Iron Condor

Many private traders deem that options are thought to be traded by experts with good mathematical skill. There are two reasons why many private traders think so, that are. trading options are too risky and difficult. Many private traders think that it is easier to just trade stocks or futures. So, a simple question, if trading futures or buying stocks looks so much easier and less complex to do, then why options are available to be traded? The actual reason is that options, which are unlike other trading vehicle, can offer a trading edge to the private traders and allow them to cover almost any investment strategy and risk profile with flexibility. In many ways, options are the most superior trading vehicles that many traders use nowadays. To trade options, you certainly do not need to be an expert in financing.

In the book “The New Market Wizards” written by Jack Schwager, concludes that nobody can win without an edge, even you have the world greatest discipline and money management skill. If you trade futures on the All Ordinaries Share Price Index (SPI), you have to know exactly what is your trading edge; particularly, if you are a professional floor trader. With the trading edge, you should able to see the buy and sell orders that coming into the trading pit and also who is buyer and seller. Besides, the speed of execution of your orders and the transaction costs also should able to see. The popularity of the stocks, options and futures is increasing; therefore, many people trade these products. Only a small proportion of these traders apply a real trading edge. The main reasons for the unsuccessful of many private traders in the financial markets are due to the lack of a trading edge, poor risk management and insufficient capital. The key point here is to find an edge, utilize it consistently and use the right risk and money management techniques. When the odds are in your favor, it is better that you learn how to trade options. It is also importantly when the odds are not in your favor, make sure you stand aside. You are doing yourself with the best possible chance of success if you doing so. Trading systems are as many as traders. We won’t trade a system if it doesn’t provide us with some sort of edge. If you have a system, which is able to give you an edge, why not further enhance your edge by trading options in a right circumstance. Before placing a trade, try to get as many factors that going in your favor as possible. By practicing this, you provide yourself with a much greater chance to success in the long run.

Without doubt, with any form of trading, there are no absolute guarantees. You can’t help compared to the many of the people who do not know anything about options and trade without an edge. But, you have a better chance to succeed in the long run and reach your financial ambitions. Flexibilities that can be offered by options are as follows:

i) Profit gained from an accurately anticipating rising or falling market. ii) With a relatively small disbursement, your potential returns can be greatly magnified.

iii) If the market goes to the way that you anticipate, you have unlimited profit potential, whilst you limit your risk by choosing an amount that you afford to risk.

iv) Profit still can be gained by correctly picking options where the market will not go.

v) Profit gained from flat or non-trending phases markets.

vi) Profit gained by letting the time passes by.

vii) Profit gained at an increasing rate when the market moves further in your favor.

Extremely flexible trading tool is option. You can use options trading strategies that are precisely suit your view of market, whilst sewing them closely to your personal risk tolerance level.

People who trade options for a living and as their business will try to understand and apply the principles, which have been outlined in this article. They do so because they know that there is an edge for then to be gained compare to the people who don’t. They are similar to the typical casino gambler if they do not trade with edge; their money will be destined to be lost ultimately. They are exactly like the casino itself if they trade with trading edge. For those people who trade the markets to make their living, you probably don’t have the chance to talk with them. Their occupation looks exotic and these people are imagined as weird mathematical geniuses who could give their money to Kasparov to run it in a chess tournament. The flair of occupational options traders couldn’t be going beyond from the veracity. Although many of the professional options traders who involve in the financial markets are intelligent people, they were not in the genius category. Nevertheless, they have one thing in common among them. They knew and applied certain unique principles in their options trading. The principles that they utilized offered then an edge to successfully trading in the market. Therefore, throughout their options trading life, they earn a good living.

You don’t have to be a professional options trader. The edge offered from the principles to the professional options traders also available to the private traders as well. Practically, these principles can be learnt and applied by yourself and the odds can be helped to put it more squarely in your favor. All the advantages that most of the professional options traders have may not be possessed by you. By using the same principles that they used, you can learn to make your trading more selective. In this way, you too can benefit from a trading edge.

