When we encounter a stock that is non-trending or drifting sideways, we look to enter an Iron Condor. This strategy involves both a Bear Call Spread and a Bull Put Spread. We look to enter this type of spread when we don't expect any news or major event to take place in the current options cycle that might cause the stock to find momentum in either direction.

In an Iron Condor, we are going to place our credit spreads in conservative support and resistance areas. If successful, we can profit on both sides of the stock. The main advantage with this spread is that if you have the right broker, they will only use one of the spreads (either call or put) for the margin requirement. This is because the broker only expects us to lose on one side of the stock (Call or Put side). Due to this, we can go further out-of-the-money and collect less premium because we are bringing in two credits in this strategy. When you combine two smaller credits, we usually have a nice profit in this spread.

In our previous examples of a Bull Put Spread and Bear Call Spread, we used the example of our January Google spreads. When you combine these two, you have an Iron Condor. It is worth mentioning that it does not matter when you enter each side of the spread. Whether you leg into them by placing one credit spread and then waiting to enter the other spread, or you enter them both at the same time. The important thing is that both spreads are the same point-spread and expire in the same month. This way your broker will only require funds to place the first spread (either put or call) as long as you have the right broker. You will want to confirm with your individual broker that this is the case for your account. If not, you might want to switch to one of the brokers listed on our Auto Trade page.

Let's look at how we entered an Iron Condor on Google. In this case, we entered them both the same day. On Monday, December 11, 2006, we sent out the following New Trade Alerts.

NEW TRADE ALERT

Google Inc.

January GOOG Bull Put Spread

Sell 10 Jan. puts at 440 strike price

Buy 10 Jan. puts at 430 strike price

Total Credit $0.85 per contract

Potential Profit $850.00

Google Inc.

January GOOG Bear Call Spread

Sell 10 Jan. calls at 530 strike price

Buy 10 Jan. calls at 540 strike price

Total Credit $1.30 per contract

Potential Profit $1,300.00

Total Potential Profit for Iron Condor

$2,150.00

BULL PUT SPREAD DESCRIPTION

In this trade, we sold 10 contracts (1 contract equals 100 shares of stock) of the January 440 puts for a credit of $3.25 per contract. To figure the total credit that you receive for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $3.25, which comes out to a total credit of $3,250.00.

If you simply entered this trade without purchasing the January 430 puts, you would leave yourself open to downside risk if the stock fell. In order to protect ourselves from an extreme downward move in the stock, we finish the spread by purchasing 10 contracts of the January 430 puts for a debit of $2.40 per contract. To figure the debit that you pay for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $2.40, coming out to a debit of $2,400.00.

When you enter both of these positions at one time, you are placing a credit spread. In this trade, you would receive the difference between the puts you sold (January 440 puts) and the puts you purchased (January 430 puts) into your account. Your broker would place that $850.00 into your account when you enter the position. As long as Google closes above $440 at the end of trading on the third Friday in January, you get to keep the $850.00.

With Google trading at $483 when we entered this position, we have a 43-point cushion. By placing our credit that far away from the stock price, we reduced our risk dramatically. This is one of the reasons why we have such a high percentage of profitable trades.

With that large cushion between the stock price and the puts we sold, you might wonder why we purchased the 430 puts. Even though it cuts down on the premium that we collect, we feel that it's important to limit our risk in case of an extreme move against us. In this case, we have limited our loss to the amount between the puts that we sold and the puts that we bought, minus the premium that we collected.

We then subtract that difference from the premium that we collected when we entered the spread.

We then take that amount, $9.15, times the number of shares (10 contracts times 100 shares per contract) and we get a total risk of $9,150.00.

It is true that spreads in general will have a negative risk to reward ratio. However, by putting on spreads that are out of the money, we are able to have a track record of highly profitable trades month after month. Everyone has heard that nearly 80% of options expire worthless. We love that figure because as option sellers, we want both the options that we bought and sold, to expire worthless on the third Friday of each month.

One thing you will notice when you enter a spread, is that your position window will probably show the spread losing money for the first few weeks. Even if the stock has not moved against you, your broker will possibly show you as having a loss, although your cash balance in the account will show the credit of $850.00 (which will be earning you interest if you have the right broker). As the expiration date nears, this loss will turn into a profit as time decay starts to eat away at the value of the options. You may want to enter some paper trades with your broker to see how the time decay and position balances react in a credit spread.

BEAR CALL SPREAD DESCRIPTION

In this trade, we sold 10 contracts (1 contract equals 100 shares of stock) of the January 530 calls for a credit of $4.40 per contract. To figure the total credit that you receive for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $4.40, which comes out to a total credit of $4,400.00.

If you simply entered this trade without purchasing the January 540 calls, you would leave yourself open to an unlimited upside risk if the stock moved above $530.00. In order to protect ourselves from an extreme upward move in the stock, we finish the spread by purchasing 10 contracts of the January 540 calls for a debit of $3.10 per contract. To figure the debit that you pay for entering this position, take the number of contracts (10) times the number of shares of stock in a contract (100) equaling 1,000 shares times the price per contract $3.10, coming out to a debit of $3,100.00.

When you enter both of these positions at one time, you are placing a credit spread. In this trade, you would receive the difference between the calls you sold (January 530 calls) and the calls you purchased (January 540 calls) into your account. Your broker would place that $1,300.00 into your account when you enter the position. As long as Google stays below $530 until the end of trading on the third Friday in January, you get to keep the $1,300.00.

With Google trading at $483 when we enter this position, this gives us a 47-point cushion. By placing our credit that far away from the stock price, we reduce our risk dramatically. This is one of the reasons why we have such a high percentage of profitable trades.

With that large cushion between the stock price and the calls we sold, you might wonder why we purchased the 540 calls. Even though it cuts down on the premium that we collect, we feel that it's important to limit our risk in case of an extreme move against us. In this case, we have limited our loss to the amount between the calls that we sold and the calls that we bought, minus the premium that we collected. 

We then subtract that difference from the premium that we collected when we entered the spread.

We then take that amount, $8.70 times the number of shares (10 contracts times 100 shares per contract) and we get a total risk of $8,700.00.

IRON CONDOR AT EXPIRATION

In this trade, Google closed at $489.75 on the third Friday of January. Because this was above our strike prices of 440 and 430 on the put side and below our strike prices of 530 and 540 on the call side, all the options expired worthless. Due to this, we were able to keep the credit ($2,150.00) that we received when we entered the spread. This is the goal for all of our spreads.