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Iron Condor Option Trading Strategy Part-2

Published on April 22, 2007

Iron Condor Option Trading Strategy Part-2

April 22, 2007

We discussed about Iron Condor in Part-1. This is Part-2 in the same series that covers about when to sell and OTM or ITM?

After learning what is an Iron Condor, next thing one need to understand is how much time do we sell? You could sell an option with the highest theta, say expiration week? or least decay say a year’s worth of time (Leaps), but would that be worth while? Normally the answer to that question is No.

The nearest time, has literally no time value and hence will be very cheap. And it may not be worth the risk you are taking. The leaps will not decay fast enough so to give you good rate of return. We know that as options reach to the expiration week, time value erodes very fast. ATM will have the maximum time value and as further OTM you go, the value starts to decrease and will have very little value, and hence the risk/reward ratio starts to look uglier. Interesting!

As a seller, you want to collect as much premium as possible but at the same time you also don’t want it to be to close so as to risk underlying penetrating your territory and eroding your gains.

Based on mathematical formula, it has been noticed the time value erodes very fast when we are roughly 4 wks closer to expiration. If we sell 4 to 8 weeks prior to expiration than there is normally enough time value remaining to be able to sell a strike far enough away from the ATM value to make for a decent risk/reward picture. In the final weeks of expiration, the time value drains out very rapidly. And this is what as an option premium seller you want to see. So in my opinion, the best time to act on selling premium is when there are less than 8 weeks until expiration.

I normally vouch for selling OTM not the ITM. Why?

The price of the underlying may move sideways, it may move away from the strike you sold or it may towards the strike you sold. So as long as the strike sold remain OTM, there is not any value to and it will expire worthless, where you keep all of the premium sold. But when you sell an ITM strike, the price of the underlying MUST move in your favor to make money or you will be facing a loss as the time value will erode as it reaches towards expiration. This means you are facing a much higher risk factor. Another negative of selling an ITM option is that when we talk about selling options it is a given we are talking about selling a spread to control the risk, and also to keep the margin manageable. When you sell an option spread the maximum reward you can get is the premium that is sold, and most of the time your risk (amount of possible loss) is going to be as high or higher than the amount of premium that you collected. So when you sell an ITM spread, first the price must move in your favor, and no matter how big of a move it makes your reward is limited to the premium sold.

It is because of the high risk and low reward that I do not want to sell an ITM option. My goal is to sell TIME value, and the time of a strike that the price is unlikely to reach to change that strike from OTM to ATM or even ITM. That’s where the probability comes into play that I will discuss in the part-3.

Profitable trading, OptionPundit

11 Comments

  • BigMike says:

    Iron Condor & ITM/ OTM, what am I missing…

    Don’t ICs always sell 1 OTM and 1 ITM ?

  • OptionPundit says:

    Not necessarily BigMike…there are several ways to create IC. Mostly it is created by OTMs though.

  • slimetar says:

    Whats the rule regarding short strikes you use? Should they be at least 1 std deviation away or or have a lower delta something less than 10 or so? In that case it has lower gama and the condor can absorb smaller price fluctuations for the duration of time. Do you Condors vega into consideration or not?

  • Rapheal says:

    hi,
    good introduction but can you write part 3 faster? i have waited so long long…
    happy trading

  • OptionPundit says:

    slimetar, there are several rules that I have devised for my RUT iron condor strategy. Opening 1 std dev is a good start. I don’t really care too much about gamma for Iron condors as I already know what is my max profit, i just need to find the rangel underlying will be within. So is with Vega, I generall want to open when IV is high.

    Dear Rapheal, thanks for waiting for the part-2. Pls note that blogging is for hobby. Trading is more important that bloggin as that’s where I earn my money 🙂 so I don’t follow a particular pattern when to write. I generally write when I am free. I shall try writing this soonest but I don’t know how soon. Hope you understand that. Should I decide to convert this site into paid one, I shall pre-announce when to expect what.

    Thanks for your kind support to OP. Profitable trading.

  • chuck7 says:

    Thanks OP, I am signing up to your paid service, and look forward to more installments on profitable index credit spread trading. I want to learn money management strategies (when to close out a condor or leg so I can free up margin).

    Cheers,
    Chuck

  • iceman says:

    Hi, could you explain when you will start to adjust and how when price move against you?

  • OptionPundit says:

    Iceman, one of key alerts I have is 25 delta i.e. as soon as underlying start to move in my shorts’ direction in such a way that delta is 25 or greater, I start to adjust.

    There are multiple methods that I use for adjustments including new type of spreads/technical trading/addition of straight calls/put etc.

  • iceman says:

    Thanks for the super fast reply! 🙂 If I have 2 contracts on each leg, and it shown delta 0.19. After I sold them, my broker shown delta of about 40 on the sold leg. Does that mean I had to divide my 40 by 2 to see match the 25 delta? When it reached delta 25, do you close the losing credit spread and create another short credit with the same amount of credit that was created originally on the losing credit spread?

  • OptionPundit says:

    In theory yes. It is always a good idea to check the delta of individual leg single contract (any broker will have the option chains, real-time data available).

    If short delta reaches 25, I don’t blindly adjust the trade. It serves as a good guideline to start preparations. I also run technical analysis to form an opinion whether or not I should make any changes. Closing one and opening another one, is one of the many good ideas to adjust the losing side of the trade.

    Profitable Trading , OP

  • Jeff says:

    I was just reading your website article “Iron Condor Option Trading Strategy Part-2” posted back in April 2007. At the end it references a Part 3, but I cannot find it. Was it ever written? Thanks.

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