DESCRIPTION: A short iron condor is constructed by selling near but out of the money puts and calls and buying an upside call and a downside put (wings) to cover the risk of a large move. The wings are usually equidistant from the price of the underlying asset, and all the options have the same expiration. This is another way for investors to sell volatility.
MOTIVATION: The investor who sells an iron condor is looking for income and is capturing it by selling volatility. They place the trade with the expectation that the share price will trade within a certain range at the expiration date.
OUTLOOK: The seller of an iron condor is looking for stable price action over the life of the trade. An investor wants the shares to trade within a certain range while selling tail risk to earn income.
MAXIMUM GAIN: Premium Collected
The most an investor can make on a short iron condor is equal to the premium they collect when the initiate.
MAXIMUM LOSS: Max (High Call Strike – Low Call Strike, High Put Strike – Low Put Strike) – Premium Collected
The seller of an iron condo can lose money when the price un the underlying security moves outside the strike price on the near the money option. The loss is capped by the purchase of further out of the money options.
BREAKEVEN: Low Strike Call + Premium Collected, High Put Strike – Premium Collected
The breakeven levels reside just outside the two near the money strikes. The breakeven is just above the near strike call and just below the near strike put
VOLATILITY: Somewhat Negative. Near-the-money strike options are more sensitive to changes in implied volatility than ones that are further out of the money. As a result, the value of a short iron condor is negatively implied by an increase in implied volatility. An increase in volatility suggests there is a greater chance the price of the underlying security will trade at an extreme, increasing the probability of a loss.
TIME DECAY: Positive. The investor is counting on time decay to generate the income they are looking to collect by selling this structure.
ASSIGNMENT RISK: Significant. An American call option allows the owner of that call to take the position at any time. As a result, the short options that form the shoulder of the short iron condor are subject to early exercise. The investor still is still long the wings of the structure, which will limit loses to their predefined range.
EXPIRATION RISK: Significant. When the price of the underlying security is trading near one of the shoulders, the investor is uncertain if the owner of those options will exercise or not. If they do, the investor will have an unhedged position in the underlying instrument.
The real challenge is to figure out which strike prices to use. In volatility environments, iVol on options will be high so the price of those options will be high and the premium collected will tend to be higher. But in high volatility environments, prices swing around more radically so there is a bigger chance the price at expiration will be lower than the lowest strike option or higher than the highest strike option, resulting in a loss.
In our experience, there is a time for selling Iron Condors and they are times to do other things. When volatility is high like during the financial crisis, realized volatility tends to be higher that iVol and prices tend to trend in a downward spiral. As a result, sellers of Iron Condors in such an environment tend to lose money as the price falls and the loose money on the put wing of the condor. In times of low volatility, realized volatility tends to be even less than implied volatility. For the past 3 or 4 years we have seen VIX in the 10 to 13% range but realized volatility was in the 6 to 9% range. This phenomenon is a bit counter-intuitive, but it is what it is, so we must trade accordingly.
Now that we are in a high volatility environment with high equity valuations, rising interest rates and political risk in the international trade arena, not to mention populist movement in Italy, Spain, UK, etc. we may very well see surprises that spike volatility causing prices to plumit and spike along the way.