Beginning options traders often make costly mistakes due to either a lack of knowledge or misinformation about the basic parameters of options and their exercise. Examples of common errors include being surprised that one is unable to close an index option position on the Friday before expiration, or being surprised by an unhedged option exercise during expiration. This paper covers some of the basic concepts surrounding option expiration and how options are exercised. Be sure you understand the settlement, exercise, and expiration characteristics of the options you trade.Option ExpirationEquity options expire on the Saturday following the third Friday of each month. It is common to hear or read that equity options expire on that third Friday. While that isn’t technically correct, it is true that Friday is the last opportunity to trade those options. Saturday expiration was established to give the brokerages time to settle the accounts before the options technically (legally) lose their value.However, some (but not all) index options cease trading at the close on the Thursday prior to expiration and those positions are reconciled on Saturday based upon the settlement price established on Friday. For example, the SPX index options cannot be traded after the close on the Thursday before expiration; but the settlement price, usually reported as SET or $SET, is established Friday morning based on the opening price of each of the 500 S&P stocks. Since many stocks do not open immediately at the opening bell, the settlement price will differ from the SPX opening price on Friday. Option ExerciseThe owner of an equity option has the right to buy or sell 100 shares of the underlying stock anytime before expiration. If you are long the option (i.e., you originally bought it), you may or may not choose to exercise the option you own; it is entirely your choice. If you are short the option (i.e., you originally sold the option), it may be exercised against you at any time. Typically, you will receive an email from your broker after the market close, notifying you of the exercise. You may be exercised for only a portion of your option position, e.g., only 2 of your 10 contracts. If you were short call options, you will now see a short stock position in your account, i.e., you were obligated to sell the stock at the strike price. If you were short put options, the exercise forces you to buy stock at the strike price, resulting in a long stock position in your account. When options contracts are first created, exercise is specified in one of two different ways: American style or European style. American style options can be exercised on any business day prior to expiration, whereas European style options can only be exercised at expiration. All equity options are subject to exercise American style, while most index options are European style, e.g., the SPX. But there are some exceptions with a small number of index options settling American style, e.g., the OEX.Upon expiration, your broker will automatically exercise any expiring options in your account that are $0.05 or more ITM (in the money) in accordance with Options Clearing Corporation regulations. If expiration is approaching and the stock price is near your strike price, and you do not want to hold either the long or short stock position that will result from the exercise of your long option, sell the option before the market closes on the Friday of expiration week. If you are holding a European style index option position and wish to close it before expiration, be sure to complete those orders before the market closes on Thursday before expiration. If you wish to exercise any of your long equity options, you must issue an order to your broker before the market closes on the Friday of expiration week. It is generally good practice to close option positions before expiration to avoid unpleasant surprises.Option spread positions always have a short option position by definition, so they are subject to exercise at any time. However, the long option protects you in this situation, e.g., if I am holding a 10 contract spread and I receive a notice of exercise from my broker for 3 of the short options, I simply ask my broker to exercise 3 of my long options to cover the exercise.In practice, it is rare that your short option positions will be exercised against you before expiration. But, as noted above, your long option position protects you against this exercise. In general, put options are rarely exercised unless there is less than $0.10 of time value left in the option. The same is true of call options with one major exception: calls are often exercised just before a stock goes ex-dividend, e.g., if the call has $0.10 of time value remaining, but the dividend is $0.50 per share, it may be advantageous to the option owner to exercise the option and hold the stock through the ex-dividend date to collect the dividend payment. Sometimes an option will be exercised against you in a situation where it makes no sense whatsoever and is probably a mistake or due to inexperience of the person on the other side of the trade.If you are holding a vertical spread position going into expiration, there are several different situations possible. If both of the options are fully in the money, your broker will automatically exercise both of the long and short options and credit your account with the spread amount less commissions. However, if the stock price closes expiration Friday within the spread, the situation is a little tricky and the results may surprise you. For example, if we were holding a bull call spread, the short OTM call will expire worthless and the broker will exercise the long call on your behalf, resulting in shares of stock in your account the following Monday (and perhaps a call from your broker if your account does not have sufficient cash to buy the stock). If you do not want to purchase the stock, you should close the spread before the market close on the Friday of expiration week.Credit spreads can also result in surprises at expiration. For example, if I hold a bull put spread and the underlying stock closes Friday of expiration week at a price within the spread, my short put options will be exercised against me, resulting in a long stock position in my account. The long put option does not protect me because it expired worthless.In general, if the stock price closes on expiration Friday within the strike prices of my vertical spread, it will result in either a long stock position or a short stock position in my account the following Monday. Unless you are willing to hold that stock position, it is usually best to close the spread on Friday. Many traders adopt a general rule of closing all option positions the week before expiration to avoid the surprises that are all too common the week of expiration.

