lystn

Hey everyone, Kirk here again and welcome back to the daily call. On today’s daily call, we’re going to talk about how to setup an iron condor trade. Iron condors are more complex, more advanced option strategies. It’s a more complex with I guess an asterisk because it's really just a couple of more contracts. It’s actually a very simple strategy. But for a beginner, it might be a little bit overwhelming, so I want to talk through the basics of how we set it up and then I would give you some guidance on how you can figure out what strike prices to use, how far to go out, how wide to make you spreads, etcetera. The basics of an iron condor is really this. The whole strategy pins itself on capturing the stock within a range. I think about an iron condor as basically this big net and we’re trying to let the stock move, but still stay within our ranges, our range bound net. We’re trying to capture the stock and catch it inside of a bigger than normal range. To use and start using some numbers to put this into terms and maybe give you a visual on this, let’s say a stock is trading at $100. We might want to assume that the stock or try to profit from the stock trading anywhere between $110 and $90, so basically this $20 range, this $10 up or down move that the stock might go into. We want to build a strategy around that range and we don’t care where the stock lands as long as it lands in between of our range, our net if you want to call it that between $90 and $110. That’s really the idea behind this. We’re trying to capture premium, but we’re non-directional in nature, meaning the stock can go higher, can go lower, it can trade sideways. Really, this is one of the ultimate strategies for trading and the building block beyond a short strangle which from our back-testing, we know is quite possibly the ultimate trading strategy. This is a really good way to replicate that type of strategy in your account if you're trading a small account or an IRA or a retirement account, etcetera. The basic building blocks of an iron condor are this. The first thing you need is you need the inside short legs. This is effectively a short strangle. With an iron condor, you’re first going to sell inside short strikes out of the money on either end, the call side and the put side. Again, using our example from a stock that’s trading at $100, we would sell the 110 call options and we would sell the 90 strike put options. Those are going to be our inside wings or our short strikes, however you want to define them. But it's the starting point at which you start to build this range for the stock to trade in. That's where the range starts. Wherever your short strikes are, that’s generally where your range is going to start. Not assuming any premiums right now. We’re just talking just raw strike prices at this point. If I think a stock is going to trade between $110 and $90, then I’ll sell the short strikes at $110 on the call side and $90 on the put side. Now, at that point, you just have a short strangle. That's the inside legs. To create an iron condor, you need to define your risk. By define our risk, it means we need to buy options further out than our short strikes that we've sold. In this case, if we sold the 110 call, we would need to buy options and define our risk further out and buy say 115 call options and give ourselves a $5 wide spread on our call side strikes. On the put side, we might also buy the 85 strike put options and that again, gives us a $5 wide spread on the put side. By doing this, by adding those long legs, we now define our risk in this strategy and that's what gives us the ability to… If you have a small account or an IRA or a retirement account, then you could trade this because it has defined risk characteristics. If we didn't buy those long legs, we would have a short strangle and we would have undefined risk. Not saying that it’s bad. You just have to understand the concept and how the mechanics work. At this point though, our iron condor is now completely setup, so let’s talk a little bit about premium and then we’ll talk about strike prices and spread width, etcetera. The only difference or the major difference between doing the short strangle and the iron condor is the premium that you’re going to collect or the net premium I would say that you’re going to collect. Using our example from before, if we sold the inside legs for let’s say $200 in total, just to use even round numbers. We sold the 110 calls, we sold the 90 strike puts and we collected $200 of total premium. Well, that would be if we had a short strangle. If we have a short strangle and we collected $2 of total premium or $200 of notional premium in our account, then that would be all that we would collect. If we don’t need to buy options, then we keep that premium and that’s what we use for the rest of our trade to offset any movement or breakeven points, etcetera. With an iron condor now, you have to use some of that premium that you collected on your short strikes. We have to use some of that $200 to go out and buy options further out on either end. Now, we’re not going to use up all of that premium. We’re still going to have some net premium left or net credit left in our account that we still collect, but it’s not going to be as high as that $200 that we collected for the inside legs or the short strangle portion of our iron condor. Let’s say we have to go out and buy option premium and now, it cost us $1 or $100 of notional value to buy those other legs, the 115 call and the 85 put. If it cost us $1 now or $100, we’re now left with a net credit of $1 between our entire trade. All the buying and selling that we had to do, selling the short strikes on the inside, buying the long strikes on the outside or the further wings. We’re now left with $1 of total credit left over $100 of notional value. You can see that you obviously get less money. Usually it’s not as black and white as that’s worth. It’s just half of the price, so don't misinterpret that. But you just have to understand the concept behind it, is that you’re going to be trading with less overall credit. Less overall credit means your breakeven points are a little bit closer in than they would’ve been with a short strangle. It means you have a slightly lower probability of success. It’s typically not that much, but it’s a slightly lower probability of success. Now, the trade-off here of course is that with a slightly lower probability of success compared to a short strangle, then you have defined risk. It’s a very balanced trade-off. You have lower probability of success, but if things go really crazy, you have defined risk. You don’t have unlimited risk. Probability of success wise, it might be with a short strangle, a 72%, 73% chance of success. With an iron condor, it might go down to a 68%, a 69% chance of success. That's the difference that we’re talking about, a couple of percentage points. If you’re listening to this, you’re probably like, “That’s really nothing.” But over time, it might add up for sure and you might get less premium even though you have a higher or not so much of a drop-off in your success rate. When we start talking about “Well, where do we sell the short strikes? How far out do we sell these inside legs or this strangle portion of our iron condor?” What I always tell people is it comes back down to our toolbox software and our back-testing research. Not to say that that’s the only way, but that's the way that we use it. A typical way to do an iron condor setup might be to sell short strikes at a 15 Delta on either end and that might be a very generic way to do it. But we’ve asked the question before. “Is that the most optimal way in every time period? If you're 40 days out from expiration versus 60 days out from expiration, should you still be selling those short strikes at 15 Deltas or does another Delta work, maybe a 25 Delta or a 20 or a 10?” That’s why we build our toolbox software to be able to do, is to give you that information on the fly very quickly using our trade-optimizer to tell you, “Hey, you need to sell short strikes at a 20 Delta and do the spreads on either end $3 wide or $5 wide or $10 wide.” That’s the type of stuff that we've been able to do with our research and now, our software which is the toolbox software. It gives us more power to be able to systematically go after higher probability of success setups over longer periods of trading. If you want to learn more about that, obviously you can go to optionalpha.com/toolbox. But the whole idea here is that you can definitely setup all your trades if you want to without it. No problem. You can set them up. 15 Delta on either end is a good starting point, but it may just not be the most optimal period or optimal strike price to setup your trades depending on where implied volatility is and depending on how far out you are until expiration. Either way, hopefully you guys enjoyed today’s little call on how to setup an iron condor. If you obviously have questions, please let us know. Until next time, happy trading!