You have probably heard about the classic iron condor to benefit from a relatively stable market, but what if you need a strategy for high volatility? The reverse iron condor strategy, also known as the inverted iron condor, is designed to profit from significant price movements and rising volatility. This article explains how to implement this approach effectively.
Key takeaways
- The reverse iron condor strategy is a neutral options strategy that benefits from rising volatility and large directional moves.
- It involves buying out-of-the-money options and selling further out-of-the-money options to reduce cost but limit profit potential.
- The strategy requires significant price changes and/or increased volatility in the underlying asset price to be profitable.
What Is the Reverse Iron Condor Strategy?
Key Points
- Market-Neutral: Designed to profit from volatility rather than directional bias.
- Risk Management: Limited risk due to capped maximum loss.
- Profit Potential: Relies on significant price movements to achieve profitability.
So, what is the reverse iron condor strategy? Simply put, it’s an options trading strategy tailored to benefit from substantial price movements in either direction and rising volatility. Unlike the traditional iron condor, which thrives in stable markets, the reverse iron condor is designed for those expecting significant shifts in the underlying asset’s price.
Definition and Purpose
The reverse iron condor strategy, also known as the inverted iron condor or the opposite of iron condor, is a market-neutral approach. It involves four options contracts: buying one out-of-the-money (OTM) call, selling one further OTM call, buying one OTM put, and selling one further OTM put. The goal is to profit from large price movements and increased volatility, regardless of the direction.
Setup
Here’s how you set up a reverse iron condor:
- Buy 1 OTM Call: Purchase an out-of-the-money call option.
- Sell 1 Further OTM Call: Sell a call option with a higher strike price.
- Buy 1 OTM Put: Purchase an out-of-the-money put option.
- Sell 1 Further OTM Put: Sell a put option with a lower strike price.
By buying and selling options both above and below the current price, you create a position that profits from significant moves in either direction.
Comparison
Compared to the traditional iron condor, which profits from low volatility and stable markets, the reverse iron condor benefits from high volatility and significant price shifts. While the regular iron condor generates income through premiums when the stock price remains within a range, the reverse iron condor seeks profit from sharp moves outside a defined range.
Profit and Loss Potential
The success of the reverse iron condor strategy hinges on large price movements and increased volatility:
- Maximum Profit: Achieved when the underlying asset’s price moves significantly beyond the range defined by the sold options. The profit is limited to the difference between the strike prices of the bought and sold options minus the initial debit paid.
- Maximum Loss: Occurs if the price stays within the range of the sold options at expiration. The maximum loss is limited to the net debit paid for entering the trade.
- Breakeven Points: Calculated by adding the net debit to the lower strike price of the call side and subtracting it from the higher strike price of the put side.
Example
Let’s consider an example using a fictional stock currently priced at $100. Let’s say that this is your profit and loss (P&L) profile:
Note that, to obtain the P&L above, you would need to do the following:
- Buy 1 $95 Put (OTM)
- Sell 1 $90 Put (Further OTM)
- Buy 1 $105 Call (OTM)
- Sell 1 $110 Call (Further OTM)
If the stock price moves significantly beyond $110 or below $90, substantial profits can be realized. Conversely, if the price remains between $90 and $110, the strategy will incur a loss equal to the initial debit paid.
By understanding the setup, comparison, and profit/loss dynamics, traders can effectively deploy the reverse iron condor strategy to capitalize on volatile market conditions.
A Real-Market Example of the Inverted Iron Condor
An example on one of the most famous tickers, SPY, will help illustrate how the reverse iron condor strategy works. Suppose you expect high volatility on SPY, and the VIX index is currently above 30 points, indicating a highly volatile market. You believe your odds are favorable but want to limit your losses if you’re wrong. The reverse iron condor strategy might be the right fit for you.
Let’s say SPY is trading at $529.67. You look up different strategies on an options screener and decide to open the following positions with options expiring in a week:
- Buy a $525 put
- Sell a $520 put
- Buy a $540 call
- Sell a $545 call
And here is your P&L profile:
Here’s what happens: If SPY stays between $525 and $540 by expiration, you’ll incur a maximum loss of $250, which is the net debit paid for entering the trade. Your breakeven points are calculated by adding and subtracting the net debit from the strike prices of the sold options, resulting in breakeven points of $522.51 and $542.49. If SPY moves beyond $545 or below $520, you achieve the maximum profit of $250, as the bought options become valuable while the sold options expire worthless.
How Does This Example Work?
- Risk and Reward: The reverse iron condor strategy gives you a balanced risk-reward ratio. In this example, your maximum loss is $250, but you also have the potential to gain $250, giving you a 100% profit ratio.
- Volatility Play: The reverse iron condor strategy benefits significantly from high volatility since substantial price movements in either direction can lead to profits.
- Market-Neutral: It doesn’t matter whether SPY goes up or down; the key is that it moves enough to break past your breakeven points.
Simple Breakdown
- Cost to Enter: The initial debit paid when you open the position.
- Profit Potential: Capped at the difference between the strike prices of the bought and sold options on each side, minus the net debit.
- Loss Potential: Limited to the net debit paid.
This approach allows you to manage your risk effectively while positioning yourself for potential gains in a volatile market. The opposite of iron condor strategies, like the inverted iron condor, can be powerful tools when you expect significant price changes in your chosen asset.
Advantages and Disadvantages of the Reverse Iron Condor Strategy
Keep in mind that, as you may have already guessed from our previous example, there are several pros and cons to the reverse iron condor strategy. The table below sums up the advantages and disadvantages of the reverse iron condor strategy:
Advantages
- Lower Cost: The reverse iron condor typically has a lower cost compared to long strangles because you are both buying and selling options, which helps offset some of the costs.
- Limited Risk: One of the most significant advantages is the defined, limited risk. Your maximum loss is capped at the net debit paid to open the position.
- Defined Maximum Loss: Knowing your worst-case scenario upfront allows for better risk management and planning.
Disadvantages
- Limited Profit Potential: The strategy’s profit is limited to the difference between the strike prices of the bought and sold options, minus the initial debit. This can be a downside if the underlying asset moves dramatically beyond expectations.
- Need for Significant Price Movements: For the strategy to be profitable, substantial price movements are necessary. If the underlying asset remains stable or moves only slightly, the trade will likely result in a loss.
- Time Decay: Options lose value as they approach their expiration date. If the expected price movement doesn’t happen quickly, time decay can erode the value of the bought options, leading to losses.
How to Adjust a Reverse Iron Condor to Changing Market Conditions
If you’ve already opened a reverse iron condor strategy and the market conditions shift, it’s essential to adapt your approach. Below are some methods to adjust your strategy:
Rolling Out to a Later Expiration
If the asset hasn’t moved significantly, you might extend the expiration date to allow more time for the expected price movement. To do this, close your existing position and open a new reverse iron condor with the same or adjusted strike prices. The adjustment might involve moving the strike prices closer to the current asset price if necessary.
Be aware that this is a debit strategy, and time works against you, so rolling the position will incur additional costs, increase the overall debit, and require a more significant price move to break even.
Rolling Up or Down
If the stock price has moved but not enough to fully profit from the strategy, you might adjust the strike prices up or down to better align with the new price levels. This involves repositioning the strike prices closer to where the stock is currently trading, depending on the direction of the price movement.
You can move the options to lock in a profit – if you move the wing in the same direction as the asset movement. Alternatively, you can bring the break-even of the other wing closer.