You don’t need to be a trader or an investor to know that the higher the risk, the greater the reward. This concept is true in all aspects of life and business. The more risk you are willing to undertake in life, the more life returns to you. Indeed, risk and reward are directly proportional and often in trading and investment, the more risk your account is exposed to, the greater the return on investment when things work out as planned.
Knowing that risk and reward are proportional makes finding the correct balance of risk and reward extremely important to all kinds of traders; stock traders, futures traders, options traders etc. There is no one solution that works for everyone and the correct balance is decided upon the risk appetite and risk tolerance of the individual trader.
For stock traders, balancing risk and reward primarily involves adjusting the amount of growth stocks and defensive stocks in one’s portfolio. Generally, the more growth or speculative stocks in one’s portfolio, the greater the risk due to greater uncertainty and therefore the higher the gain when things works out as expected. The more defensive stocks in one’s portfolio, the more predictable returns become and therefore the lower the return as these stocks does not generally move a lot. This degree of risk / reward balancing is at best crude compared to the surgically fine degree of balancing you can have in options trading.
Stock options are the most versatile trading instrument in the world right now due to the wide array of options strategies that are employable. Yes, not only can risk and reward be balanced through employing different mix of strategies in your portfolio, there are also different risk and reward profiles achievable by each individual options strategy. There are options strategies that range from making over 1000% profit while risking all your money to options strategies that make a mere 0.01% return while risking nothing as well as every centimeters in between.
As long as you understand what your personal risk appetite and risk tolerance is, you will be able to find an options strategy that suits your needs 100%. Here’s a general outline of the kind of risk reward balance that can be achieved through options trading:
Highest Risk, Highest Reward – OTM Call / Put buying
This is the options strategy that produces the legendary 1000% profit that amazed so many beginners. What those ads did not tell you is that the risk is losing ALL the money that you put into the strategy. This options strategy involves buying out of the money(http://www.optiontradingpedia.com/out_of_the_money_options.htm)call options when you think a stock is going to go up or buying out of the money put options when you think a stock is going to go down. Professionals use this options strategy with only a very small portion of their money in order to place a bet on an uncertain event such as leveraged buyout. Some lucky amateurs use this options strategy with all their money and then become millionaires overnight. The downside of this strategy is the fact that if the stock did not move far enough in the direction you expected it to, you can lose all the money you put into the strategy. That is also why so many beginners break their accounts overnight in options trading.
Various Degrees of Risk and Reward – Options Spreads
There are literally hundreds of possible options spread strategies out there with various degrees of risk and reward for every market condition. There are more aggressive bullish, bearish, neutral and volatile spreads and there are more conservative ones. All of them shares the same logic of higher risk compensated with a higher profit potential.
Lowest Risk, Lowest Reward – Options Arbitrage
Yes, there are literally risk free trading opportunities in options trading which also returns very small, sometimes negligible returns. These are the legendary options arbitrage strategies. Options arbitrage strategies such as conversion/reversal aims to make a fixed return totally risk free through simultaneously buying the underlying and shorting the overpriced synthetic equal or vice versa. The problem with such strategies is that the returns are so low that most of the time, it’s even lower than the commissions you will pay for the trades made. Even if you manage to return a positive return, the return can be as low as 0.01% in percentage terms. That is why arbitrageurs aim to make an absolute return using enormous amounts of money.
With this in mind, the most conservative traders may choose to specialize totally in arbitrage strategies (http://www.optiontradingpedia.com/options_arbitrage.htm) while the most aggressive traders may choose to specialize in leveraged speculation using OTM options. Everyone else would be able to find something to suit your risk appetite in the hundreds of spread possibilities. This degree of flexibility and range of risk/reward possibilities makes stock options the most versatile trading instrument in the world today and why options trading (http://www.optiontradingpedia.com) is so popular these days.

