Many options investors who are new to the Iron Condor strategy might question why they should trade the Iron Condor instead of a Short Strangle.
An Iron Condor trade consists of selling an out-of-the-money (OTM) put and buying a deeper OTM put for protection, then at the same time selling an OTM call and buying a deeper OTM call for protection. The investor receives a net credit for the four-legged transaction as the short (sold) options have a higher premium than the long stock options. In simpler terms, it is a combination of a Bull Put Credit Spread and a Bear Call Credit Spread.
Let’s look at an example:
- XYZ is trading at $110.
- Sell 120 Call for $1.25.
- Sell 100 Put for $0.75.
- Buy 125 Call for $0.65.
- Buy 95 Put for $0.20.
- Total Net Credit = $1.15 (2.00 – $0.85).
As long as XYZ stays between $120 and $100, all four stock options will expire worthless and the investor will keep the net credit. By purchasing the outside stock options the potential risk is limited. If the stock goes to $130 for example, the investor is obligated to deliver shares of stock at $120, but has reserved the right to buy shares of stock at $125. The maximum loss on the position is $3.85 (5 point max loss – the net credit). This means that the margin requirement for the Iron Condor trade (for 10 contracts) would be:
- $3.85 * 10 * 100 = $3,850.
- The maximum % return would be: $1,150/$3,850 = 29%.
In comparison, the Short Strangle consists of selling an OTM put and an OTM call just like the Iron Condor, however, the investor does not purchase the deeper OTM put and the deeper OTM call.
The similar Short Strangle trade would be:
- Stock XYZ is trading at $110.
- Sell 120 Call for $1.25.
- Sell 100 put for $0.75.
- Total Net Credit = $2.00
Because the investor does not purchase the outside options, the Total Net Credit is $0.85 higher. Also, this is only a two-legged strategy so the investor will save on commissions cost.
So why would an investor ever trade the Iron Condor over the Short Strangle?
The reason is simple: The margin that is required for the Short Strangle is much higher than the requirement for the Iron Condor. Although brokerage houses differ in their requirements, the standard requirement for the Short Strangle trade is the call strike price + the put premium * # of contracts * 100. In our example (for 10 contracts)…
- Margin requirement would be: (120 + $0.75) * 10 * 100 = $120,750.
- The maximum % return would be: $2,000/$120,750 = 1.6% return.
The purchase of the outside wings in the Iron Condor trade limits the margin requirement for the trade. In the above examples an investor would look to make $1,150 against a $3,850 investment with the Iron Condor trade. With the Short Strangle the investor has no outside protection and is exposed with two naked options. In the similar Short Strangle trade the investor could make $2,000 but it is against a $120,750 investment. This is why it is generally better to trade an Iron Condor instead of a Short Strangle.
Here’s another thought: With $120,000 set aside an investor could place a 10 contract Short Strangle trade as outlined above, however, they could diversify their personal stock portfolio and place three 10 contract Iron Condor trades. This limits the overall exposure if the first selected trade were to go against the investor.
The margin requirements listed above are based only on the standard of some options brokerage houses. Many online options brokers will only require you to cover one side of the Iron Condor spread (as shown in the example). The theory being that if the stock or index goes against the investor in one direction, the other side of the spread will be further OTM and at less risk. However, some brokerage houses still might require the investor to cover the margin on both sides of the Iron Condor spread.
If you use a broker who has lower requirements for the Short Strangle or Iron Condor trades, let us know!
[tags]iron condor, short strangle, stock options[/tags]
Michael Mathews
It is really more complicated then that. The risk vs reward is much safer with the naked strangle. The Iron Conder gives one the opportunity to make more money on the trade while risking everything which is very unwise. Remember that a credit spread is actually the same thing as naked options for the spread. With naked options there is the theoritical absence of a limit but if one suffers the loss through the entire spread the loss can be one’s enitre account.
Richard W
Michael, I’m not sure I understand your statement. It sounds like you have mixed up the definition of the iron condor and the strangle. For the same sold put and call, the strangle (which is naked) will always make more money because you don’t give up some of that premium to buy the protection. However, whereas the iron condor loss is limited (roughly) to the difference in the strike between the sold option and the protective one you bought, the strangle loss is the difference between the price of the security at expiration and the closer strike of the two sold options. So on the low side, the worst case scenario is the security drops to zero, and you are forced to buy a worthless stock at the strike of the put you sold with no way to get any money back out of it. On the high side, the loss could be infinite as the security price could rise without limit until expiration, so you have infinity-call strike = infinity, though practically speaking, it’s hard to imagine a stock going up infinitely. But if your 40 dollar stock with a 55 dollar long call hits 220 bucks after inventing the cure for cancer, you’ll wish it had dropped to zero instead. I think that is the loss of the entire account you mentioned, which is the risk of the strangle, not the iron condor, correct?
mike
The comments by Michael Mathews and Richard W seem to add confusion to the already confusing explanations and conclusions.
Shesh
Assuming I have the margin, does keeping a market stop loss work cheaper than iron condors?
Gesmin goh
I bought a strangle recently dte 48days, can i wait for worthless (auto close if otm) or do i need to close it before worthless?