One of my favorite trading strategies—and one that big-time money managers and volatility traders use—is trading an iron condor.
An iron condor is selling a downside put spread and an upside call spread at the same time. In this scenario, you cap your risk because you have a spread with a defined loss.
A common phrase you’ll hear is that selling options is “picking up pennies in front of a steamroller.” It simply refers to the fact that you have potential to make a little money, but also the potential to lose a lot. The iron condor setup eliminates the steamroller, allowing you to compound your pennies and generate a significant income stream over time.
At the outset, the iron condor strategy is a market-neutral trade. You are not making a prediction on which way the market is headed. Rather, you are making a bet that the market will not have a large move in either direction before the expiration date of the options that we are selling.
Most traders execute iron condor strategies on very short-term expirations (one month or less). The main reason for this is the compounding. If we can extract premium every month, then the compounding effect really starts to become a tailwind.
How Do You Place This Trade?
Let’s start with an example with a $100,000 account.
My preferred underlying instrument is SPX (the S&P 500 index). It’s super liquid, cash settled (you’ll never be assigned on stock or have to sell stock that you don’t own), and it’s the standard benchmark used by money managers.
When I select the strikes, I usually look for the short strike on each leg to be approximately 3%–5% out of the money depending on how pricing (risk/reward) is set up. When I was writing this article, the SPX closed at 4184. Therefore, today I’m looking at:
Sell May 20th expiration 4400/4455 call spread for $12.40
Sell May 20 expiration 3990/3935 put spread for $9.50
Total premium collected = $21.90
Let’s say you trade one contract, which would get you $2,190 of cash up front. The most you can lose on this trade is $2,810 ($5,000 strike width—the premium collected).
If SPX stays between 3990 and 4400 for the next four weeks, you will make all $2,190. Even if the market stays within this range for a few weeks, you will likely be able to close the trade at a gain, as option values decay over time.
If $100,000 is way too much, you can follow the same principles with $10,000 or even $1,000, although you might have to use a different underlying stock. SPDR S&P 500 ETF Trust (SPY) would be a nice alternative as it’s an ETF one-tenth the size of SPX.
While your potential loss exceeds your potential gain, the likelihood of winning on the trade is significantly higher than losing on the trade due to how far the market would have to move in a short time period to realize a loss. It would take more than a 5% move by the option expiration in either direction for this trade to settle at a loss.
Even though your max loss is around 3%, don’t allow it to get to that point. You don’t want to hit the max loss. As such, there are trigger points at which you would roll this investment out to the next month and reset your strikes. A trigger could happen either once the trade reaches a certain loss, or if SPX approaches one of the strikes that you have sold (in this case 4400 on the upside or 3990 on the downside).
How Much Can This Trade Make?
Likewise, you would probably want to close the trade and roll it out to the next month once you have realized a sizeable gain on the trade (maybe 80% of the max potential gain—in this case $1,600 or 1.6% of your account).
Compounding is a beautiful thing. The more we can realize our monthly premium and the better we get at cutting losses when things don’t go our way, the greater the reward will be. While 1.6% doesn’t seem like much, on an annualized basis it works out to 20.9%!
This is not a get rich quick scheme; it’s a sustainable way to earn an income with a true cap on losses in times of increased volatility.