One will commonly hear or read the following “rule of thumb” for options spread trading:When implied volatility is high, sell credit spreads and when implied volatility is low, buy debit spreads.Unfortunately, this is simply not true. The credit spread and its corresponding debit spread at the same strike prices will always have virtually identical returns on investment (ROI). This paper addresses the role of implied volatility in the vertical spread, both at initiation and over the course of the trade.BackgroundVertical spreads derive their name from the wall originally used to display option prices when they were first traded in Chicago many years ago. The months of expiration were displayed horizontally across the top of the board and the strike prices were displayed vertically along the left edge. Thus, spread trades using two options at two different strike prices in the same expiration month were in the same column and thus constituted a vertical spread. This includes bull call, bear call, bull put, and bear put spreads.Similarly, horizontal spreads are created by buying and selling options from the same row – different months of expiration, but with the same strike price. Horizontal spreads are also known as calendar spreads or time spreads.Diagonal spreads are created when different strike prices and different expiration months are used – thus, a diagonal line across the board between the option sold and the option purchased. An example would be buying the September $300 GOOG call and selling the July $320 GOOG call to create a diagonal bull call spread.Vertical spreads either require a net investment to initiate (a debit spread) or we initially receive money into our account (a credit spread). For this reason, it is common terminology for us to say we are “buying a call spread” when establishing a debit spread and “selling a call spread” to refer to initiating a credit spread. Bull call spreads are created by buying a call and selling another call at a higher strike, or farther OTM (a debit spread). A bear call spread is created by buying a call and selling a lower strike price call, or farther ITM (a credit spread). Similarly, a bear put spread is established by buying a put and selling the lower strike price put that is farther OTM (a debit spread). And a bull put spread consists of buying a put and selling another put at a higher strike price, farther ITM (a credit spread).  Credit or Debit?There are many decisions made before we put on a trade, but for this discussion we will assume that a vertical spread strategy has been chosen as the optimal trading strategy for this situation. The next decision is whether to use a credit or a debit spread.  The maximum potential gain for the vertical spread, all variables held constant except the choice of calls or puts, will be indifferent to whether the trade is established as a credit or debit spread. For example:GOOG closed at $310.71 on October 5, 2005.  If one were bullish on this stock, one could place an Oct $310/$320 bull call spread for a debit of $430 ($960 – $530) and a maximum potential gain of 133%, assuming expiration with GOOG trading above $320.Similarly, one could place an Oct $310/$320 bull put spread for a credit of $560 ($1400 – $840) and a maximum potential gain of 127%, assuming expiration with GOOG above $320.The small difference between the two returns is insignificant; we are using the closing bid and ask prices for these options, and the option prices are very fluid, so picking prices at any arbitrary point and getting exactly identical results would be unusual.  The conclusion is that any difference in returns between a credit and debit spread for the same underlying stock, strike prices, and expiration month will be small and temporary, because market forces will quickly adjust them to parity.It is commonly taught that one should establish a credit spread when placing a trade with high implied volatility (IV) options and a debit spread with low IV options. But the previous example illustrated identical returns for the credit and debit spreads.  So, in that example, we would be indifferent to placing a debit or a credit spread. But let’s take it a step further.We will use the Black-Scholes model to compute the theoretical prices of the GOOG $310 and $320 options from the previous example, but with IV boosted up to 60% (the actual IV values in the above example ranged from 33% to 34%). Now the spread values become:The Oct $310/$320 bull call spread could be placed for a debit of $436 ($1613 – $1177) and a maximum potential gain of 129%, assuming expiration with GOOG above $320.Similarly, the Oct $310/$320 bull put spread could be placed for a credit of $563 ($2058 – $1495) and a maximum potential gain of 129%, assuming expiration with GOOG above $320.Thus, if we were considering placing a bullish vertical spread on Google, the returns would be virtually identical whether the IV was 34% or 60%, or whether we used a credit or debit vertical spread. The higher IV value increased the individual option values dramatically, but the spread values were unchanged. Higher IV does result in higher option prices, but in a spread, we are both buying and selling that high value.I also computed these option values with IV adjusted to 20%. As we see below, at this very low IV, the returns for the credit and debit spread were still identical so there would be no advantage to placing the debit spread for this low IV stock as some have taught.The Oct $310/$320 bull call spread could be placed for a debit of $381 ($580 – $199) and a maximum potential gain of 162%, assuming expiration with GOOG above $320.Similarly, the Oct $310/$320 bull put spread could be placed for a credit of $623 ($1084 – $461) and a maximum potential gain of 165%, assuming expiration with GOOG above $320.However, the returns for both spreads at IV of 20% are higher than we saw with the other examples with volatilities of 34% and 60%.  