Constructing Trades to Maximize Profit

Many traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why Diversification. Because indexes are made up of many stocks, they usually don’t have big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’s not just selecting the right underlying to trade that is the challenge. A trader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well.

Three Looks at the Condor:Strike selection is essential for a successful condor. If strikes are too close together or two far apart, the trade can become much less attractive.Strikes Too Close The QQQs are options on the ETFs that track the Nasdaq 100 (QQQ).They have strikes in $1 increments, giving traders a lot to choose from. With QQQ trading at around $55.95, consider the 54555758 iron condor.In this example, with 31 days until expiration, the following legs can be executed:Buy 1 54 put at 0.80 Sell 1 55 put at 1.10 Sell 1 57 call at 0.75 Buy 1 58 call at 0.42 Total credit 0.63 In this trade, the maximum profit is 0.63. The maximum risk is 0.37.

This isn’t a bad profit-to-loss ratio. The break-even price on the downside is 198 Spreads $54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for a mover like the QQQ to occupy in a month. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes a loser. No one needs any fancy math to show that this is likely a losing proposition in the long run.

While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.Strikes Too Far:Strikes too far apart can make for impractical trades as well. Exhibit 10.7
shows an options chain for the Dow Jones Industrial Average Index (DJX).These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example,DJX is around $135.20 and there are 51 days until expiration.If the goal is to choose strikes that are far enough apart to be unlikely to come into play, a trader might be tempted to trade the 120123142145 iron condor.

With this wingspan, there is certainly a good chance of staying between those strikes—you could drive a proverbial truck through that range. This would be a great trade if it weren’t for the prices one would have to accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts are 0.25 bid. This means that the put spread would be sold at zero! The maximum risk is 3.00, and the maximum gain is zero. Not a really good risk/reward. The 142145 call spread isn’t much better: it can be sold for a dime.At the time, again a low-volatility period, many traders probably felt it was unlikely that the DJX will rise 5 percent in a 51-day period.

Some traders may have considered trading a similarly priced iron condor (though of course they’d have to require some small credit for the risk). A little over a year later the DJX was trading around 50 percent lower. Traders must always be vigilant of the possibility of volatility, even unexpected volatility and structure their risk/reward accordingly. Most traders would say the risk/reward of this trade isn’t worth it. Strikes too far apart have a greater chance of success, but the payoff just isn’t there.

Strikes with High Probabilities of Success So how does a trader find the happy medium of strikes close enough together to provide rich premiums but far enough apart to have a good chance of success? Certainly, there is something to be said for looking at the prices at which a trade can be done and having a subjective feel for whether the underlying is likely to move outside the range of the break-even prices.A little math, however, can help quantify this likelihood and aid in the decision-making process.

Recall that IV is read by many traders to be the market’s consensus estimate of future realized volatility in terms of annualized standard deviation.While that is a mouthful to say—or in this case, rather, an eyeful to read—when broken down it is not quite as intimidating as it sounds.Consider a simplified example in which an underlying security is trading at $100 a share and the implied volatility of the at-the-money (ATM) options is 10 percent.

That means, from a statistical perspective, that if the expected return for the stock is unchanged, the one-year standard deviations are at $90 and $110.1 In this case, there is about a 68 percent chance of the stock trading between $90 and $110 one year from now. IV then is useful information to a trader who wants to quantify the chances of an iron condor’s expiring profitable, but there are a few adjustments that need to be made.