In my previous post, I talked about compounding money at a rate of 5% per month… This may not sound like a lot, but if you understand the power of compounding, you’ll appreciate that with 5% per month, your money will grow by about 79.5% in one year!!! I don’t know about you, but I’ll be pretty satisfied with such growth rate… imagine getting a 79.5% increment in your wage every year….

So, the million dollars question (no pun intended) here is: How to grow your money at 5% per month…

My answer? SELL IRON CONDORS….

What are Iron Condors?

An iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit. It consists of a combination of a bull put spread and a bear call spread*. It is best used when one predicts that the underlying asset (e.g. a company’s stock) will not move beyond a certain price range.

For instance, let’s consider an actual iron condor position in GS (Goldman Sachs) that I had in the month of August.

Using options expiring on the same expiration month (August in this case), I created an iron condor by selling a lower strike OTM Put ($145), buying an even lower strike OTM Put ($140), selling a higher strike OTM Call ($175) and buying another even higher strike OTM Call ($180). This results in a net credit of $131 per lot (before commission).

Notice that an Iron Condor ONLY involves OTM options. Since I sold a OTM Put and a OTM Call, I have no risk of being assigned as long as GS trades within $145 to $175. That’s a pretty wide range for a stock to move within a month. In addition, the 50% and 61.8% Fibonanci levels of GS was at $149.14 and $173.35 respectively. So I was pretty confident when putting on this trade. Eventually, the trade went well and all the options expired worthless.

(How I view Iron Condors….)

Why do I love Iron Condors?

Limited Risk

Maximum loss for the iron condor spread is limited, although significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.

For instance, in the example above, if GS does not stay within the $145 to $175 range, I will start to lose money.

Case 1 (GS stock price is $178 on expiry date)

If GS goes above $175 and continues to rise to $178 on expiry date, I will lose ($178 – $175)*100 = $300 per lot (1 option lot = 100 shares). This is because the buyer who bought the $175 CALL option from me will now exercise his option and ‘demand’ that I sell the GS stock to him at $175. Since I do not own any GS stock, I’ll have to buy it from the market at the market price of $178, resulting in a loss of $300. However, since I received a premium of $131 when I sold my Iron Condor, my final loss is actually $300 – $131 = $169 per lot (still a very ugly loss).

Case 2 (GS stock price is $20000 on expiry date)
If GS starts a mad rally and suddenly shoots above $175 to $20000 on expiry date, my loss, fortunately, is not going to explode through the roof. Since I bought a $180 CALL to protect myself, I’m not gonna lose my pants… I do not need to buy the GS stock at the market rate of $20000. I can exercise my CALL and buy the stock at $180, resulting in a net loss of $500 – $131 = $369. Good luck to the seller who sold me the $180 CALL ;p.

But seriously, although my loss in this transaction is capped at $369, I’ll freak out if I really lose such an amount… (well, not really, but I really don’t consider it worthwhile losing $369 when I could have reduced the loss if I acted earlier)…

I am extremely risk-averse… which explains why I never busted my account… Therefore, I will never allow my Iron condor positions to go against me to such extent… I’ll probably close the position at breakeven or a small profit once the stock gets too close to my “defense lines”… I’ll talk more about my exit strategies next time…

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* If you are totally new to options, do check out my “Options Trading 101” guide. It’s largely incomplete at the moment, but I’m working on it…