This is consistent with the overall financial laws of balancing risk and return, i.e., higher returns always carry higher risk. This example has us placing a bullish spread on a stock currently priced near the bottom edge of the price spread; the stock price must make a significant price move of over $9 before expiration for the spread to achieve maximum profitability.  However, the low implied volatility tells us the probability of a significant price move is low.  Therefore, the returns will be higher, commensurate with the lower probability of success, and therefore, a higher risk of loss.These examples illustrate two important conclusions:•    The returns for a credit spread and a debit spread placed at the same strike prices for the same equity or index will be identical. Any price differences seen in the marketplace will be transient, as arbitrage will quickly bring the prices back to parity.•    The level of implied volatility (IV) is not a consideration when placing a vertical spread and deciding on a credit or debit spread. High IV does increase the individual option prices, but we are both selling and buying option premium in a spread, so the returns for the credit and debit spreads remain identical.Changes in IV During the TradeThe maximum profitability of a vertical spread, once placed, cannot change due to changes in implied volatility after the trade was initiated.  The initial investment and the width of the spread are fixed; therefore, the maximum potential return is fixed.  This is equally true for both credit and debit vertical spreads. However, the time decay curves of the spreads are affected by changes in implied volatility.  The value of the spread varies with time to expiration, implied volatility, and the price of the underlying stock.  Of course, interest rates and dividends will also affect spread values, but these will be less significant effects. Experienced spread traders know that even though the underlying stock price may have moved as predicted above or below the spread strike prices, the spread cannot be closed for a value close to the maximum theoretical profit until close to expiration. The value of the spread will gradually approach the maximum profit as the time value of the options decays away.Increasing implied volatility (IV) during the trade results in the time decay curves being flattened so that the value of the spread approaches the ultimate value at expiration more slowly.  Therefore, the probability of closing the trade early for a majority of the maximum profit is reduced. We won’t illustrate it here, but the flattening effect on the time decay curves due to increasing IV during the life of the trade is identical for credit and debit vertical spreads.  Therefore, if one is expecting a large IV increase, such as in advance of an earnings announcement, there is no inherent advantage to either a credit or a debit spread.  But one should expect to have to carry the trade closer to expiration to achieve a majority of the potential profit if IV increases.Vertical spreads have an inherent advantage over long or short option positions in that the ultimate profitability of the vertical spread is unaffected by IV changes while we are in the trade.  By contrast, if we buy a call option in anticipation of a positive earnings announcement, we may be disappointed in the results. Most likely, IV will decrease dramatically following the announcement, and this will drive down the value of our call option. This negative effect may be of equal or greater magnitude than the positive effect on our call option due to the increased stock price.Decreasing implied volatility (IV) during a vertical spread trade results in the time decay curves spreading out so the value of the spread approaches the ultimate value at expiration more quickly. This effect on the time decay curves due to decreasing IV during the life of the trade is identical for credit and debit vertical spreads. The maximum profit available hasn’t changed, but the prospect of closing the trade early for a large portion of that maximum profit is now more probable.ConclusionsThe maxim to use credit spreads when implied volatility is high and debit spreads when implied volatility is low may be a confusion that arose out of long and short option positions.  It is indeed true that one should consider buying low volatility options and selling high volatility options. If we are considering a long call or put position, we would look for options with low implied volatility because these are inexpensive options. And similarly, we would target high IV options if we were considering a short call or put position.However, when playing the stock’s directional move with a vertical spread strategy, the choice of a credit or debit spread is largely a personal preference.  Some prefer a credit spread because they can earn interest on the credit monies in their accounts while in the trade; another advantage of credit spreads is fewer trading commissions (assuming the spread is allowed to expire worthless).  Others prefer debit spreads because they have spent the maximum that can be lost on the trade; there is no possibility of an ugly surprise later if the trade turns against them (as there is for a credit spread).  The returns for credit and debit spreads will be identical and IV levels will have no effect on the returns.  The effect of the volatility (either high or low) effectively cancels itself out by the opposite nature of the two legs of the spread.  Thus, vertical spreads are an excellent way to trade high volatility options when establishing a long or short option position would be both expensive and risky.The change of IV during the course of the vertical spread trade will shift the time decay curves. Decreased IV will make it easier to exit the spread early for a large portion of the maximum profit, while increased IV during the trade will make it more likely one will have to take the spread into expiration.  But the ultimate profitability of the spread is unaffected by the change in implied volatility.

