the risk curves for a typical iron condor.

Figure 1: Risk curves for an iron condor

Source: Optionetics Platinum

Click to Enlarge

One key thing to note in Figure 1 is that the trade has two breakeven prices-one above the current price and one below. This trade will make money if the price of the underlying security remains between the two breakeven prices, but will lose money if the underlying security moves too far in price in either direction.

In this example, the maximum profit potential is $365, which would be realized at expiration if the underlying security is trading between the strike prices of the call and put that were sold. The trade will generate some profit as long as the underlying is trading between the two breakeven prices of 106.27 on the downside and 134.73 on the upside.

The ideal setup for an iron condor is an underlying security that is relatively quiet and locked into a trading range. Whether that is or is not the case for the security in Figure 1 is somewhat in the eye of the beholder. The security had been trending higher but now is in the middle of a two-month trading range with clearly identified support and resistance levels.

NEXT PAGE: The Nuts & Bolts of the Modidor