Tuesday, October 10, 2006

How Iron Condors Put Cash Into Your Account

Wow, it's been some time since I've added some tips here. It's a long story, which I will go into over the next few weeks.

In the meantime, here's a reasonable approach to putting some cash into your pockets, while remaining protected.

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An Iron Condor is just a quirky term for two credit spreads. One at the top of the market and one at the bottom.

Each spread consists of two options. You sell the first option and collect the premium. Then you take part of that premium and buy a second option.

The result is that you end up with a net credit in your account, because the option you bought cost less than the option you sold. That's right, you place the trade and you end up with money in your account!

For example, if you were to sell the April 1355 S&P 500 Index (SPX) call for $1.50 per 'share'. And then you were to buy the April 1365 SPX call for $0.80. You would end up with a net credit in your account of $0.70 per 'share' or $70 per contract.

As long as the S&P 500 Index did not trade above 1355, you would retain the entire net credit in your account.

And you know up front both the maximum gain and the maximum loss on your trade.

That's because the first option - the one you sold - determines the amount of your gains. Your total profit is simply the premium you collected less the cost of the option you purchased.

And the second option - the one you purchased - defines and limits your loss. That's because even if you lose money on the option you sell, you're protected by the option you purchased. Think of it as 'cheap insurance'. You can never lose more than the difference between the two options.

In the above example, the maximum you could lose would be if the S&P 500 Index were to trade above 1365.

In this case, you would be forced to deliver the 1355 calls because you sold the contract. But because you also purchased a 1365 call contract as protection, you would only be on the hook for the ten point difference. Or $10 per 'share'. Even if the SPX were to skyrocket to 1380, you couldn't lose any more than $10 per 'share' or $1,000 per spread.

And because you placed two credit spreads, one at the top of the market and one at the bottom, even if the market penetrates one of your credit spreads, your other spread should still be profitable.

So the market can go up and down like a roller coaster for all you care. As long as it doesn't come off the tracks, you could still profit.