Many conservative income generation trading strategies depend on the time decay inherent in options pricing. When I establish an iron condor well OTM (out of the money), I am selling option spreads and expecting those spreads to slowly lose value as the underlying stock or index trades within a channel. Other traders may use butterfly spreads or place OTM credit spreads on one side only (calls or puts); all of these trades are based on time decay working in the trader’s favor. This is in contrast to the long option position designed to benefit from my prediction of a particular directional move for the underlying index or stock. Those positions lose value over time if the predicted move does not occur, so time is not your friend for those trades.

One of the items on your checklist before making a trade should be a glance at the calendar to see if any exchange holidays are upcoming. When time decay is on your side, exchange holidays are also your friend. If the market isn’t open, it can’t move against your positions, but time decay is still occurring and improving the profitability of your position. I will often establish my OTM credit spread positions before long holiday weekends to add to my edge.Another important factor to keep in mind is the historical seasonality of volatility. Trading activity slows during several of the holidays every year, as traders take time off to be with their families and exchange business tends to slow. March and October have historically displayed the highest volatility for the year, whereas the summer months and the week between Christmas and New Year’s Day are historically slow periods of market activity. An old wall street maxim is “sell in May and go away.” It refers to the tendencies for many market participants to take vacations and long weekends over the summer, resulting in lower trading volumes and lower volatility. This tends to favor strategies like iron condors that benefit from slower moving, sideways markets.Another factor tracked by many traders is which monthly options cycles have 5 weeks and which only have 4 weeks. Option prices will be skewed because of the number of days in an option cycle.  If your trading style involves consistently selling premium each option cycle, you should be aware of the five week option months, since the amount of premium income may be affected.Options trading strategies that benefit from the time decay of options prices are attractive for monthly income generation. Pay attention to the calendar and put time on your side.

One will commonly hear or read the following “rule of thumb” for trading:Only trade positions with potential profits of at least three times the potential loss.This sounds like a reasonable rule, risking a little to make a lot. However, it ignores the probabilities involved. Buying a lottery ticket for $1 to potentially make one million dollars certainly meets this criterion for a good trade. But we intuitively know that the odds against us winning are astronomical. This paper will define risk/reward ratios, define the concept of expected value, and begin to explore the relevance of these concepts to success in trading strategies.Risk/Reward RatiosIf we are considering an investment where the maximum gain we can expect is $100 and the maximum loss that we may incur is $500, we would compute a risk/reward ratio of 500/100 or 5:1 (five to one) . This is a high risk/reward ratio in that we stand to lose a large amount compared to the maximum gain. The trading rule above of “potential profits of three times the potential losses”, would result in a small risk/reward ratio of 1:3.Expected ValueThe probabilities of the various outcomes of a proposed investment are often overlooked. When someone tells you an investment will return 300%, but doesn’t tell you the probability of success, you are missing critical information necessary to make a decision about that investment. When one accounts for the probability of the profitable outcome, one computes the expected value, sometimes called a risk adjusted return on investment.For example, let’s assume we are considering a covered call on IBM and the called out return is 4% for IBM closing over $90. If we were to determine the probability of IBM closing over $90 is 65%, then we would say that the expected return or risk adjusted return is 2.6% (0.65 x 4%). We can take this analysis one step further by accounting for the probability of loss. Using the same IBM covered call, let’s assume we have a stop loss order entered that we believe will take us out of the trade with a 8% maximum loss. Now our expected return has two terms:Expected Return = (probability of gain) x (maximum gain) – (probability of loss) x (maximum loss), or,Expected Return = (0.65)(4) – (0.35)(8) = (2.6) – (2.8) = -0.2%Therefore, if we were to place this trade many times, our expected return, based on the probabilities of gain or loss, would be a net loss of 0.2%. One could improve this strategy by either improving the probability of success or tightening the stop loss to reduce the maximum loss.High Probability TradesTrading strategies can be positioned in a variety of ways resulting in a broad range of risk/reward ratios. One extreme category may be called the high probability trades, i.e., trades that have probabilities of success of 85-90%. One type of option spread strategy, known as the iron condor, can be positioned in such a way as to have an 85% probability of profit. On the surface, that sounds very attractive. However, the losses for these trades can be quite large, even though their occurrence is unlikely. For example, a typical iron condor might be characterized as having an 85% probability of achieving a 19% return but a 100% loss with a 15% probability of occurrence. The expected return:Expected Return = (0.85)(19) – (0.15)(100) = 1.2%Or the calculation can be done with the dollar amounts. The 19% gain could correspond to a $1,600 gain and a maximum loss of $8,400. The expected return is:Expected Return = (0.85)(1600) – (0.15)(8400) = 1360 – 1260 = $100Therefore, trading this strategy over time and many trades is going to be close to break even, and probably a loser after trading commissions are included. Let’s consider the opposite style of trading and then draw some conclusions.Low Probability TradesLow probability trades are akin to the lottery ticket, i.e., the maximum loss is small, but the probability of success is also extremely small. There is a category of option spread known as “far out of the money vertical spreads”. The basic characteristic of this trade is a small maximum loss, but with a high probability of incurring that loss. An example might be a vertical spread that only cost $130 to establish, but could potentially return $870. Since the maximum loss is $130 with a probability of success of 12.5% and the maximum profit is $870, the potential gain is 669%, so the expected return is:Expected Return = (0.125)(669) – (0.875)(100) = 83.6 – 87.5 = -3.9%or,Expected Return = (0.125)(870) – (0.875)(130) = 109 – 114 = -$5So, the expected values of this low probability strategy result in small losses over time.ConclusionsTrading strategies come in all sizes and shapes to suit anyone’s style and risk preferences. But the reality is that none of these strategies have an inherent advantage. Some trading education firms and authors of trading books will often claim that they have found the holy grail of trading and have the “best” trading strategy. Each trading strategy has its own set of advantages and disadvantages. In addition, if each trading strategy was applied in a blind, “ put it on and let it run” methodology, the net results would be very similar: near break even or a small loser over time. However, the pattern of the results would be quite different. For the examples above, the high probability trading strategy would have many small positive gains throughout the year, but would be expected to have a small number of large losses that wipe out the gains. Whereas the low probability trading strategy would have a small number of large gains, but those gains would be wiped out by a large number of small losses.Therefore, one must manage the trade in such a way as to develop a probabilistic edge. The best analogy is a Las Vegas casino. If you analyze any of the games played in the casino, you will see that the odds favor the casino. The casino has a small probabilistic advantage, so the owners know that over time, they will come out winners. In stock and options trading, one must understand the probabilities and have developed a trading system that gives the trader a positive edge. You want to learn to trade like the casino, not the gambler at the tables.

Placing iron condor spreads on the broad market indexes is a relatively conservative, non-directional trading strategy that may be used for consistent income generation.  This strategy profits as long as the index trades within the channel formed by the two spread positions.  It is best used during sideways or slowly trending markets.Condor SpreadsA condor spread is a debit spread, established by placing a bear call spread at or above resistance and placing a bull call spread at or below support. The condor may also be established using puts with a bear put spread above and a bull put spread below.  The iron condor is a variation on this trade by using a bear call spread above and a bull put spread below the price of the underlying stock or index.  The iron condor is a credit spread and achieves maximum profitability if the price of the underlying closes between the short options (the strike prices we sold) of the two spreads at expiration.  In that case, all options expire worthless and you achieve the maximum profit, i.e., the credits originally collected.  The profitability of the iron condor is assisted by the fact that the broker only requires margin for one of the credit spreads, effectively doubling the return on investment.Condor spreads are effective when the underlying is expected to trade within the channel defined by the spreads during the life of the options.  The closer one places the spreads to the current price of the underlying, the higher the returns; however, this comes with a higher risk of the price of the underlying stock or index entering one of the spreads and causing a loss on that spread.Trading the stock indexes with condors is effective for several reasons: 1) the indexes generally move slower than most individual stocks, 2) the indexes are less affected by an individual stock’s bad news, 3) the premiums of the index options are generally much higher than individual stock options, 4) index options trade in high volume because large institutional investors use these options to hedge their portfolios; this results in high liquidity, and 5) 60% of the gains with broad index options are taxed at long term capital gains rates, regardless of the length of time in the trade. Money ManagementMoney management refers to the rules used for determining the amount of capital devoted to a trade and spreading risk among strike prices and time. Determine the total dollar value you wish to devote to this strategy.  For this example, we will assume we have a $100,000 account we will exclusively trade using the iron condor strategy.  Take 40% of the total portfolio ($40,000) and divide by $1000 to get 40.  This is the total number of contracts you will trade in this strategy each month (40 contracts total in the bear call spreads and 40 contracts total in the bull put spreads).  This approach lessens your exposure during any particular month and leaves you room in the account to put on next month’s positions before last month’s positions have expired. This also reserves an additional 20% of capital as a safety margin and for possible use in trade adjustments. IMPORTANT: when learning this or any options trading strategy, start very small with one or two contracts and gradually increase your size as your experience and confidence grow.Money management also includes the concept of limiting your losses. Playing iron condors on the indexes as outlined in this paper are conservative, high probability trades. However, the potential loss is quite large, even though the loss has a low probability of occurrence. Therefore, one loss may wipe out several months of profits. Stop loss and adjustment rules and the discipline to strictly follow them are critical to the success of trading iron condors. Those stop loss and adjustment systems are taught in detail in the Advanced Options Trading Strategies course offered by Parkwood Capital, LLC.Timing (Days to Expiration)You can establish your condor position sometime in the range of 40 to 50 days until expiration.  The precise time is not critical.  The trade-offs are as follows: the earlier I put on my spread positions, the more time premium is present in the options and therefore I can receive the minimum credit I am willing to accept farther out from the current levels of the index; therefore, more safety margin is achieved.  However, the more time I use in the spread, the more time that exists for the market to move against me; thus, I am incurring more risk.  As time decay reduces the option premiums, I must move my spreads in closer to achieve a reasonable credit, reducing my safety margin and increasing my risk.  