What Your Mother Didn’t Tell You About Trading Iron Condors

Iron Condors are a great strategy for option traders. But like all things in life, there are some key points that you need to understand completely before jumping in with both feet. Iron Condors are a relatively conservative, non-directional trading strategy that when used properly can produce some very nice monthly returns.

As the payoff diagram above shows, this strategy profits as long as the stock or index you are trading stays within the two upper and lower spread positions. Sounds simple and easy right? Just find a market that is in a trading range and BOOM, you have a profit. Well, it’s just not that easy.

Our RUT Iron Condor Problem

Just last month we had a problem Iron Condor trade. And as always, I’m never afraid to talk about these “bad trades” because we can all learn from them. We had to make an adjustment to the position which cost us money and threw the trade into a slight loss overall. So what went wrong?

When I entered the position I was being extra conservative (as always) and had a very wide Iron Condor. But what happened on this particular trade was that I left more downside room anticipating a continued sell-off.

Below is the exact chart that I sent out with the trading alert…

Looking back now, I still would have done the same thing given a second chance. The markets can always fall much faster than it can rise. So leaving room for downside movement and volatility is a must!

Where this trade when wrong was that we got just the complete opposite. An unexpected and relentless move higher only seen a few times in the past couple years of this magnitude.

Being as the trade was getting close to the upper spread, I decided to roll the upper spread higher and take a small overall loss on the position at expiration. Looking back of course the market move lower right after we put moved our spread higher and had we not done anything we would have had a completely profitable Iron Condor.

Oh well, it was still the correct trade to make!

What Did We Learn?

Iron Condors are effective when the market or stock is trading in a tight range. Of course as traders we can never know for sure where the market is going which is why I’m so conservative in my own trading. The closer you place the spreads to the current price of the stock, the higher the returns, but this also dramatically increases the risk of a loss on that spread.

Iron Condor Money Management

Money management is always important with trading but more so with Iron Condors. This strategy naturally requires more adjustments with all the moving parts. I use my own set of adjustment rules and a strong discipline to strictly follow them in times of market volatility.

Establishing your Iron Condor position sometime in the range of 30 to 40 days until expiration is best. This will optimize the time decay feature of the options and still allow you enough time to get far from the market with the premiums. Anything inside of 30 days forces you to get way too close to the market’s current price.

The precise time is not critical of course, but suggested. Different market conditions will yield different opportunities and you have to balance the risks and rewards. If you enter the position earlier then you can get higher premiums and therefore increase your monthly income. However, the more time you give the market, the more risk exists for the market to move against you right? Experience really helps in this area.

Choosing The Right Strikes

I have learned over the years that probabilities are your best friend. Knowing what the likelihood is that the market will move to such and such price really helps determine if the trade is worth risking the money. And it’s these probabilities that keep me profitable overall.

With Iron Condors, you should apply some basic statistics when deciding if strike prices are “far enough” out of the money and safe. The classic “bell shaped curve” is something we have all seen in various areas can also be applied to the stock market.

If we assume that future moves of the market will be random and similar in frequency then we can calculate the probability of the market reaching a particular price point at some time in the future.

It’s this constant trade-off between risk and reward that we have to look at as option traders. I would suggest that you start out trading the spreads that have 80% probabilities of being successful and tweak your trading plan as needed from there.

IMPORTANT NOTE: Keep in mind that the “normal bell curve” may have fat tails in the stock market. These fat tails are the “Black Swan” type events that are rare but can cause huge losses.

Summary

The Iron Condor strategy is a great conservative, non-directional tool for options traders. If you focus on trading high probability spreads and stay away from the high return trap that some beginners fall into, then you will be well on your way to success.

Take your time with these as a beginner and learn how each part works when building the Iron Condor position.

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  • Dhruv

    [divider_line_dashed]Insert Your Text Here[/divider_line_dashed]

    What’s this? Some plugin has been removed or something like that?

    Anyway, nice article on iron condor. I am new to options and trying to analyse logic behind iron condor. So it seems like iron condor is not for trending market, right? Just wondering if we use in the money options for selling in the iron condor, will that help in trending market because premium is always high for in the money options. I am sure you can give me some advice on this.

    • http://optionalpha.com/ Kirk Du Plessis

      Yes when I updated the website theme some of these short codes didn’t follow over – I’ll go through and remove them one by one over the next couple weeks. Regarding the IC, yes they are not for trending markets and work best in high volatility markets and I would never sell ITM options.

  • Jaff

    Hi Kirk,
    Thats an excellent visual probability curve incorporating the time aspect. Is this from some software ? or is it just a diagram ?

    • http://optionalpha.com/ Kirk Du Plessis

      Just a diagram that I quickly put together but I think about it visually so this always helps me.