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Iron condor

by
Topics 4

Basics of stock market

• Induction
• Bull call spread
• Bull put spread
• Call ration Back spread
• Bear call ladder
• Synthetic long & Arbitrage
• Bear put spread

• Bear call spread
• put ration back spread
• Long straddle
• Short straddle
• Max pain & PCR ratio
• Iron condor

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14.1 – New margin framework

We are living in fascinating times, especially if you trade options in India.

The NSE’s new margin framework, which goes into effect on June 1, 2020, reduces the margin requirement for the hedged position.

You might wonder what a hedged position is. Although we have already covered this topic extensively in this module, we will quickly go over it again to ensure that this chapter is comprehensive.

Let’s say you are not wearing a helmet and are riding a bike at 75 kilometers per hour. You suddenly encounter a pothole and slam on the breaks to slow down, but it’s too late; you crash and lose balance. What is the likelihood of suffering a head injury? Quite high considering you aren’t wearing a helmet. Consider the same scenario now, but this time you choose to wear a helmet instead of being carefree. How likely is it that you’ll sustain head injuries given the crash? The low likelihood, right? because wearing a helmet keeps you safe from harm.

This means that whenever you start a hedged strategy, your broker will block fewer margins than would be needed for a naked position.

In the new margin framework, NSE essentially made the same suggestion.

For more information, see this NSE presentation.

The presentation is quite complex, but unless you really want to, you won’t need to scratch your head to understand it.

There are three main lessons to be learned from the new margin policy from the perspective of a trader. All three are highlighted on a single slide in this presentation. Here is a quick summary:

Starting from the top –

  • Portfolio 1 – Margins have increased for naked unhedged positions to 18.5% from the current 16.7%.

  • Portfolio 2 – 70% reduction in margins for market-neutral positions

  • Portfolio 3 – 80% reduction in margins for spread positions

What does this mean for you as a trader of options?

So some of the practical strategies that on paper looked great but were impossible to implement due to excessive margin requirements, now appear alluring.

I have a trick question for you: Why do you believe the spread position’s margin reduction is greater than that of a neutral market position?

Please consider it and share your thoughts in the comment section.

Given this, I would like to talk about one more options strategy in this module. Previously, I had refrained from doing so because the margin requirement was so high, but that is no longer the case.

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14.2 – Iron Condor

An alternative setup with four legs is the iron condor. An improvement on the short strangle is the iron condor.

Check out this –

This screenshot was taken using Sensibull’s Strategy Builder. As you can see, I’m attempting to set up a short strangle by selling OTM calls and puts while Nifty is at 9972.9.

9800 Put at 165.25 10100 Dial 145.25.

The fact that both options are written/sold entitles me to the sum of 164.25 + 145.25 = 309.5 in premium.

I would advise you to read this chapter if you are unfamiliar with the strangles.

This short strangle setup has the following payoff:

This strategy is my favorite because it allows me to keep the premium as long as Nifty stays within a range, which it does the majority of the time. Additionally, this is a fantastic way to trade volatility. When you believe that the volatility has increased, which typically happens around significant market events, you would want to sell options and keep the high premiums. Such trades are ideal for short strangles.

Since you sell or write options in a short strangle, you receive a net premium credit. You receive a premium of Rs. 23,288 in this situation.

The exposed ends of short strangles are the only drawback. If the underlying asset changes direction, the strategy bleeds.

For instance, the safety range for this specific short strangle is between 9490 and 10411.

I concur that this is a wide enough range, but markets have shown us that they are capable of making absurd moves very quickly. The most recent crash was COVID-19 in early 2020, which was quickly recovered from.

If you are caught in a market move that is moving so quickly, the potential loss could be enormous and could empty your account. The risk to you and the broker is now quite high because the amount of loss that could occur is limitless. Eventually, this also results in higher margins.

5.3 – Strategy Generalization

which is quite expensive.

This does not, however, mean that you must abandon a quick strangle. The short strangle can be modified to create an iron condor, which is a much better tactic in my opinion.

By closing the ends, an iron condor improvises a short strangle. Consider an iron condor in three sections:

Part 1: Sell a slightly OTM Call and Put option to set up a short strangle.

