The Hindu Business Line : Iron Condor - to benefit from a range-bound market

The last couple of months have seen an unprecedented rise in options trading volumes. And why not, for in such volatile markets it is always options that come to the fore. The simplest of option strategies that can be used in such markets are call and put spreads, both of which have been discussed previously in this column.

However, the flip side, if we can call it that, of these options spreads is that it requires you to be fairly sure of the trend (moderately bullish or bearish) in the underlying. That may leave you with little choice in markets where you are relatively clueless about the underlying’s movement, but for it being range-bound. While the easiest thing to do during such times is to stay away from markets, for those of you who are willing to raise the stakes, here is another strategy – Iron Condor.

When to use?

An Iron Condor can be used when you are neither overtly bullish nor bearish – basically neutral as far the market trend is concerned, but at the same time believe it to remain within a range. For instance, this strategy can be used on Nifty, if you are reasonably confident of the range the index is likely to remain in, but are not as sure about which end of the range it is more likely to trend towards.

For instance, suppose you expect the Nifty to trade between 3800 and 4100 levels in the coming week, you can play the range by setting an iron condor. You can set an iron condor by combining a bull put and bear call. Here is how it can be done.

Setting the bear call

Since you believe 4100 to be the upper range for Nifty, you can consider selling a call at that strike price (sell Oct Nifty 4100 call trading at Rs 67). But, as that will expose you to unlimited losses should Nifty rally beyond 4100, you can buy Oct Nifty 4150 calls to protect yourself (trading at Rs 54) from such a move. By doing this, you have now set a bear call spread, in which the maximum profit will occur when Nifty trades below 4100 and maximum loss if Nifty moves above 4150.

Setting the bull put

The second part of this strategy is the bull put spread, which will cover the lower end of the expected range for Nifty. In this example, since you believe 3800 to be the lower limit for Nifty, you can sell Oct Nifty 3800 put (trading at Rs 140) to seal that level. But as this will expose you to unlimited losses if Nifty trends below 3800, you can buy additional protection by buying Oct Nifty 3750 puts (trading at Rs 118). This bull put spread will enjoy maximum profits when Nifty trades above 3800 and maximum losses when it falls below 3750.

The big picture

The combination of these two strategies gives you an Iron Condor, whose maximum profit zone is when the Nifty closes between 3800 and 4100 and maximum losses when Nifty moves either above 4150 or below 3750. You can tweak the strike prices of the long options (options that are bought) on both the ends, depending on the extent of protection you need from a surprise movement in the index. But before you do that, remember that the cost you pay for purchasing the options will reduce the maximum profitability by that much. So, ahead of finalising the option strike prices, work out the risk-return payoff.

Note that, while this strategy can also be set using stock options, it is better to stick to index options as at any point in time index options enjoy higher liquidity. Also, to best enjoy the advantages of this strategy, you will need to set both the spreads at the same time.

That will not only lower your cost and margin requirement for the strategy, it will also protect you from any untoward movement in the underlying.

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