Iron Condors: Credit Spreads on RUT
Doc Maher kicks off a new blog series for income traders. 
I wanted to start a series on one of my favorite trades, the Iron Condor (IC). For income traders this strategy is an essential tool to stash in your toolbox.
The iron condor is a range trade, like the calendar spread. That means it profits if the underlying stays within a specified range. This makes it especially good for sideways markets or sideways-moving stocks. Iron condors come in handy a lot because, most of the time, stocks are not clearly trending. So while you’re waiting for a clear trend to emerge, these kinds of strategies can bring in steady profits.
Like most strategies, there are a number of ways to use IC’s but the basic setup is the same. In this series I’ll explore what makes this strategy work, what to look out for and set up an example trade and follow it.
So let’s get to it.
Iron condors and credit spreads
To understand iron condors, first you should get familiar with the “credit spread”. The credit spread is just a vertical spread, which we do for a credit.
For instance, let’s look at the Russell 2000. The Russell 2000 (RUT) is an index; however, we can trade options on it like we do on a stock. There are a few differences between index options and standard options, but they’re not important for this part of the discussion.
Looking at a price chart for RUT, we can see that since November it’s been going sideways. Granted, the range looks large but it still looks mostly sideways. If we look at January, for instance, the high was 519 and the low was 432. For February the high was 471 and low 387. In each case it’s less than 100 points.
See a bigger version of this chart.
When I drafted this on Friday 3/13, the RUT was at 393, and it looks like we may be rebounding off of a low on March 9 of 343. We might start with the premise that the RUT is unlikely to go below 343 before April expiration. So to construct a credit spread we’d make a bullish vertical spread out of puts. For example we might sell an April put somewhere below 343 and buy a put at an even lower price. This will result in a net credit.
The P&L for this credit spread looks like this:
See a bigger version of this image.
Looks like this trade would bring in somewhere between $1.30 and $1.90. I have assumed that we could get executed for $1.50, which was just below the mid-point on 3/13. (These numbers are per contract and each contract has a multiplier of 100.) Commission costs to enter this trade at TradeKing would reduce the credit of $150 by are an additional $11.20 to execute this trade.)
This $1.50 credit is all that this spread can make. How much can it lose? Well, if the RUT went below 330, we could get “put to” at 340 because we sold a 340 put. However, since we also own a 330 put, we could conceivably put to someone else at 330, limiting our loss to $10. Plus we got $1.50 when we entered this trade, so the total risk is $10 - $1.50 = $8.50. (Plus commission, assignment and exercise costs would increase the max loss of $850 by of $11.20 + $14.90 to close out this trade.) That means that the gross potential percentage gain is 1.50/8.50 = 17.7% on April expiration.
This may not sound like a great potential, however the RUT does not have to move up for us to get it. In fact, it can even drop to 340 and we’ll still get it. As of Friday the RUT was at 393, so this gives us 53 points of downside protection. If the RUT goes up everything is fine. At April expiration we don’t even have to close the trade. All the options expire worthless and we already have the $1.50 credit.
The mentality is a little like selling a covered call. Only you’ll have a very hard time finding a covered call that returns 17.7% for about a month (5 weeks) and has this much downside protection. (Be sure to familiarize yourself with both strategies’ risks and rewards before proceeding.)
So how does that sound? We can get 17.7% in 5 weeks as long as the RUT stays above 340. That’s not at all a shabby return. I mean, if you could get 17.7% every 5 weeks you wouldn’t need to read me much anymore. And the RUT can even go down 53 points and we will still get it. Of course we cannot make the assumption that this will happen with regularity or predictability. We are exposed to the max loss at any time.
Still not impressed? 17.7% might seem good to many of you, but others will point out that 340 is a little too close for comfort. I hear you. With this concern in mind, let’s sell a 310 put and buy a 300 put. That will protect us down to 310 or 83 points from the current level. That spread looks like this:
See a bigger version of this image.
Again I have “shaved” a little and assumed that we could get executed at $0.55 credit, a little less than halfway between the bid and ask. So now we can only hope to keep the $0.55 and we could lose up to $9.45, which is a measly 5.8% return over 5 weeks. (Again, plus commission costs would reduce the return of $55 by of $11.20 for this one contract spread.) Oh wait, maybe 5.8% in 5 weeks is not so bad. In fact a lot of people think 5.8% isn’t bad for a year and now are protected all the way down to 310. The RUT hasn’t been that low since July 1996! It’s unlikely to get down there, but anything can happen.
Now for the bottom line: the beauty of the credit spread is its combo of a low potential return but a high probability of success. “High probability of success” is in the eye of the beholder, of course, and there’s certainly no guarantee the RUT won’t go below 310 before April expiration. On the other hand, the RUT can go down 83 points to the 1996 level and this trade will still be successful for 5.8%.
What’s all this got to do with iron condors? Well, the credit spread is the basic building block of the IC. So we had to start there. Next time I’ll show you how to use them to create the iron condor, another great tool for the income trader.
Until then,
--Doc Maher
"Income Trader"
DocMaher Trading LLC
All-Star Commentator
Doc's previous posts: Calendar spreads: a time AND vol play? and Is Ford ready to bounce back?
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
I wanted to start a series on one of my favorite trades, the Iron Condor (IC). For income traders this strategy is an essential tool to stash in your toolbox.