It is also possible to trade the iron condor starting at about 30 days to expiration, but the system rules and adjustments must be adjusted accordingly.Determining Optimal Entry PointsSome traders place the call spreads when the index is hitting resistance and appears to be turning down, and place the put spreads when the index is hitting support and appears to be turning back upward. This will maximize the size of your credits. However, if the index continues to move in that direction, your position could be in trouble quickly and you will not have the compensating spread position helping to hedge your position. For this reason, I generally establish both the call spreads and put spreads on the same day.Choosing the StrikesWe can apply basic statistics to our deciding which strike prices are “far enough” out to be safe. The classic “bell shaped curve” we have seen in various contexts is the mathematical function known as a normal or Gaussian distribution. If we assume that future moves of the index price will be random and similar in frequency and absolute size to previous fluctuations up and down, then we can calculate the probability of the index price being at a particular price on a particular date in the future. I calculate the standard deviation for the index, based upon its level of implied volatility and the time left to expiration. The call spreads are placed just outside one standard deviation above the index price and the put spreads are placed just below one standard deviation below the index price. This results in an iron condor position with a probability of success of approximately 80-85%. The details of this methodology are taught in the Equity and Index Options course offered by Parkwood Capital, LLC.Entering the Order and Getting FilledNow that we have determined the strike prices for our spread, we need to calculate the credit we are going to ask for in our order. Compute the natural price for the credit spread, the natural debit spread price, and the midpoint of the spread (most online brokers calculate this for you).Enter your order at a credit limit at the midpoint and wait to see if the order is filled. After a few minutes, adjust the credit downward by $0.05. Repeat until both spread orders are filled. But do not drop below the lower quartile of the bid/ask spread.Never place an order for less than $0.60 to $0.70 in credit; trading commissions become too large a factor for smaller credits.  My spread credits normally range from $0.60 to $1.05 per spread or about $1.20 to $2.10 per iron condor.Stop Losses and AdjustmentsThe topics of setting stop losses and the variety of adjustment methodologies available are beyond the scope of this paper. An effective, but simple, risk management technique is to monitor the debit spread necessary to close your condor spreads, and when that debit is double the original credit received for that spread, close that side of the condor. This technique will close out positions more frequently, but it will result in very small losses or near breakeven results in the “bad” months when the index moves against you.Index Option SettlementIndex options are cash settled options; there is no underlying instrument like stock shares to be called away or put to you.  You simply lose or gain the dollar value at expiration, e.g., you hold 10 contracts of the $1400 call and the SPX settlement price is $1405; your account will be credited with $5,000 ((1405 – 1400) x 100 x 10). If you were short the $1400 calls, your account would be debited $5,000.Most index options are somewhat unusual in that they cease trading for the month at market close (4:15 pm ET) on the Thursday before expiration, but the settlement price is not that closing price on Thursday or the opening price Friday morning.  Therefore, all final adjustments to positions must be done on Thursday before the close. On Friday morning, the settlement price will be computed based upon the opening prices of each of the stocks that make up that index.  Since each stock may not trade immediately at the open, the settlement value may not be available until later that Friday morning. Since the settlement price may vary several dollars up or down from Thursday’s close, one must be cautious about going into settlement with any spread positions remaining open.Expected ReturnsIf you are placing your spreads for credits of $0.70 or more, then the returns for that iron condor will be about 15% for the month (remember that margin is only charged for one half of the iron condor).  If we are using roughly half of our capital for an iron condor each month, then you can expect to average returns of about 6% to 8% per month.  Of course, you may have to defensively close one of the spreads a few times per year and that will reduce the annualized return of this strategy. SummaryThe iron condor trading strategy is a relatively conservative, non-directional options strategy that may be used for consistent income. However, this strategy is typical of low return strategies with high probabilities of success.  The probability of a loss is small, but one large loss will wipe out several months of profits. Thus, the key to success for trading iron condors is solid risk management rules for entry and exit, stop losses, and adjustments. When deployed conservatively as outlined herein, this strategy should reasonably be expected to return 5% or more per month.