A definition: An iron condor is a position in which you sell one call spread and one put spread. Although it may not ‘feel’ logical, when you sell those spreads, you buy the iron condor.
The Expiration Month
Iron condors become profitable as time passes, unless the underlying stock or index makes a significant move in one direction or another. Thus, the passage of time is your ally when you buy iron condors. For that reason, most iron condor traders prefer positions that expire in the front month (the month closest to expiration). Time decay, as measured by theta, is not linear. That means it’s not constant throughout the life of the option. As expiration approaches, time decay accelerates. Near-term options have the most rapid time decay, and when you are a seller of option premium, rapid time decay is good for your position.
However, it’s not that simple because there are additional negative factors associated with front-month options:
—You collect less cash when making the initial trade. That means risk, as measured by your maximum loss, increases. An iron condor can reach a maximum value, and the more cash you collect upfront, the less you can lose. This will be discussed in greater detail in a future post.
With less time remaining, the trader on the other side of your order (probably a market maker) pays less for those positions. Why? Because an iron condor is a position that is worth more when there is more time in the life of the option contract – more time for the stock to make a favorable (large) move. Obviously if the move is favorable for the other trader, it’s unfavorable for you.
When you collect less cash, you must decide if it’s a reasonable trade-off because there is less time for something bad (large move) to happen.
—If the index undergoes a substantial price change, the rate at which money is lost is significantly greater when you have a front-month option position. Depending on how much you already know about options trading, it may be too early in your education to discuss why this is true. However, it’s because the options gain or lose value more rapidly than options with longer lifetimes. This is effect of gamma, one of the ‘Greeks’ used to quantify risk when trading options. Negative gamma is not your friend when you sell options.
Once again it’s a trade-off. You get more rapid time decay and the chances of something bad happening are reduced when you trade near-term options, but if something unwanted does happen, losses mount more quickly.
When you sell options that expire later (in the 2nd or 3rd month), you collect more cash (good), have positions that lose less when something bad happens (good), but there is more time for something bad to happen (not so good).
Choosing which expiration month to trade requires the ability to recognize subtle differences in how your position performs during the time you own it. It’s one of those decisions that becomes easier to make after you have some practice trading – and that decision is going to be based on your comfort zone. To get started, I suggest opening a new position with five to seven weeks remaining before the options expire. You will soon discover whether that suits you and your trading style. If not, move to shorter or longer-term options. But I strongly recommend not going out further than three months.
You will discover which strategies are comfortable to trade, how much risk you are willing to take in an effort to earn a given reward (maximum profit potential for a trade), how many options to trade at one time (position size), etc. This takes time, and when you discover where you are comfortable, and can sleep at night with no worries over your trading portfolio, you have found your comfort zone.
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Further Reading, Options: