Options Trading Strategy Guide: Using ADX to Backtest Iron Condors

As an options trader, don’t you think it would be nice to have a way to know when a stock price is most likely to move sideways for a while? This guide shows how the ADX indicator can help you set up Iron Condors, a neutral options strategy composed of four options contracts aiming to profit when the price of the underlying stock stays within a defined range. By using this indicator, you can more effectively construct an iron condor with maximum profit potential by targeting periods of low volatility. We also provide free backtesting tools to review past stock behavior, enabling you to make informed decisions about selling an iron condor with increased confidence.

Key takeaways

• The ADX indicator helps identify trending markets and stationary phases, aiding in more effective Iron Condor setups.
• You can use the ADX indicator and Option Samurai to find an iron condor opportunity and check how these stocks behaved in the past in similar conditions.
• We offer a free backtesting file to check what happened to any stock price in the past based on the value of its ADX indicator. This allows you to have more confidence in a trade and make a more informed decision.

What is the ADX Indicator?

The Average Directional Index (ADX) is a technical analysis indicator used to measure the strength of a trend in the market, regardless of its direction. Developed by J. Welles Wilder, the ADX helps traders identify whether a market is trending or ranging, a key distinction when constructing a neutral options strategy like an iron condor.

Because an iron condor is an options strategy designed to profit in low-volatility markets, knowing whether the market is likely to range allows traders to better assess the strategy’s potential success at expiration. As with any multi-leg options strategy involving four different options contracts, it’s essential to understand the characteristics and risks of standardized options before trading.

The ADX can thus serve as a valuable tool to gauge trend strength, helping you time your purchases and sales of options carefully when setting up your iron condor.

How the ADX Measures Trend Strength

Here is what the ADX indicator on Apple (AAPL) looks like:

• Calculation: The ADX is derived from two other indicators: the Plus Directional Indicator (+DI) and the Minus Directional Indicator (-DI). These indicators compare current highs and lows to previous period highs and lows. Note that, for simplicity, the image above does not feature the positive and negative components of the indicator, but only the indicator itself.
• Values: The ADX typically ranges from 0 to 100. Values above 20 usually indicate a trending market, while values below suggest a lack of trend or a ranging market.
• Strength: A rising ADX indicates strengthening trend momentum, whether the market is going up or down. Conversely, a falling ADX suggests weakening trend momentum.

Importance of ADX in Trading Strategies

• Trend Identification: For Iron Condor strategies, knowing whether the market is trending or ranging is crucial. The ADX helps traders decide when to enter or avoid trades based on trend strength.
• Setup Optimization: When the ADX shows a low value, it indicates a ranging market, which is ideal for Iron Condors. Since Iron Condor strategies profit from low volatility and minimal price movement, using the ADX can improve the probability of success.
• Risk Management: By incorporating the ADX into their trading strategy, traders can better manage risk. It allows them to avoid entering Iron Condor trades during strong trends that might lead to significant losses.

Understanding an Iron Condor and the Edge You Can Gain with the ADX Indicator

So, how do you use the ADX indicator to gain an edge on the market with iron condors? Well, we’re not just here to write articles – we’re options traders too, so let us share some insights from experience.

The Average Directional Index (ADX) is a technical analysis tool that measures the strength of a trend, which can guide the use of a neutral options trading strategy like an iron condor. With values ranging from 0 to 100, an ADX above 20 often signals a trending market, while a reading below 20 suggests a weaker or range-bound market, ideal for iron condor setups.

Keep in mind, this isn’t a rigid rule: traders frequently combine the ADX with other indicators to refine entry points, adjusting ADX thresholds depending on the underlying asset or timeframe. This careful approach lets you plan for options to expire worthless, capturing the premium of the entire iron condor for maximum profit potential.

How the ADX Measures Trend Strength

• Trend Strength: The ADX helps determine whether a market is trending or not. A rising ADX indicates increasing trend strength, while a falling ADX points to decreasing trend strength.
• Non-Directional: The ADX doesn’t show the direction of the trend, only its strength. This makes it useful for identifying both bullish and bearish trends.

Using ADX with Iron Condors

• Ideal Market Conditions: Iron Condors perform best in low-volatility, non-trending markets. By using the ADX, traders can identify these conditions and avoid periods of high volatility.
• Entry and Exit Points: Traders can use the ADX to time their entries and exits, ensuring they engage in Iron Condor trades when the market exhibits weak trend strength, enhancing the probability of success and maximizing profit potential.
• Our intuition: Suppose you spot a stock with an ADX that has very recently moved below the 20-level, indicating a shift from a trending market to a ranging one. In that case, this might be an excellent time to consider setting up an Iron Condor trade on that stock. There you go: this is the idea we want to explore in this blog article (and spoiler alert: historical data analysis shows that this is a rather good strategy, but we’ll tell you more about that below).

An Iron Condor Example with Real Data

We want to quickly look at a typical result you could obtain with our backtest based on the ADX indicator. Through the “High probability iron condors” predefined scan on our website, you may find this trade opportunity on PYPL, which may enhance your overall profit potential:

• Buy: $50 put
• Sell: $52 put
• Sell: $66 call
• Buy: $68 call
• Expiry: 38 days

And here it is for you, directly from our options scanner:

Note the $47 maximum profit, compared to a maximum loss a little above $150 on both sides of the trade. In short, you want PYPL to trade between $51.53 (-14.30% from the current price) and $66.47 (or +10.54%) during the next 38 days to have a profit. The fact that you may earn $47 against a maximum loss of $151 means that your profit ratio here is slightly above 31%.

Why Pick This Trade?

There are several reasons to consider a trade like this one. PYPL is technically classified as a tech company, but it functions more like Visa and Mastercard, primarily as a payment gateway. This classification means its price is relatively stable, and, in fact, its beta is typically below 1.5. As discussed above, the difference between the strikes in this neutral strategy creates far-apart breakeven points, making it a strong probability trade that profits when the underlying stays within a range.

In this section, we’re focusing on the example outcome rather than the input values for the Google Colab file. Don’t worry, though—later in the article, we’ll guide you through each step so you can create your own analysis.

For now, take this initial analysis output as an example: PYPL’s ADX indicator recently moved below 20, and historically, it remains below this threshold for around 11 days on average. This suggests that you can expect PYPL to stay relatively calm for the next couple of weeks, which benefits the strategy’s potential.

Next 38 Days Movement

Now, if you are like us, just knowing the two numbers mentioned above isn’t enough. You probably want to know how PYPL tends to move over the next 38 days (remember, your options expire in 38 days) after entering a sideways trend situation (as measured by the ADX dropping below 20), and here it is:

This is what happens after the ADX moves below 20 for PYPL. Here is a breakdown of what you should understand from the chart above:

• The average price (blue line) moves sideways for the first couple of weeks and then moves down for another couple of weeks.
• Note that we’ve also added a statistical confidence interval of 75% (the blue area)
• The average cumulative price change in PYPL on a normal day (the black line) is there to act as a benchmark for your analysis.
• The red lines simply indicate your breakeven prices (in percentage terms): you will need the stock to remain between these two lines to have a profit.

During the first two weeks, you can expect the ADX indicator to stay below 20 (approximately 11 business days on average). However, beyond this period, a trend usually manifests, often slightly negative.

It’s important to note that the 11-day average statistic is just that—an average. There have been cases where the ADX remained below 20 for much less or much more than 11 days, and vice versa, as you see below (refer to the highlighted periods):

This is not an oracle; keep your trade under control and ask yourself daily: “Should I close the Iron Condor earlier or wait for my options to expire?”. The answer is far from trivial, as sometimes closing an iron condor before it expires is likely the best choice you can make. Therefore, this is a good trade setup, but it’s not perfect, as the average sideways trend for PYPL is much shorter compared to the options expirations. Otherwise, this would be a perfect trading idea.

Using Our Backtest File

After the very quick PYPL example above, we want to take a little bit more time to guide you through every step of the way. We’ll teach you a new way to select iron condors using our backtest file.

Step 1: Finding a Trade Idea for Your Favorite Options Strategy

Let’s assume you find a cool trade idea on our options screener, such as Medtronic (MDT). Suppose this is a stock you’ve traded in the past and know that MDT has a low beta (< 1). You notice that the stock’s ADX indicator seems lower than usual, making it a good opportunity to trade an iron condor. Remember, an iron condor strategy profits if the stock price doesn’t move much over time.

This is the trade idea, for full disclosure:

We’re basically saying that, with MDT trading at $80.41, you’d do the following:

• Buy a $76 put
• Sell a $77.5 put
• Sell an $87 call
• Buy an $87.5 call

Note that all these contracts have the same expiration date (23 days from now). Your breakeven points would be at $77.10 (-4.12% from the current price) and $87.40 (or a +8.69% price change). On the downside of the trade, you’d be losing $110, while you’d lose $10 on the upside of the chart. Between the two prices mentioned above, you’d earn $40. This means that the maximum return on margin would be 36.36%, or 570.23% if you annualize the number.

Step 2: Entering the Iron Condor Options Strategy Details in the Backtest

Now, enter the details of the trade in the backtest file:

• Ticker: MDT
• Lower Breakeven Point: -4.12%
• Higher Breakeven Point: +8.69%
• Days to Expiration: 23 days

You can also choose the starting year for your historical analysis. For example, you might select 2019, but you could input 2021 to avoid including periods like the Covid-19 pandemic. Typically, the 20 threshold is used to differentiate between trending and sideways markets in the ADX indicator, but you can adjust this if you have a better idea:

Step 3: Running the Backtest

Go to the “Runtime” tab at the top of the file and click the “Run all” button. In a few seconds, you will have the results you need.

Which Results Will You Receive?

Once the backtest runs, you will be provided with several key pieces of information:

• Historical Performance: How MDT has performed historically when its ADX was below the specified threshold.
• Average Days Below Threshold: The average number of days MDT stays below the ADX threshold you set.
• Price Movement Analysis: How MDT tends to move during the specified period (e.g., does it trend sideways or slightly up/down?).

The section below will teach you to interpret the analysis results soundly.

A Real-Life Example of ADX-Based Iron Condor Trade

Now that you have a general idea of how to set up our backtest file based on a trade you found on our options scanner, let us guide you through the results we obtained on the MDT stock. Of course, this is where the value of the trader’s experience is vital: we will give you our own interpretation of the analysis output, but there is no reason why you should not disagree or give a slightly different interpretation to it.

Key Analysis Outputs

First of all, focus on two sentences that our analysis will give you:

• The last time the ADX indicator moved below 20 was on 2024-06-25.
• Note: on average, the ADX indicator remains below 20 for 10.09 days.

This means that:

• The ADX indicator for this stock moved below 20 just yesterday.
• The ADX indicator remained below 20 for an average of 10 days in the past.

So, how does the price of MDT change, on average, once the ADX moves below 20? As you see from the chart below, not much:

Note that we have added the average price change (in blue) with its 75% confidence interval (the blue area). We have also added the two breakeven thresholds (the red horizontal lines) and the average price change of the stock on a normal day, ignoring its ADX indicator (the black line).

Chart Analysis

The chart basically tells us that MDT price remains between -2% and +2% for several weeks, which seems to be a great confirmation for our trade. Of course, past performance cannot confirm future price changes, but you may be onto something here: this is a stock that does not move a lot on average when the ADX is low.

Visualizing Low-ADX Phases

As another piece of evidence, you may like the idea of actually visualizing the low-ADX phases on the historical stock price. The chart below helps with this: the gray areas correspond to those days in which the ADX indicator was below 20:

Note that there were phases in which the ADX remained low for many more days compared to the 10-day average mentioned above, while there were even days in which the ADX moving below 20 was just a touch-and-go.

Practical Considerations (Keeping Profit and Loss in Mind)

• Likelihood of ADX Moving Above 20: Understanding how likely the ADX is to move above 20 in the short term is crucial. For instance, if MDT has an imminent earnings report coming, or if there’s an important announcement expected, the ADX might spike above 20, making the trade less favorable.
• Historical Context: Always consider the historical context. If the stock has had periods where the ADX stayed below 20 for longer than average, it might indicate a prolonged calm period, which is good for iron condors.
• Market Conditions: Check the broader market conditions. Even if MDT’s individual metrics look favorable, overall market volatility can impact the stock. Ensure the market environment supports your strategy.

Understanding the ADX Methodology (and Its Limitations)

The reason why the ADX indicator is a reliable signal for spotting when a stock is range-bound comes down to its methodology. The ADX smooths out price movements, offering a clearer view of the trend’s strength rather than its direction—an insight especially useful in spread trading strategies like iron condors, where profit is capped and stability is key.

The ADX measures both positive and negative directional movement by comparing the current high to the previous high, and the current low to the previous low, to assess the trend’s strength. When ADX values rise above 20, traders often see this as a sign to shift to a trend-following approach. On the other hand, when it remains below 20, they might look for a neutral options strategy that profits from low volatility, like an iron condor, where one side of the iron condor benefits if the stock stays range-bound.

That said, the ADX methodology has its limitations. As with all complex options strategies, carry additional risk and rely on statistical analysis rather than certainty. There will be times when the ADX indicator remains below 20 for a period and then suddenly jumps up, challenging the range-bound assumption. For this reason, the ADX indicator should complement your overall trading options strategy rather than act as a sole decision-maker.

Also, remember that while we didn’t dive deeply into fundamental analysis for MDT in our example, this is essential for every trader to do before trading options. Never rely solely on statistical tools; instead, use them wisely alongside personal judgment and experience to make consistent, informed decisions.

Run Your Own Backtest

If you enjoyed the examples in our article and want to run your own backtests on various tickers to increase your max profit chances and avoid a loss on an iron condor, you can easily use our Google Colab notebook. Just make a copy and modify the parameters to your preference.

For quick access to all necessary resources, we’ve included a few links below:

Predefined scan for high probability Iron Condors

Perform your own backtest with our free Colab file

Frequently Asked Questions about Trading an Iron Condor

Is the Iron Condor Strategy Profitable?

The iron condor strategy can be profitable, especially when implied volatility is high, and the stock price remains within a defined range. By selling both a call spread and a put spread, you receive a net credit upfront. If the options expire worthless within your strike price range, you keep the full credit received as profit.

What is the Success Rate of the Iron Condor Strategy?

The success rate of an iron condor depends on various factors, including market volatility and accurate selection of strike prices. By managing the four options carefully and choosing the right conditions, such as low trending ADX signals, you increase the chances of the spreads expiring worthless and keeping the credit received.

What is the Probability of Profit on an Iron Condor?

The probability of profit with an iron condor strategy generally ranges from 60-80% if the trade is set up with appropriate strike prices and low market volatility. Selling both a call option and a put option as credit spreads helps maximize the net credit while keeping the stock within your expected range, enhancing the likelihood of a profitable trade.

What Are the Disadvantages of Iron Condor?

Iron condor strategies come with certain disadvantages. If the stock moves sharply beyond the spread’s strike prices, you may incur losses that can exceed the initial credit received. Additionally, since this strategy profits from low volatility, any sudden increase can reduce the likelihood of both spreads expiring worthless, making this strategy less effective in volatile markets.

How Accurate is the Iron Condor Strategy?

While iron condors can be accurate in low-volatility markets, their effectiveness decreases if the underlying stock breaks through the chosen strike prices. By monitoring implied volatility and carefully selecting strike prices based on ADX indicators, you can improve the accuracy and profitability of the strategy.

Why Trade Iron Condor?

Trading iron condors is beneficial for options traders seeking to profit from low volatility. By combining a call credit spread and a put credit spread, you create a position that benefits if the stock stays within a certain price range. With four options in place, you can achieve a balanced risk-reward profile while receiving a net credit on entry.

Can I Lose Money on an Iron Condor?

Yes, you can lose money on an iron condor if the stock price moves significantly outside the range defined by your call and put spread strike prices. If the stock moves beyond these boundaries, the spreads may not expire worthless, resulting in potential losses exceeding the credit received from the options contracts.