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Iron Condor vs Strangle

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by Gavin in Blog
August 17, 2021 0 comments

Today we are analyzing why we would trade an iron condor vs strangle.

An iron condor has protective wings while a short strangle involves naked options.

So, which is best?

Read on to find out.

Contents

Introduction

Choosing between iron condors vs strangle can sometimes be difficult.

Both are relatively similar positions and have almost identical exposures.

Despite this, some slight differences cause even more significant contrasts between the two structures.

So, let’s compare them head-to-head.

This article will explore when to use a short strangle and when to use an iron condor.

The Set Up

A setup for a short strangle consists of selling an out-of-the-money put and simultaneously selling an out-of-the-money pall.

A short strangle is generally done in a delta-neutral fashion.

iron condor vs strangle

An iron condor is remarkably similar as it starts with the same short strangle but with added wings for protection.

See the structure below as an example.

iron condor vs short strangle

We can see off the bat that both structures benefit from stable stock prices.

They will both make money if the position stays range-bound while losing money if the position moves too far in one direction.

The only significant difference is that the iron condor has a defined risk while the strangle does not.

Why Would I Sell A Strangle?

Initially, it may not make much sense to sell a strangle.

I can have a risk-defined structure in the iron condor, which still expresses the same view.

Yet remember that initially, we receive a credit for the strangle, just like an insurance provider receives a premium for selling insurance.

Now in the short strangle, if we are correct, we can keep this entire premium.

In contrast, when we buy the wings to make the strangle into an iron condor.

We give up some of that premium in exchange for downside protection.

Essentially, we are selling comprehensive insurance then going down the street and buying cheaper insurance to protect ourselves.

Giving up some of the credit of the strangle will also reduce the profit area of the trade itself.

Another thing that is important to remember is that trading is not free.

Every additional trade incurs commissions and slippage.

A short straddle has two legs; an iron condor has four.

Thus, the iron condor has significantly higher transaction costs to open and close.

This can be especially problematic in illiquid stocks can have extremely wide spreads.

Why Would I Sell An Iron Condor?

The overwhelming benefit of the iron condor is its risk-defined nature.

When we place an iron condor, we know exactly how much our maximum loss is, unlike the strangle.

Many advocates of the strangle will argue that they can simply dynamically delta hedge a position.

Despite this, hedging a position is impossible overnight or in the event of a flash crash.

Even for highly active hedgers, the hedging of deltas itself increases transaction costs.

An iron condor is much closer to a set and forget type of position, which may only require periodic adjustments.

An additional benefit of iron condors has to do with their capital efficiency.

Short strangles can be highly capital intensive for the average retail investor, who does not have access to portfolio margin.

This can involve putting a considerable amount of capital on the line for a relatively small trade.

In contrast, because an iron condor is risk-defined, the margin required is vastly lower.

Tips To Choose Between A Short Strangle And Iron Condor

Neither the short strangle nor the iron condor is universally better.

Despite this, one may be better than the other, depending on the circumstances of the trade.

Let’s explore some tips to decide which one to use.

Liquidity

Since iron condors have four legs while short strangles only have two, they are more commission intensive.

Slippage can add up.

Slippage is not a significant issue with indexes where spreads are a tick wide.

However, it can be devastating for illiquid options chains, especially for the condor wings.

Verdict: Lots of Liquidity = Short Strangle

Low Liquidity = Iron Condor

Curvature

Each option strike will trade at a different level of implied volatility.

For this reason, we have skew and curvature.

As a result, prices for OTM options have higher levels of implied volatility than ATM options.

This phenomenon is known as the volatility smile or volatility smirk.

Here is an example of the current volatility smirk on Facebook’s options chains.

strangle vs iron condor

Source: Predicting Alpha

An important note.

Some curvature is expected on options chains as distributions are far from normal.

Often curvature is high for a reason, though generally, it still is overpriced.

If the curvature is exceptionally high, this can mean buying overpriced wings for the iron condor.

Thus, looking to see whether the skew is typical can be another good metric to choose between a Condor and Short Strangle.

Verdict: Low/Normal Curvature = Iron Condor

Lot of Curvature = Short Strangle

Margin Availability

As the short strangle ties up a lot of buying power, placing these types of trades when your account already has little margin available can result in unintended stress and margin calls.

Additionally, it can result in missing other trade opportunities when capital is tied up.

Verdict: Not much Buying Power = Iron Condor

Lots of Buying Power = Short Strangle

Jump Risk

Short strangles can only be hedged when trading is available, which often leaves jump risk.

Many securities such as biotechs can have extreme price jumps, instantaneously bankrupting short options sellers in progress.

Situations like this lend themselves to iron condors.

Despite this, wings on these stocks are often highly overpriced because of point 2 above.

Hence often, no trade is the best trade on these names.

Verdict: Substantial jump risk = Iron Condor or no trade

Lower Jump risk = Short Strangle or Iron Condor

Personal Circumstances

If you are an active investor checking trades every day to see if you need to hedge can make sense.

Though for investors who spend a little bit of time once a week or a month, having the undefined risk of strangles doesn’t make sense.

For these passive investors, iron condors are superior from a risk management perspective.

Verdict: Passive Investors = Iron Condors

Active Investors = Short Strangles

Concluding Remarks

Short strangles vs iron condors express remarkably similar views.

Despite this, there are slight advantages of using one over the other given specific circumstances.

Short straddles are better for more illiquid underlying’s that have more curvature relative to jump risk.

Iron condors are better for margin efficiency, risk management, and more liquid underlying’s.

For active investors who want to trade often and manage positions proactively, short strangles can be used.

For passive investors who want to take advantage of the variance risk premia but check their portfolio infrequently, iron condors are a much better choice.

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.

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Options Trading 101 - The Ultimate Beginners Guide To Options

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