Technical Analysis

Do the Derivatives: Iron Condor for range-bound market

Shaurya Mishra | Updated on November 03, 2012 Published on November 03, 2012


Iron condor strategy is best used when markets are expected to be range-bound. It is designed in such a way that there is a high probability of earning at least a small profit. Iron Condor can be created by buying a higher strike out-of-the-money call and selling another even higher strike out-of-the-money call and selling a lower strike out-of-the-money put and buying an even lower strike out-of-the-money put. It should be noted that all the contracts should have same specifications. Since options closer to strike price costs higher therefore there is a net inflow of premium which is also the maximum profit.

This strategy becomes unprofitable if markets move unilaterally in one direction, a simple example will help explain the above strategy.

If Nifty spot is trading at 5,664, we can construct an iron condor strategy by selling 5,700 call with premium of Rs 94.5 and 5,600 put (Rs 52) and buying 5,500 put (Rs 29) and 5,800 call (Rs 51.5). There will be a net inflow of premium which will be equal to Rs 66 (94.5+52-51.5-29). So if market is range bound i.e. it closes between 5,600 and 5,700 then the option which were written will not be exercised (5,700 call and 5,600 put) and options which were bought will remain worthless and thus initial premium (Rs 66) which was collected will be the profit. Now, what will be the outcome if the trader was wrong and the market moves in one direction i.e. it either gains or loses?

When market rallies: If the Nifty closes between 5,700 and 5,800 then the investor will lose money since he/she has written 5,700 call and thus the maximum loss will be Rs 34 (66-(5800-5700)). If it rises above 5,800 then the profit from the 5,800 call will compensate the loss from the written 5,700 call.

When market declines: If the Nifty closes between 5,500 and 5,600 then the investor will lose money since he/she has written 5,600 put and thus the maximum loss will be Rs 34 (66-(5600-5500)). If it falls below 5,600 then the profit from the 5,500 put will compensate the loss from the written 5,600 call.

So the overall profit is capped at Rs 66 and loss is capped at Rs 34.

Price of options are largely influenced by time and volatility. Near the money options have higher time decay factor than out of money options. Time decay factor means change in price of option due to change in time.

Iron condor strategy benefits since near-the-money options are written. Assuming that market is range-bound, time decay is faster in the near the money option. This ensures that most of the premium collected while writing the near-the-money call or option is retained.

>shaurya.mishra@thehindu.co.in

Published on November 03, 2012

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