The iron condor is a range trade, like the calendar spread. That means it profits if the underlying stays within a specified range. This makes it especially good for sideways markets or sideways-moving stocks. Iron condors come in handy a lot because, most of the time, stocks are not clearly trending. So while you’re waiting for a clear trend to emerge, these kinds of strategies can bring in steady profits.
Like most strategies, there are a number of ways to use IC’s but the basic setup is the same. In this series I’ll explore what makes this strategy work, what to look out for and set up an example trade and follow it.
So let’s get to it.
Iron condors and credit spreads
To understand iron condors, first you should get familiar with the “credit spread”. The credit spread is just a vertical spread, which we do for a credit.
For instance, let’s look at the Russell 2000. The Russell 2000 (RUT) is an index; however, we can trade options on it like we do on a stock. There are a few differences between index options and standard options, but they’re not important for this part of the discussion.
Looking at a price chart for RUT, we can see that since November it’s been going sideways. Granted, the range looks large but it still looks mostly sideways. If we look at January, for instance, the high was 519 and the low was 432. For February the high was 471 and low 387. In each case it’s less than 100 points.
See a bigger version of this chart.
When I drafted this on Friday 3/13, the RUT was at 393, and it looks like we may be rebounding off of a low on March 9 of 343. We might start with the premise that the RUT is unlikely to go below 343 before April expiration. So to construct a credit spread we’d make a bullish vertical spread out of puts. For example we might sell an April put somewhere below 343 and buy a put at an even lower price. This will result in a net credit.
The P&L for this credit spread looks like this:
See a bigger version of this image.
Looks like this trade would bring in somewhere between $1.30 and $1.90. I have assumed that we could get executed for $1.50, which was just below the mid-point on 3/13. (These numbers are per contract and each contract has a multiplier of 100.) Commission costs to enter this trade at TradeKing would reduce the credit of $150 by are an additional $11.20 to execute this trade.)
This $1.50 credit is all that this spread can make. How much can it lose? Well, if the RUT went below 330, we could get “put to” at 340 because we sold a 340 put. However, since we also own a 330 put, we could conceivably put to someone else at 330, limiting our loss to $10. Plus we got $1.50 when we entered this trade, so the total risk is $10 - $1.50 = $8.50. (Plus commission, assignment and exercise costs would increase the max loss of $850 by of $11.20 + $14.90 to close out this trade.) That means that the gross potential percentage gain is 1.50/8.50 = 17.7% on April expiration.
This may not sound like a great potential, however the RUT does not have to move up for us to get it. In fact, it can even drop to 340 and we’ll still get it. As of Friday the RUT was at 393, so this gives us 53 points of downside protection. If the RUT goes up everything is fine. At April expiration we don’t even have to close the trade. All the options expire worthless and we already have the $1.50 credit.
The mentality is a little like selling a covered call. Only you’ll have a very hard time finding a covered call that returns 17.7% for about a month (5 weeks) and has this much downside protection. (Be sure to familiarize yourself with both strategies’ risks and rewards before proceeding.)
So how does that sound? We can get 17.7% in 5 weeks as long as the RUT stays above 340. That’s not at all a shabby return. I mean, if you could get 17.7% every 5 weeks you wouldn’t need to read me much anymore. And the RUT can even go down 53 points and we will still get it. Of course we cannot make the assumption that this will happen with regularity or predictability. We are exposed to the max loss at any time.
Still not impressed? 17.7% might seem good to many of you, but others will point out that 340 is a little too close for comfort. I hear you. With this concern in mind, let’s sell a 310 put and buy a 300 put. That will protect us down to 310 or 83 points from the current level. That spread looks like this:
See a bigger version of this image.
Again I have “shaved” a little and assumed that we could get executed at $0.55 credit, a little less than halfway between the bid and ask. So now we can only hope to keep the $0.55 and we could lose up to $9.45, which is a measly 5.8% return over 5 weeks. (Again, plus commission costs would reduce the return of $55 by of $11.20 for this one contract spread.) Oh wait, maybe 5.8% in 5 weeks is not so bad. In fact a lot of people think 5.8% isn’t bad for a year and now are protected all the way down to 310. The RUT hasn’t been that low since July 1996! It’s unlikely to get down there, but anything can happen.
Now for the bottom line: the beauty of the credit spread is its combo of a low potential return but a high probability of success. “High probability of success” is in the eye of the beholder, of course, and there’s certainly no guarantee the RUT won’t go below 310 before April expiration. On the other hand, the RUT can go down 83 points to the 1996 level and this trade will still be successful for 5.8%.
What’s all this got to do with iron condors? Well, the credit spread is the basic building block of the IC. So we had to start there. Next time I’ll show you how to use them to create the iron condor, another great tool for the income trader.
Until then,
--Doc Maher
"Income Trader"
DocMaher Trading LLC
All-Star Commentator
Doc's previous posts: Calendar spreads: a time AND vol play? and Is Ford ready to bounce back?
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Jonathan F. Maher, PhD has a professional business relationship with TradeKing.
TradeKing provides self-directed investors with discount brokerage services, and does not make recommendations or offer investment, financial, legal or tax advice.
(c) TradeKing, Member FINRA, ISE, and SIPC. http://www.tradeking.com
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