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An iron condor is an advanced trading strategy that enables a trader to make a profit when a stock doesn’t move much in price.
It involves executing four options contracts, two calls, and two puts, with the aim of collecting premiums on the trade.
However, like all trading strategies, it is not without its risks.
This article will explore what the key risks are for trading iron condors and how you can best mitigate or avoid those risks.
Risk 1: Having The Right Market Conditions
Unlike some other strategies, an iron condor is heavily dependent on the market conditions at the time of the trade.
To be most effective, an iron condor should be entered when the stock is likely to stay in a trading range, which enhances the probability of success.
The challenge for traders is in how to identify whether a market is in a trading range – this requires a solid background in technical analysis that exceeds the scope of this guide.
So before you start to trade iron condors, take some time to get a thorough understanding of technical analysis so that you can spot markets in a trading range.
Risk 2: Black Swan Events
Markets are regarded as highly efficient, with most information ‘priced in’.
This means that prices generally reflect all known information and stocks are fairly valued.
A fact of life, however, is that black swans occur many times in our lifetime.
A black swan is a significant but rare or surprising event, resulting in many unforeseen impacts.
The recent COVID-19 pandemic of 2020 is an example of a black swan event.
Black swan events create a lot of unknowns for investors, which results in a wide divergence in what information is ‘priced in’.
As a result, markets can fluctuate widely as investors try and get to grips with what is the new normal for both markets and the economy.
Due to the exceptional volatility typically experienced both during and after black swan events, they pose perhaps the most significant risk when trading iron condors.
Risk 3: Federal Reserve Market Manipulation
Iron condors work well in mean-reverting scenarios within range-bound markets.
In markets that function normally, there should be plenty of these opportunities.
However, sometimes the Federal Reserve decides to manipulate markets in response to adverse economic conditions.
This can take the form of various monetary policies such as easing interest rates and buying government securities.
These policies have the effect of driving up asset prices, particularly the stock market as the flood of free money finds its way to financial assets.
This can create a situation where assets increase in price in a way that is disconnected from past behavior and even the underlying asset’s fundamentals.
These changes can come on suddenly and with little warning, introducing strong upwards bias in prices and creating a high-risk scenario for iron condors.
To mitigate this risk, when economic conditions are deteriorating and market intervention is looking increasingly likely, create a hedge to the upside whenever you initiate your iron condor.
A hedge can be as simple as buying stocks, calls, or something more advanced like a call spread.
Risk 4: Timing The Entry
Since iron condors function well as a means-reverting strategy, many novice traders will load up on iron condors when the price of a stock has run up and appears overbought.
It is not unreasonable to believe that a stock with a very high, overbought price will come down eventually, but the reality is that prices can remain irrational for a lot longer than most traders realize.
The key way to mitigate this risk is to focus mainly on implied volatility, rather than just the stock price.
As implied volatility falls, the price of the options falls as well.
This serves to generate high option prices while allowing you to execute a position that is deep out-of-the-money.
So keep an eye out for when implied volatility is both high and falling.
Observing a falling implied volatility is critical as this is a good sign that the stock price isn’t changing.
Unfortunately, some novice traders get caught out in not knowing that high implied volatility can still rise further, obliterating your trade.
Risk 5: The Call Side
The call side of an iron condor is usually the side where you tend to lose most of your money.
The reason behind this is that most traders have a natural desire to protect their portfolios.
Since most investors will carry a long position in stocks, they will protect their portfolio to the downside by purchasing put options which gain in value as stocks decline.
The purchase of these put options drives prices higher, creating skew and resulting in a negative delta when you open your position (the call spread will be closer to at-the-money).
One way to mitigate this risk is to leg into your position, e.g. starting with your put spreads then executing your call spreads at a favorable time, or trading less call spread than put spreads.
Risk 6: Earnings Events
Earnings events are a popular way for novice traders to trade iron condors.
The problem is that they’re binary events, meaning that you’re either right or wrong at a singular point in time.
When trading during normal market conditions, you have many opportunities to manage your position, constantly re-evaluating and adjusting to improve your chances of success.
Trading an iron condor across an earnings event leaves you without the ability to manage your position – you wake up the next day either a winner or a loser so you better be sure you know something more than the majority of the market.
The best way to mitigate this risk is to simply avoid trading earnings announcements.
Conclusion
Like any trading strategy, iron condors are not without risk.
Some of the key risks are:
- Having the right market conditions
- Black swan events
- Federal Reserve market manipulation
- Timing the entry
- The call side
- Earnings events
By being aware of the risks and implementing appropriate mitigation and avoidance strategies, traders can improve their profitability and protect against adverse events.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
