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Last week I discussed how I will be using vertical spreads on FANG stocks, like Amazon.com (AMZN), in my new FANG portfolio for Options Advantage subscribers. This week I want to discuss how I plan on using iron condors and the iron condor strategy in the new FANG portfolio. The portfolio will start trading towards the latter part of this month.
If you would like more details on the options strategies I am going to use in the new FANG portfolio, be sure to attend my free webinar on Wednesday.
First, a disclaimer of sorts. If you don’t understand the terminology, don’t be discouraged. Focus on the concept. Pay attention to the numbers; you’ll learn the terms with repetition.
An iron condor strategy is a non-directional options strategy that profits when the option on the underlying stock or exchange-traded fund of your choice expires within your chosen range at expiration.
The basic premise of the iron condor strategy is easy. You choose the price range of the trade. Increasing the range will decrease your potential profits, but will increase your likelihood of success.
Using the Iron Condor Strategy
The first requirement when trading iron condors is to make sure you are using a highly liquid security, like one of the FANG stocks. Highly liquid, in the options world, just means that the bid-ask spread is tight, say within $0.01 to $0.10, at least in most of the stocks and ETFs I trade.
For instance, take the heavily traded Netflix (NFLX).
The stock is trading for $138.41.
NFLX is just one of a small basket of stocks and ETFs that is considered “highly liquid” among most options traders. I focus my attention on only these underlying securities as it makes absolutely no sense to do otherwise from an efficiency standpoint.
I then move on to my mean-reversion indicator, otherwise known as RSI.
RSI can be seen at the bottom of the NFLX chart above. You’ll notice peaks (overbought) in green and valleys (oversold) in red. I typically want to place a trade when the indicator is in between those areas. It’s called being in a neutral state, but I’m going to offer a slight variation to the strategy today due the overbought nature of the trade. I’ll get to that soon.
An appropriate implied volatility rank and implied volatility percentile is also needed.
Without going into great detail (I’ll save that for the webinar) the IV rank and IV percentile simply tell us if the implied volatility is high or low in the highly liquid stock or ETF that we want to trade.
If it’s normal to high, we want to trade it.
A normal-to-high IV rank and percentile just means we can sell options for fair-to-inflated prices. And as anyone who sells anything for a living, your preference is to always sell your product for inflated prices. Options are no different.
Typically this type of setup occurs when a security moves from an oversold state back into a neutral state. When a security is oversold, it has trended lower, and thus, fear has increased. The increase in fear inflates the price of the option, because more investors are buying options for protection. And that’s the reason why prices are skewed slightly higher for put options.
So, assuming NFLX’s implied volatility is at least slightly above historic volatility (remember this is just an example), we can proceed to the next step: choosing your return.
Again, NFLX is trading for roughly $138.50.
I typically like to start with a trade that has a probability of success around 80%, if not higher. But I’m going use 80% as my starting point.
First, I look at the call side of the iron condor, also known as a bear call spread. I want to find the short strike with an 80% probability of success.
The February 150 calls fit the bill, with an 85.21% probability of success.
Next I look at the put side with the same goal in mind: a probability of success of around 80% or higher. However, since NFLX is overbought over the short term, and I strongly believe in statistical truths like mean-reversion, I want to increase my probability of success slightly. I’ll have to forgo some of my potential return to do so, but it’s a reasonable approach given my view on the market.
At 92.77%, the February 120 puts work. If I were to go with my typical 80% probability of success I would need to sell the 125 strike or higher. But again, in this example I want to take a more conservative approach, so adding a 4% margin of error to increase my probability of success by over 6% is worth forgoing roughly $0.20 in total premium on the iron condor trade.
So, right now I have my starting range of $150 and $120 established. Obviously, I can alter it as needed, but first I want a good base for my iron condor trade.
Iron Condor Strategy: What’s the Return?
By selling the 150/155 bear call spread and the 120/115 bull put spread simultaneously – thereby forming an iron condor – you can make $0.48, or 10.6%, over the next 29 days. If it pushed the put side up to the 125/120 strikes I could make roughly $0.73 for 23.4%. Again, and as always, it just depends on your appetite for additional risk.
With NFLX trading at $138.41, the underlying price in NFLX would have to breach the breakeven levels of $150.58 or $149.52 by February expiration before the trade begins to take a loss.
It would take a 8.7% move to the upside or a 13.6% move to the downside over roughly 29 days before the position is in jeopardy of taking a loss.
Best of all, the probability of success on the trade is a staggering 85% on the upside and over 92% on the downside. I like those odds.
I typically manage the trade by taking a loss if the spread increases to around roughly double the premium sold. I want to keep my losses small, knowing that I can make up for the loss if all goes well in the next trade.
Remember, we are trading math here. It’s all about allowing the probabilities to work themselves out amidst the iron condor strategy, so we want to try and keep losses to a minimum, knowing that if the statistics play out, our wins should far outweigh our losses.