My friend recently became interested in the long iron condor strategy, a technique used by option traders that speculate an asset will remain within a price range at the option's expiration date. There are many websites that explain how a long iron condor can be executed, however, these sites must assume that the reader is knowledgeable enough to understand the terminology. Understandably, these sites would need to use the proper jargon as the strategy is often implemented by sophisticated traders only. It's a sharp learning curve for beginners wanting to understand the complicated technique regardless of their intentions to execute the trade or not. The strategy employs four individual option strategies combined into one large strategy. The trader will buy a call (profit when a stock rises), sell a call (profit when the stock does not rise), buy a put (profit when a stock falls), and sell a put (profit when a stock does not fall). Most of these trades counteract each other; this is the fundamental key in an iron condor as it allows speculators to make larger returns with less risk.
Imagine yourself playing a game with a colleague that carries two 12-sided dice at all times. He whips out his dodecahedrons and plays a game of pure speculation. You decide to start simple..
Your first speculation is that the combined total will be below 13 (which is the half way point). You pay $3. For every number below 13, he will pay you $1. If the roll is 2 (the lowest possible number), you will receive $11. Subtracting your original cost, you will earn $8 profit. This is essentially why a put option is employed in an account. In such a scenario, an investor may own the shares and is concerned the value of the stock will drop. Therefore, the investor pays $3 a share to protect a stock worth $113 a share. Any price drop is equally offset by the increase in the price of the put option.
Your second wager is that the combined total will now be above 13. Much like in the first example, you will receive $1 for every number above 14 to a maximum of 24. This is similar to the purchase of a call option. A trader would purchase a call option for $3 in hopes the underlying asset will rise above a pre-determined value. Investors will make this purchase because it is cheaper to speculate. Instead of purchasing the stock for $100 a share, they can make the same prediction for just a fraction of the stock price.
In the above example, you sacrifice your original $3 investment if you are wrong. Speculators use options because the stock may be un-affordable or the speculator does not feel the need to invest large capital to speculate. If the same profits can be earned with the fraction of the cost, then it may be deemed more effective and efficient. Another note, in the above example, your friend is receiving the money from you in advance. You decide you would like to be the "dealer" but you choose the ranges and he will pay you what he feels is fair value considering its chances of success.
Your third bet, you decide to change it up. You will now be the one paying out to your friend. However, you get to predict the next roll. You inform your friend that you think the roll will be below 20. The odds of success is 15/144. Therefore, your friend will be willing to make that bet, however, he feels he only wants to pay 40 cents. In return if he is right, he will earn up to $4 or 9.6 times his money. This is essentially how a trader sells a call option. A stock may be trading at $113 and he believes that the stock will remain below $120. It would require a stock price to rise over 6 per cent before the option seller loses money. The trader is willing to make this bet because the odds are extremely low and the investor receives an immediate cash return by selling the option to the other investor.
You make a fourth bet and predict the next roll will be above 6. Again, the odds are identical and your friend only wants to pay 40 cents. This is identical to an investor selling a put option. The investor selling the put option is anticipating the stock remains above a certain price. The lower the probability of it being wrong, the less the investor earns.
With additional combinations at your disposal and a willing partner to accept any selection of ranges, you spice up the bets.
Your fifth bet becomes a two-legged bet. Firstly, you speculate the dice roll will be above 13, however, this time, you will receive the $3. You realize you only have $7 in your pocket, so if you're wrong, you won't have enough to pay the $8 max profit. So, you add a second component that speculates the next dice roll will be below 6 and pay 40 cents. The most you can lose is the $7 difference. Since you already received $3 and had to pay 40 cents, you will earn $2.60 immediately and keep it if the roll is over the par line. If you are incorrect, the max loss is $4.40. In fact, in this situation, if the roll is 12, you will return $1, but have made a profit of $1.60. This strategy is similar to a bull put spread. It is bullish (investor thinks it will not fall) and uses two put options. A trader would employ this strategy if they have limited investment capital or would prefer to concentrate their potential. The trader speculates that the stock will either remain flat or rise. This gives the speculator two ways to earn money. As well, by receiving cash in advance, the trader can earn interest on the premiums received.
Your sixth bet is now the reverse of the previous two-legged bet. You bet the dice roll will be below 13 and protect it with a bet that it will be above 20. Again, you will receive $2.60 immediately and earn money if the roll remains below the par line. Again, all the same arithmetic applies. This investment strategy is known as a bear call spread. The bet is bearish (investor thinks the asset will not rise) and uses two call options.
Now, you have mastered the art of dice rolling and do a four-legged bet that employs all four wagers. With all being said and done, you will receive a total of $5.20. Since there is only one roll that provides maximum profit (13), you expect to lose a little bit of the $5.20. You will profit if the stock is between 7 and 19. There are only 30 combinations that will net you a loss. The employment of a bull put and bear call spread is known as the long iron condor strategy. This strategy is popular among sophisticated investors because only one side can be wrong and therefore, the profits are doubled if they are correct without having to deposit or offer any additional margin to the broker.
In reality, the trader would rarely choose the exact middle due to the fact that there are costs and commissions associated. It would also potentially require the trader to close out both sides if the stock is right down the middle to prevent either option from being assigned. A speculator would leave a buffer area of any range. 7 and 13 if they feel the next dice roll, that is, the stock may dip, or 7 and 19, or 15 and 20. Their success will ultimately be determined based on the stock's closing price on the day of expiration, assuming the options are not closed in advance.
The long iron condor is a fantastic and efficient way to capture the time value of an option. As time passes, the odds of any option being correct decrease and therefore, investors looking to purchase these options are willing to pay less. The goal of the option seller is to capture the time value and hope that the stability of the market reduces the value of the options to zero. It is also a more efficient use of capital. A trader employing strategy number three can theoretically lose an infinite amount of money. A stock at $113 does not cap at $124 a would occur in the dice example. It could go to hundreds of dollars. The trader would be responsible for this infinite gain and traders may want to cap their losses by reducing their return. As well, strategy three would typically require 30 per cent of the value of the stock. Therefore, a stock at $113 would require at most $33.90 immediately as margin. However, a spread would only require a deposit equal to the maximum loss.
Using the values above, a trader wanting to earn $3 would require $33.90, which equals a rate of return of 8.8 per cent. The trader of either strategy 5 or 6 would only require $4.40. The trader would return 59 per cent by simply paying that 40 cents. This is how yields are concentrated. The iron condor trader would then apply both sides and receive $5.20 and could net at most 289 per cent return, assuming the dice roll was exactly 13 or the stock closes at exactly $113.
The long iron condor is a tool used by many range traders and is an optimal way to earn large returns for less risk than owning capital. Its implementation requires extreme precision and knowledge of the options market. However, with the education and tolerance for risk, traders can reap huge rewards for simply working minutes a week.
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