Introduction
Every option strategy comes with the potential for profit. There is also the possibility of losing money – representing the risks of trading. When you start trading, you should have some expectations regarding the likelihood of experiencing a loss in pursuit of potential rewards.
Definitions
The broken iron condor is a neutral market strategy, meaning it makes a profit when the market trades in a relatively tight range. Neutral market traders make money from the passage of time – but only when the highs and lows do not incur a loss greater than the positive time decay. When the stock moves close to the strike price of one of the options you are selling, its price increases rapidly, and the broken iron condor loses money.
How does a trader make money from the passage of time?
Options are assets that lose value every day. Theta measures the rate of decay. The market expectations of traders buying options must be validated – sooner rather than later – otherwise, the purchased options will lose much of their value while the trader holds the position and waits for their expectation to come true. Options sellers do not face this issue. They make money every day – unless the underlying asset (stock, exchange-traded fund, index) moves too far in the wrong direction. [Options sellers do not want the stock price to rise nor do they want it to fall.]
Risks and Rewards of the Broken Iron Condor
Let’s examine a typical broken iron condor. Buy 1 INDX January 16 ’15 1240 Call Sell 1 INDX January 16 ’15 1230 Call (these two options form a call spread; Premium $0.95) Buy 1 NDX January 16 ’15 1110 Put Sell 1 INDX January 16 ’15 1120 Put (these two options form a put spread; Premium $1.05) Let’s assume the combined amount is $2.00 per share or $200 for one broken iron condor.
When does the trade fail?
If the index price (INDX) approaches 1230 (short call option) or 1120 (short put option), the opposite spread gains significant value, and the entire broken iron condor position will cost more to exit than was collected when starting the trade. As a result, the position incurs a financial loss or is “underwater.” There are three ways to handle the situation. Two are acceptable actions traders can take when facing this losing money scenario. One is unacceptable.
When does the trade succeed?
Winning scenario: Time passes. The options remain out of the money. The options you sold (1230 call and 1120 put) are always worth more than the options you bought (1240 call and 1120 put). This means they gain or lose value faster. Therefore, over time, both the call spread and the put spread lose value, and eventually, you can buy back both spreads to exit the broken iron condor with a profit. Important note: Broken iron condor traders do not rush to exit with a small profit. Neither should they seek the maximum possible profit. Knowing when to exit is a skill in itself and is another aspect of risk management for a broken iron condor position.
Source: https://www.thebalancemoney.com/the-iron-condor-trader-s-mindset-2536645
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