Just three months ago, volatility levels were near record lows. The absence of moderate to elevated option premiums made it hard to justify selling vertical spreads or iron condors. The allure of short volatility products resulted in the strategy becoming a crowded one. When low volatility levels began to reverse course, the move higher became exacerbated by the number of short volatility positions in the marketplace.
As the equity market pulled back from all-time highs last month, the VIX moved from 12.5 to 50.3 in less than a week! Ironically, the liquidation of many of the short volatility positions presented new opportunities for those who resisted the temptation to follow the herd. With this recent rise in volatility, it could be time to talk about a risk-defined strategy that is designed to capitalize on elevated volatility levels in a range-bound market: the short iron condor.
A short iron condor is a four-legged spread constructed by selling one call vertical spread and one put vertical spread simultaneously, in the same expiration cycle. Typically, both vertical spreads are out-of-the-money and centered around the current underlying price. Similar to a single vertical spread, the risk is determined by the distance between the strikes of the vertical. See figure 1.
For example, if the vertical spread is $2 wide, the risk would be $200 per contract, minus the credit received for selling the iron condor, plus transaction costs. In the best-case scenario, the underlying stays between the two short strikes through expiration, and both vertical spreads expire worthless. This would allow a trader to keep the full credit that the iron condor was sold for, minus transaction costs.
Let’s look at an example. Suppose a trader would like to place a neutral short iron condor on XYZ trading at $52.50. To create the position, the trader could sell a 47.5 put and buy a 45 put and a sell a 55 call and buy a 57.5 call for a combined credit of $0.70. This would give the trader a $7.50 range — between the put with a low strike at 47.5 and call with a high strike at 55 — in which the trade could achieve its maximum profit potential. The position would have an upside breakeven level of $55.70 and a downside breakeven level of $46.80, as shown in figure 1. If the stock remains between the short $47.5 and $55 strikes through expiration, the maximum potential profit would be $70 per contract, minus transaction costs, which is the credit received when initiating the position.
The maximum potential loss would be $180 per contract plus transaction costs, if the underlying closed below the long 45 put strike or above the long 57.5 call strike at expiration. See figure 2.
When volatility levels are elevated, so are the credits that can be collected when selling an iron condor. Any increase in volatility typically expands an option’s premium, which inflates prices of the individual vertical spreads.
The short iron condor is a neutral strategy when centered around the current underlying price, but it can be made bullish or bearish by skewing it toward either of the verticals.
The short iron condor is a potential strategy to implement in times of uncertainty. It allows a trader to create a position that takes advantage of excessive risk premium in a risk-defined manner. By initiating this position, a trader is making two basic assumptions: that current volatility is elevated and will decrease at some point before the position expires; and the underlying will remain between the two short strikes of the iron condor through expiration. The key is to understand that fear-driven markets all come to an end eventually, and a short iron condor can be used when a trader feels fear is about to subside.
Spreads, iron condors and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
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