Options Trading 101: Part 3 - Iron Condors perform better in higher volatility environments

An Iron Condor is a limited risk, non-directional option spread designed to have a high probability of earning a limited profit

So if an Iron Condor profits when the underlying security doesn’t make any major moves in either direction, you must be wondering why anyone would open them when markets are experiencing a lot of volatility.  Wouldn’t it stand to reason that I would want to sell my Iron Condors during periods of low volatility and calm markets?

Intuitively that makes sense and many Iron Condor traders out there believe that very thing.  However the truth is the best time to open new Iron Condor trades is during times of higher implied volatility.  Let me show you why:

 

The above picture shows what an Iron Condor opened on March 22nd, 2010 would have looked like.  I have drawn 3 circles to show the key points:

• Yellow circle:  The implied volatility for the SPY on March 22nd, 2010 was 18.41%

• Green circle:  Sold for a premium of 0.22$. This makes it a 89% probability trade

• Blue circle:  These are the strike prices for the trade: 104 /  106 / 128  / 130

A SPY volatility reading of 18% is reasonably low.  If we take the difference between the two short strikes ( 128 – 106 ) and divide that by the price of the SPY at the time we sold it ( 116.59$ ) we get about 19%.

What this means is the SPY can move about 9% up or 9% down and it will still be within our expiry profit range.

* We don’t hold trades to expiry, but this is just an illustration of the math.

Now let’s look at how that changes with higher implied volatility readings.

 

The above picture is for an Iron Condor opened on October 17th, 2011  (high volatility during European debt crisis)

• Yellow circle: SPY volatility on October 17th, 2011 was 33.64% ( nearly double )

• Green circle: Sold for the same premium of 0.22$, making it a 89% trade

• Blue circle: Strike prices for this trade are: 98 /  100 / 140  / 142

As you can see the higher volatility reading actually allowed us to sell an Iron Condor with much wider wings for the same 0.22$ premium.  So I’ll do the same calculation as before.  You take the difference in the short strikes ( 140 – 100 ) and divide that by the price of the SPY ( 120.23$ ) and you get about 33%.

For this trade, the SPY can now move over 16% up or 16% down and it will still be within the expiry profit range.

Let’s see how wide we can get our strike prices if we sell an Iron Condor during extremely volatile times.

 

The above picture is for an Iron Condor sold on November 17th, 2008  (shortly after the collapse of Lehman Brothers)

During the aftermath of the Lehman Brothers collapse we saw several months of extremely high market volatility.  Most people were just too scared to jump in with new trades, but that period from September 2008 to May of 2009 turned out to be a very profitable time to be an Iron Condor trader.  The high implied volatility is the reason for that.

• Yellow circle: SPY implied volatility on November 17th, 2008 was 64.77% (extremely high)

• Green circle: Sold for the same 0.22$ premium making it a 89% probability trade

• Blue circle: Now the strike prices are very wide: 53 /  55 / 116  / 118

Let’s go through the math one more time.  Take the difference in the short strikes ( 116 – 55 ) and divide by the price of the SPY ( 85.47$ ) and we get 71%.  For that Iron Condor, the SPY could drop another 35% or rise 35% and our trade would still be within the expiry profit range.

The higher the volatility at the time of opening the trade, the wider the wings the Iron Condor will have.  This dramatically increases the margin for error and gives those high volatility trades a higher probability of success.

There’s another reason why opening new Iron Condors during times of higher volatility is more advantageous:

Short Iron Condors always have a negative Vega

This means they profit as volatility falls.  If you sell an Iron Condor when the volatility is already very low there isn’t much room left to profit by a further drop in implied volatility.  However if you sell Iron Condors when implied volatility is high there is plenty of room for things to settle down and for your trade to quite quickly be in the money.

Think about results for trades opened and closed during various volatility environments:

 

 As far as Vega is concerned, of the four possible outcomes during the life of a trade only one of them is distinctly negative.  That happens if you sell an Iron Condor during times of low implied volatility and during the course of your trade volatility rises.

This is why we are currently in Cash (Feb 10th, 2017)  It’s very dangerous to be opening new Iron Condors when volatility is in the gutter like it is today.  Right now Vega is not our friend.

This will have a negative impact on our daily profit curve.  Even if the price of the SPY is still within our desired range we may still have to close the trade out for a loss due to rising volatility.

It can be an emotional challenge to open new trades when the markets are seemingly falling apart. Often times our natural reaction is to just sell everything and wait for things to calm down.  However as I have demonstrated, an Iron Condors probability of success is actually higher if you open new trades during times of extreme market volatility.

It also takes a lot of patience and discipline to NOT open new trades when volatility is too low.

Market sell-offs are a great time for a savvy trader to turn calamity into opportunity.  It’s not just a bull market strategy.  With good trade selection we can actually do pretty well during bear markets as well.