John Jagerson

Trading Iron Condors -- Part I

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To illustrate this strategy, we will use a case study in the video at the end of this article. The steps we will follow to enter an iron condor are as follows.

1. Liquid ETFs and index options

Costs are the enemy of option traders, and many trading costs are contained in the bid/ask spread. Because and iron condor has four legs (four different options) it has four bid/ask spreads, which can really add up to your disadvantage.

Liquid exchange-traded funds (ETFs) like the SPDR S&P 500 (SPY), iShares Russell 2000 Index (IWM) or SPDR Gold Trust (GLD), and index options have tighter spreads and, therefore, smaller costs. In our example we will use the S&P 500 ETF, which fits this liquidity requirement.

2. Create your profitability range

An iron condor starts with a short strangle. That means you are trading a short call and put that are both equidistant from the at the money strike price.

You are paid the premium from these two short options, but have potentially unlimited risk if the market moves beyond either strike. This is why many iron condor traders are tempted to make the range between the two short strikes very wide. (Get more information to help you understand strangles and selling options.)

This is where we run into the "high probability" problem. A wide range seems to make it more likely that the trade will end successfully, but it also increases the potential losses relative to profits if you are wrong. In the video on the next page, we will walk through some specific strike prices for our case study.

3. Cover the short options with long options that are even further out of the money

Short strangles make many option traders nervous because a short option has theoretically unlimited risk. One alternative to this problem is to cover each short option with a long option that is even further out of the money. This step adds a long strangle to the short strangle that has the affect of limiting the maximum risk in the trade.