Markets

Options Strategy of the Day: Using a Condor to Profit from Falling Volatility

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While volatility is trekking higher once again, the CBOE Market Volatility Index ( VIX ) is stalling near the round-number 30 level once again. In fact, the 30 level has long been a technical sticking point for the VIX, with the so-called "fear barometer" peaking at this round-number level on several occasions dating back to July 2009. Should volatility once again decline from near-term peaks, so too will options prices. Novice investors will merely note that the covered call positions they are rolling forward are pulling in less of a premium than they were last week. Veteran options traders, however, realize that you can profit from declining volatility in the current market environment.

One strategy designed to capitalize on both imploding volatility and flat-lining stocks is the iron condor . Overall, this options strategy is designed to take advantage of time decay, with the trader typically betting on the underlying shares to remain range-bound through option expiration. As such, traders employing this options strategy tend to avoid equities with potential momentum-inducing catalysts, such as earnings reports or sales releases.

The trade is essentially the combination of a short put spread and short call spread. More specifically, the position is initiated by opening four separate options: sell an out-of-the-money put, buy a further out-of-the-money put, sell an out-of-the-money call, and buy a further an out-of-the-money call. All of the options should have the same expiration date, and the position should be established for a net credit.

As hinted at above, the objective of the iron condor is for the underlying security to finish within a strict trading range by option expiration. In this instance, all four of the options will expire worthless, allowing the trader to pocket the net credit received at initiation. This represents the most the trader can possibly gain on the play.

While the trader's profit is limited, so too is his loss. More specifically, the iron condor's maximum potential loss is limited to the difference between the bought put/call strike and the sold put/call strike (depending on whether the stock moved higher or lower), less the initial net credit. In order to avoid a loss, the stock must remain pinned between two breakeven rails through options expiration. The lower breakeven level is equal to the difference between the sold put and the initial net credit, while the upper breakeven level is calculated by adding the net credit to the sold call strike.

Breaking Down an Example

The best way to fully appreciate the potential of this options strategy is to take a look at an example. Let's assume that XYZ Solutions Inc. ( XYZ ) has been batted around by market forces during the past several weeks, with the shares hitting long-term support near 60 and overhead resistance in the 65 region. In an attempt to take advantage of this situation, you decide to employ an iron condor.

Since you believe that XYZ will remain contained between the aforementioned support and resistance levels, you sell out-of-the-money July 60 put, which was last bid at $0.70, as well as an out-of-the-money July 65 call, which as last bid at $0.60. For the "wings" of your iron condor, you simultaneously buy the out-of-the-money July 55 put, which was last asked at $0.20, and the out-of-the-money July 70 call, which last crossed at $0.14.

Since the premium received from the sold options exceeds the premium paid for the purchased options, your iron condor is initiated for a net credit of $0.96 ([$0.70 + $0.60] - [ $0.20 + $0.14]). As such, you need XYZ to remain between $59.04 per share ($60 - $0.96) and $65.96 per share ($65 + $0.96) through expiration to avoid incurring a loss on the play.

A hypothetical iron condor on XYZ

Potential Outcomes

There are several potential outcomes for this iron condor position. Under the best-case scenario, XYZ closes between $65 and $60 per share when July options expire, allowing you to retain the $0.96 net credit received when establishing the position.

However, what happens if XYZ takes a turn for the worse and falls to $50 per share at expiration? In this case, the two call options will expire worthless. However, the sold 60-strike put will finish 10 points in the money, and the purchased 55-strike put will close 5 points in the money. To exit this leg of the position, you will need to repurchase the written July 60 put for $10, and sell (to close) the July 55 put for $5. Subtracting the net credit of $0.96 received at initiation, your loss adds up to $4.04, which represents the maximum risk on the iron condor.

On the other hand, if XYZ were to rally to $75 per share by July options expiration, the two put options would expire worthless. The sold 65-strike call would finish 10 points in the money, and the purchased 70-strike call would close 5 points in the money. You would exit the trade in the same fashion as noted above, repurchasing the written July 65 call for $10, and selling (to close) the July 70 call for $5. Subtracting the net credit of $0.96 received at initiation, your loss adds up to $4.04.

Wrapping Up

In conclusion, the iron condor requires a moderate degree of accuracy in order to achieve a profit. As such, only veteran option traders should attempt this trade. However, if you decide to take flight with an iron condor strategy, you can improve your chances of achieving a profit by targeting low-volatility stocks with a lack of potential technical triggers, as an unexpected price swing can ruin even the best prepared positions.

Furthermore, strategists should consider trading near-term options, as time decay is the iron condor trader's best friend. By targeting short-term options over their longer-term counterparts, the underlying stock will have a narrower window to make any potentially detrimental moves on the charts.

Schaeffer's Investment Research Inc. offers real-time option trading services, as well as daily, weekly and monthly newsletters. Please click here to sign up for free newsletters. The SchaeffersResearch.com website provides financial news, education and commentary, plus stock screeners, filters and many other tools. Founder Bernie Schaeffer is the author of the groundbreaking book, The Option Advisor: Wealth-Building Techniques Using Equity & Index Options .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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