To address this concern, Maya suggested two alternative approaches to Tara: using stop-loss orders or transforming both sold options into credit spreads by purchasing far out-of-the-money (OTM) options.
This transformation turns the short strangle into a well-known strategy known as Iron Condor.
Iron Condor:
Tara, intrigued by the idea, asked Maya to elaborate on the Iron Condor and its popularity. Maya, appreciating Tara’s enthusiasm for exploring new trading strategies, gladly obliged. She explained, “The Iron Condor is a versatile options trading strategy known for its popularity among traders looking to limit risk and generate consistent income. It’s a valuable tool in an investor’s toolkit.”
“But why is it so popular?” Tara inquired further.
Maya replied with a smile. “The Iron Condor gains its popularity for several reasons. Firstly, it allows traders to profit in neutral or range-bound markets, which is a common market scenario. In other words, it’s effective when you believe that the underlying asset will stay within a certain price range.”
Tara was eager to grasp the concept and asked, “Could you explain it in more detail, Maya?”
“Sure, let me illustrate with an example,” Maya began. “The Nifty October futures are currently trading around the 19950 level. Suppose you anticipate a sideways market for the next two months, with Nifty expected to remain range-bound. In this scenario, you can create an Iron Condor. Here’s how it works: First, you would simultaneously sell an out-of-the-money (OTM) 20200 call option for 160 points and an OTM 19700 put option for 167 points. This creates a short strangle and generates a premium of 327 points, which is also the maximum profit. However, it’s essential to note that the maximum loss is unlimited.”
“So, you’re essentially betting that Nifty will stay within the range of 500 points, between 19700 and 20200?” Tara sought clarification.
“Exactly,” Maya confirmed. “If Nifty expires within this range in October, we achieve the maximum profit. However, the breakeven points would be 327 points beyond this range but in the event of a significant price move, losses can escalate beyond control. To safeguard against unexpected price movements, you also buy a higher strike call, like the 20500 call for Rs 70, and a lower strike put option, the 19400 put for Rs 100. This creates a ‘condor’ around your naked option sell positions, costing you a premium of 170 points but limiting your maximum profit to 157 points. On the flip side, your maximum loss is also capped at 143 points. The payoff chart for this strategy will resemble this.”
“So, you end up with four options in total?” Tara clarified.
“Yes, Tara,” Maya confirmed. “You sell two options (one call and one put) and buy two options (one call and one put) with different strike prices, thus creating a ‘condor’ spread.”
Tara was concerned about the reduced profit potential due to hedging and asked, “Maya, when we convert our short strangle to an Iron Condor, our maximum profit potential nearly halves, from 327 points to 158 points in this example. So, if we’re confident about a range-bound market, is the short strangle a better strategy than the Iron Condor?”
“Well, Tara,” Maya replied, “In the markets, nothing is certain, and no one can predict the future. However, the Iron Condor is generally preferred over the Short Strangle, provided you select your strike prices wisely and initiate the position at the right time. This preference arises because the margin required to create a Short Strangle is more than double that of an Iron Condor. Therefore, with the same amount of capital, you can create twice as many Iron Condors as Short Strangles, achieving a similar Return on Investment (ROI) but with limited risk.”
“So, when should we consider entering Iron Condors?” Tara asked.
“For Iron Condors, we look to enter positions when premiums are high. These elevated premiums can result from high implied volatility (IV) or a longer time until expiry. That’s why, in our example, we chose the October month expiry, as it offers higher premiums due to the time factor,” explained Maya.
Tara was following along but still had questions. “In case the market doesn’t stay range-bound and moves significantly in one direction, how do we manage that, Maya? What adverse moves should we be cautious about?”
“Great questions, Tara,” Maya acknowledged. “With an Iron Condor, you should closely monitor the underlying asset’s price. Your goal is for it to stay within the range defined by your strike prices. If it does, you collect the premium from the options you sold. However, if the price moves too far in either direction, you could incur losses. The two adverse scenarios to watch out for are a sharp move in the underlying asset’s price beyond your strike prices or a sudden spike in volatility, which can inflate option prices.”
“What if things don’t go as planned?” Tara wondered.
Maya smiled, knowing that risk management was a crucial aspect of options trading. “Experienced traders have several techniques to manage Iron Condors. They might adjust the strike prices, roll their positions to a different expiration date, or even close out one side of the trade to minimize losses on that leg. It’s all about adapting to changing market conditions, and every experienced trader has their own ways of handling it. One critical thing to remember while making adjustments is that your overall risk should not exceed your risk appetite or risk management goals. If it does, it’s often better not to adjust and accept the actual loss.”
“This was very insightful, Maya. I now understand why the Iron Condor is a popular options trading strategy. It’s because of its versatility and potential for generating income in a range-bound market. Thanks, Maya, for explaining options and these various strategies,” said Tara.
Maya responded, “You’re welcome, Tara. Just remember, it’s crucial to identify a sideways market for implementing this strategy and not a strongly trending market. To do that, you can use various technical analysis tools like ADX or ATR, which can provide insight into the strength of a trend.”
With this, Maya bid farewell to Tara, leaving her equipped with knowledge and eager to implement what she had learned.
(The author is CEO Yubha.com, TradingHeads.com)
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)