Understanding Iron Condors, Part IV, Strike Prices
When trading iron condors (see also part I, part II, and part III) you are looking for a trade that has a good probability of being profitable. For the trade to be worthwhile, you should be trying to earn a minimum profit (the reward) because the trade involves the risk of losing money. Many investors refer to this as an acceptable risk/reward ratio. When you initiate a trade for which both the risk and reward are acceptable (to you), then you are within your comfort zone.
That requires finding a good compromise between two conflicting objectives.
- It’s important to sell call and put spreads that allow you to earn a good profit. There is no point in taking risks to earn almost nothing. That profit is earned when the options expire worthless, or are repurchased for far less than the original selling price. Too many investors believe a good iron condor trade is to collect $0.10 for the call and put spreads, knowing there is at least a 90 to 95% chance of seeing the options expire worthless. That’s a very poor strategy. Please avoid the trap of selling options for very low cash premiums.
- The idea is to minimize the risk that one of the options you sold eventually moves, or threatens to move, into the money. Further out of the money (OTM) options are much more likely to expire worthless than options that are closer to the money (CTM). Selling CTM options allow you to collect more cash, providing the opportunity to earn a larger profit. As an alternative, CTM options can be repurchased more quickly – after earning an acceptable profit. There is no need to hold the position until expiration.
NOTE: Exiting early means the options cannot expire worthless, but if you meet your profit goal, taking the money, closing the position, and sitting on the sidelines (with no risk) until it’s time to open a new position, is a reasonable course of action.
Selling CTM spreads runs the risk that one of the spreads you sell moves into the money and that you may have a losing trade. On the other hand, selling option spreads that are too far OTM generates a small quantity of cash – and that cash is your potential profit. The less cash you collect, the longer you will hold the position (to earn as much of that premium as possible). Holding longer increases risk – because something unfavorable may occur.
It’s also important to own a position that does not result in anxiety or loss of sleep. It may be difficult for the new iron condor trader to know – in advance – which option spreads to sell, but if you begin by trading small size, you can gain experience and allow your comfort zone to define itself.
Recommendations to help you get started trading Iron Condors:
1. Unless you have specific stock to trade, I suggest trading iron condors on cash settled, European style, index options.
2. You may change your style later, but begin with spreads that are as near each other as possible when trading the higher priced indexes. That means 10-point spreads for RUT, 25-point spreads for NDX. SPX options offer more strike price choices, and sometimes you can choose anything from 10- to 25-point spreads.
3. I suggest OTM options, but not far OTM. That means don’t sell spreads for small amounts, such as $0.10 or $0.20 when the strike prices are 10- points apart. If you trade an ETF (QQQQ or SPY – these are American style options) for which the strikes are 1-point apart, then this does not apply.
4. How much to seek in premium depends on the price of the underlying index, the implied volatility, and the time to expiration. Thus, it’s difficult to provide guidelines. (My Book, The Rookies Guide to Options, provides several detailed examples of how to choose which options to trade.)
See Also: Iron Condors Part I, Iron Condors Part II, Iron Condors Part III, and Iron Condors Part V.
Mark Wolfinger is a 20 year CBOE options veteran and is the writer for the blog Options for Rookies. He also is the author of the book, The Rookie’s Guide to Options.
Further Reading, Options Trading:
- For Options Beginners, What Is An Option?
- 6 Great Option Strategies For Beginners
- 7 Reasons Investors Should Trade Options
- Options Basics Quiz
- 9 Option Terms Every Investor Should Know
- Entering an Order to Buy or Sell Options Investor Series, Part I