Part 2: Purchase an additional OTM Call to hedge the short call against a significant market rally.

Part 3: Purchase an additional OTM Put to hedge the short Put against a large market.

An iron condor is a four-legged option strategy as a result. Let’s see how this appears.

Sell a 10100CE at 145.25 and a 9800PE at 165.25 to earn a premium of 310.5 or Rs. 23,288.

Buy 10300 CE at 77 to cover the short position on 10100 CE in part two.

Buy 9600 PE at 105.05 to cover the short 9800 PE in part three.

If you give this some thought, you can see that the long option positions are funded by the short option premium.

Because you purchase two options to hedge against two short options, the profit potential is somewhat diminished –

As you can see, the maximum profit is now Rs. 9,634; however, the decreased profit also results in less stress.

Because I can now see the risk and it isn’t open-ended, the maximum loss is now limited to Rs. 5,366, which in my opinion is awesome.

As long as Nifty stays within a range—in this case, between 9672 and 10228—the profit is constrained. In comparison to the short strangle, observe how the range has decreased.

The iron condor’s payoff is as follows:

Now, what do you think about the risk? The risk here is completely defined. You have clear visibility of the worst-case scenario. So what does it mean to you as a trader, and what does it mean to the broker?

You guessed it right since the risk is defined, the margins are lesser.

Here is where the NSE’s new margin framework is put to use. When compared to the short strangle, which has a margin requirement of Rs. 1.45L, an iron condor only requires you to pay an upfront margin of Rs. 44,303.

Additionally, executing an iron condor was not a very viable option for a retail trader prior to the new margin framework. The margin needed for an Iron Condor was roughly between 2 and 2.2L for these strikes and premiums.

14.3 – Max P&L

There are a few important things you need to remember while executing an iron condor –

  1. The PE and CE that you buy should have even strike distribution from the sold strike. For example, here we have sold 9800 PE and 10,100 CE. We have protected the sold strikes by going long on 9600 PE and 10,300 CE. The difference between 9800 PE and 9600 PE is 200 and 10,100 CE and 10,300 CE is 200. The spread should be even. I cannot protect 9800 PE by buying 9700 PE (difference of 100) and then protect 10,100 CE with 10,300 CE (difference of 200).
  2. The Max loss occurs when the market moves either above long CE i.e. 10,300 CE or moves below long PE i.e. 9,600PE
  3. Spread = 200 i.e. the difference between the sold strike and its protective strike.
  4. Max Profit = Net premium received. In this case, it is 128.45 (9634/75)
  5. Max loss = Spread – Net premium received. In this case, it is 200 – 128.45 = 71.54.

I’d suggest you look at the excel sheet at the end of this chapter for detailed working on this. Please note, I updated the excel sheet 2 days after I wrote this chapter, hence the values are different.

14.4 – ROI and Logistics

You can set up a short strangle and get a premium of Rs. 23,288. For an iron condor, you can get a premium of Rs. 9,643. Undoubtedly, the iron condor offers a much lower premium inflow in terms of absolute rupees. But the ROI shifts in favor of the Iron Condor when you compare it to the margin requirement.

The required margin for a short strangle is Rs. 1,45,090. The ROI is, therefore –

23,288/1,45,090

is 16 percent.

The amount of margin needed for an iron condor is Rs 44,303. The ROI is, therefore –

9,643/44,303

As a trader, you must consider ROI rather than absolute values, and the margin benefit is crucial in this regard.

Here, the order in which trades are executed greatly affects the outcome. Here is the trade sequence for an iron condor, if you are thinking about using one:

Purchase the long OTM call option.

OTM Call option should be sold.

Purchase the far OTM PUT.

OTM PUT option to sell

The key takeaway is that establishing a long position is necessary before beginning a short position.

Why? Because a short option position eats up the margin, the system will request fewer margins for the short position when you have a long position because it knows the risk is contained.

Please be aware that I only

Please note that I have only taken into account the margin blocked when calculating ROI; I have not taken into account the cost of purchasing the options or the payment received when you write an option.

Therefore, traders, as a next step, I’d advise you to choose various strikes for the long positions and observe what happens to the premium payable, breakeven points, and maximum loss.

Please post your thoughts and inquiries below.

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