Part 2: How Do You Structure An Iron Condor?

This is a continuation of my iron condor series. See Part 1 here and Part 3 here. There are different approaches to structuring an iron condor. I will simply highlight the way I do it.

1. First, I calculate the standard deviations using the formula: Price * Volatility * SQRT(Days to Expiration/Days in a Year).

Keep in mind that any number of days may be used in “days to expiration.” For example, if you want to find the 1 standard deviation move for 1 day, you would use 1 in the “days to expiration” field. Also, this formula assumes normal distribution of returns which may be debatable so use this method at your own risk.

I will be using RUT as my underlying. I also chose a volatility of 25% because this looks to be the high-end of the historical 1 year average as seen on Thinkorswim & Livevol. Here are the calculated standard deviations:

2. I am looking to sell strikes at least outside of the 1 standard deviation range. In this example, the strikes of choice would be at least 760 and 880.

3. However, I like to place high probability iron condors meaning that I would like to see a probability of profit of at least 80%. In order to figure out the probability of profit, we take a look at the deltas. The delta of an option is also the probability of expiring in-the-money. In the below image, the June 735 Put has a delta of -0.09 while the June 880 Call has a delta of 0.09. We add both of these delta, ignoring signs, and subtract them from 1 in order to find the probably of profit when selling both of these options. The probability of profit is 82%.

RUT June 2011 Option Chain (click image to enlarge)

4. The call side of the iron condor is only 1 standard deviation away while the put side is about 1.5 standard deviations away. A good reason for this is because the markets tend to “take the stairs up and the elevator down.” In other words, I want more downside protection. Below is the risk profile for the RUT iron condor.

RUT June 2011 Iron Condor Risk Profile (click image to enlarge)

The current mid-price for this condor is a credit of $0.70. The difference between my strikes is 5 points so the margin per spread is $500. In the above example, the margin requirement would be $1500 and credit would be $210 before commission. This leaves a max return on risk of 14%. Although, I do not intend to leave positions until expiration. I will discuss my exit and adjustment plan in Part 3 of this series.

To re-cap:

1. Calculate standard deviations and look to sell the contracts outside of the 1 standard deviation range.

2. Look to enter an iron condor with a probability of profit of 80%+. This means that the options sold have a delta of 0.10 or less.

3. Exit and adjustments will be discussed in Part 3.

Disclosure: This post is for educational purposes only.