Introduction of the Reverse Iron Condor. A trade that expresses a long perspective of volatility and is the opposite of a typical Iron Condor.
Many people like to trade Iron Condors for short volatility with a defined risk.
This article will examine the opposite trade.
Let’s sum it up.
A regular customer Iron condor consists of selling one out of the money strangle then you buy even more strangle out of the money to limit losses on the short options.
A reverse iron condor is the opposite.
At the beginning we have one long strangle.
In the example below, Docusign (DOCU) is trading at USD 210.
We buy the 205/220 Würge.
Then we sell another strangled one out of the money. In this example the 200/225 strikes.
This trade will be made for a direct debit of $ 3.45.
In terms of our risk / reward profile, our maximum loss is our debt paid (i.e. $ 3.45).
If the DOCU inventory is between 205 and 220 when it expires, the Reverse Iron Condor will expire worthless.
Our maximum profit is the width between long and short strikes, minus the debt paid.
In this example, the difference between long and short strikes is $ 5.
So our max profit is $ 5 to $ 3.45 = $ 1.55.
In the graphic above, the DOCU has to move in both directions to benefit.
Hence, the main view expressed when placing a Reverse Iron Condor is volatility.
By placing this trade, we are conveying that we expect more volatility than the market implies.
At the beginning, we don’t care whether the stock moves up or down.
Still, we need the stock to move. In short, we expect a realized volatility of more than implied volatility.
A reverse iron condor is placed directionless, but what is unique about the options is that you can express any view you want.
Let’s say you think volatility is undervalued and you have a slight bearish trend in the stock price.
By tilting your body slightly, you can express a directional view. In the example above, trading is bearishly distorted.
To get full profit, the stock needs to move $ 15 up but only $ 10 down.
Therefore, at the beginning, in addition to my view of volatility, I will express a slight directional view.
Best of Options Trading IQ
Once the trade is placed, our exposures will constantly change as the price moves.
Imagine we placed the trade on top with our negative view, but the DOCU is hovering around USD 215.
Trade now has a positive delta.
If we want to stay directionless, we just can short shares of the stock or readjust the strikes of the options.
Though a word of caution.
As a general rule, minor adjustments of this type should be kept to a minimum for most retailers, especially with a long option position.
Since our maximum loss is our debts, which are constantly being readjusted, there is a slip and Commissions.
This cost will impact any positive advantage we have had in trading. That being said, there are certain times when position adjustment is required.
Use the example above.
DOCU is recovering hard to the top tomorrow.
It turned out we were right.
The stock is now trading at $ 230.
What are our exposures now?
Of course we have a long delta.
We don’t want the stock to go down again.
But all our trade has now turned.
If the price stays where it expires, we’ll make our full profit.
So we benefit even if the share does not move.
We are now short volatility.
When we entered the trade we were long gamma, Vega and short Theta.
Now we are short gamma, vega, and long theta.
The question you need to ask yourself is that after this step you want to switch sides and keep the volatility short.
The answer is probably no. In this case, it is best to remove the position and take profit.
The same idea applies to a normal iron condor if the implemented move takes the population outside of its wings.
The investor initially wanted a short volatility.
Because of the step taken, they are now volatile for a long time. Many investors will leave the position in the hope that it will return.
In general, you will hear them make an excuse like “I’m ready to lose X”.
However, the trade still has time to expire.
They are now taking the opposite view they originally had on volatility.
4 tips for a better trade in iron condors
If these traders had so little conviction in their trades to play flip-flop, they probably didn’t have enough conviction to take the trade in the first place.
One might ask.
While I think it’s more likely, they just aren’t aware of their new exposures.
Alternatively, they are aware but avoid loss emotionally.
Ultimately, you could close the position for a small loss while still accumulating some of the remaining time value in your long leg.
Most of the time, they hold the bag in this new position with long volatility until expiration and pray that it will come back.
For a reverse iron condor falling into the opposite trap waiting to collect the last few cents of theta, this is just as ill-advised.
If your trade doesn’t express the view you want, there is no point in expressing the trade.
Hope is not an investment strategy.
At this point it is valid to discuss the alternatives in order to get a long volatility view.
Why place a reverse iron condor when you can just place a strangle?
Why should you limit your winnings?
These are fair questions.
One of the main proponents of the Iron Condor over the Short Strangle is that it takes undefined risk and limits it.
These wings are tail risk guards.
In contrast, in a long choke, the most we can do is lose the debt we paid off.
So if we have a long volatility trade with high conviction, choking on the reverse iron condor makes sense.
There is no reason to limit your winnings.
Who wants a slice of pizza when you could have the whole cake to yourself?
However, by giving up the possibility of unlimited profits, we receive a credit that reduces our cost base for trading.
While our uptrend is limited, we have offset the direct debit we paid significantly.
Another benefit of selling the wings is that these are the most overpriced options historically.
While they are cheap in price, they are expensive in terms of volatility.
Everyone wants to buy tail risk protection.
Even people who are shorting volatility buy the wings as protection.
Hence, trading can sometimes make sense.
Here are my thoughts on when to pick a Strangle vs Reverse Iron Condor
Choose Strangle if:
- Trade with high conviction
- Illiquid underlying asset (or illiquid wings)
- Favorable base value
- Relatively flat vol surface
Choose Reverse Iron Condor if:
- Trade with less conviction
- Liquid underlying
- Higher-priced underlying
- Very smiley surface
Regarding points 2 and 3, we want to avoid cheaper and illiquid stocks for Reverse Iron Condors because there simply isn’t enough juice to justify the higher commissions and transaction costs.
Trading four option branches has higher transaction costs than trading two.
If the wings have 1,000% volatility then it doesn’t matter if the option is worth 2 cents.
With regard to the volatility surface, the following applies: a smile we have the better.
This means that the implied volatility of the wings is much more expensive than that of the body (see below).
This OTM offset will be overpriced.
There is a premium called the Skew Risk Premia, which is an additional premium that you can reap over time by selling these options.
Almost always the high offset is there for a reason.
Maybe a biotech stock launching a new drug or a company has a big release.
In these situations, we should expect a very smiley face as the returns do not follow a normal distribution.
It can be a tough choice, but often you find yourself on the gagging side only in terms of price and liquidity.
In both cases, the most important view is that of volatility.
By trading a Reverse Iron Condor, you believe that the implied volatility is undervalued compared to your estimate of the realized volatility.
Perhaps you’ve done some technical analysis or feel like you might see a message about earnings.
Or maybe you just buy Vol where you think it’s cheap.
In either case, your primary expression will be in volatility.
Otherwise, just trade the stock.
The Reverse Iron Condor offers a unique exposure to long volatility while paying a modest charge.
While not that popular, it can be a great alternative to a long choke in certain situations where the investor thinks the volatility is cheap but the variance is too expensive.
Disclaimer: The above information applies to For educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are unfamiliar with exchange-traded options. All readers interested in this strategy should do their own research and seek advice from a licensed financial advisor.