Monday, October 12, 2009

Mailbox- Strangles vs. Iron Condors

Received this question in response to my GLD Stranglehold post.

Why not always put on iron condors instead of strangles? You're paying some for the wings, but it reduces your capital outlay so much (lower margin) that the trade, if successful, has a much higher ROI. I'm not sure what the down-side of the IC over a strangle would be, aside from higher commissions and a slightly reduced profit range...

Thanks for the question. You already alluded to two of the differences. I'll start with the disadvantages, then move on to the advantages of the iron condor over the strangle.

Disadvantages of iron condor vs. short strangle:
-2 extra legs
-2x as many contracts (increased commissions)
-Less potential profit

Although most explain the structure of an iron condor as simultaneously entering a call vertical and put vertical spread, another way to think about it is as a short strangle plus a long strangle (protection). In a minute we'll review an example on GLD where we short the 113-97 strangle and buy the 118-92 strangle as protection. Because we're buying the "wings", the condor involves 2 extra legs. Which means we have to navigate 2 more bid-ask spreads, and pay commission on twice as many contracts compared to the strangle. In addition, buying the wings does cost money, so it reduces the profit potential on a dollar basis vs. the strangle. These are the three most common cited disadvantages I know of when entering an iron condor vs. the strangle.

Advantages of iron condor vs. short strangle:
-Less/Limited Risk
-Lower margin requirement

Despite the aforementioned disadvantages to the condor, there are certain advantages as well. As mentioned in the question, condors do typically reduce the margin required to enter the trade. Whereas the strangle has theoretical unlimited risk, the condor's risk is limited to the difference between strikes less the credit received. In addition, the margin required for the condor is fixed and thus doesn't change after you enter the trade. The margin required for the strangle, on the other hand, can change if the stock moves adversely. So in addition to having enough capital up front to enter the strangle, it would be wise to not max out all your buying power in other trades so you have additional funds if needed.

GLD 113-97 strangle
Reward = $142
Risk = Unlimited
Margin required ($1416.50)... roughly 10% of stock price
ROI = $142/$1416.50 = 10%

Note- the margin required may differ depending on your broker or if you have portfolio margin. I used Think or Swim for the calculation.

GLD 97-92, 113-118 iron condor
Reward = $92
Risk = $408
Margin Required= $408
ROI = 22%

Set aside the fact that the condor has a higher ROI for a minute. Let's say we want to receive around $3.00 of credit in either trade. Since the strangle brings in $142 credit, I would merely need to sell 2 strangles (4 contracts). The condor brings in $92, so I'd have to sell 3 condors (12 contracts). Depending upon how big your account size is and how many contracts you're dealing with, the condor can potentially rack up trading costs much quicker than the strangle.

I don't mean to overemphasize the importance of trading costs per se, nor am I recommending that it should be the only factor influencing whether you take one trade or another. I merely want to point out it is one legit difference between the two strategies. Truth is, some traders shun naked strangles like the plague and would never trade them due to the theoretical risk. In addition to personal preference, it also depends on the situation. In certain circumstances I don't mind selling strangles vs. condors. Just depends on the underlying and whether or not I'm willing to pay up for the protection inherent with the condors.

For example, on cheaper stocks (like the USO) the difference in margin on a strangle vs. a condor becomes less significant.


m said...

Good discussion.

You touched on one important point - the desire to collect $300 for the position.

IMHO, 'cash collected' should not be the important factor when deciding how many contracts to trade.

Obviously you want to do the specific trade, or you would not be doing it. But I believe the number of contracts should not increase solely because your maximum possible profit or loss has been reduced.

If I believe writing two covered calls is the right size, then I would consider the sale of two naked puts instead. Those are equivalent.

But I would sell only two put spreads. For me, there's no need to increase the size of the trade just because the profit potential is less.

That would be like saying: If you like the idea of selling FOTM options at $0.05, then sell 20 as an alternative to selling a single option @ $100. You would not do that (I hope).

Just another point of view on how to manage risk. I am not saying you are wrong - because you are not wrong.

Tyler Craig said...


Thanks for the comments. I agree 100% with your assessment. It's not the credit received, but the amount of risk inherent to the trade that is the determining factor in position sizing. I could have taken the analogy the other way and looked at the risk or margin required for either trade to illustrate an apples to apples comparison of the amount of contracts involved.

If I wanted to tie up roughly $1400 in either trade, it comes out to 1 strangle (2 contracts), vs. about 3 condors (12 contracts). To be fair, 3 condors net's more premium but the point was the difference in contract size.

Shane & Buddy Hoover said...

Having started by trading Condors and moved to Strangles/Straddles I have found my profitability increase substantially for two reasons.

1.) It is easier to repair/adjust S&Ss. This comes down to the lower trading costs both commissions and bid/ask.

2.) There is a higher probability that you will enjoy an acceptable profit prior to expiration thus allowing you to take the position off early.

If you typically experience 65% of condor trades to be profitable, one could conceivably increase that by 10% or 20% depending on the rules you hold yourself to.

Tyler Craig said...

Like everything else it comes down to risk management. Though you may have a higher "probability of profit", you also have more potential risk. The question each trader must ask themselves is whether or not the the "xtra potential reward" is worth the occasional higher loss you'll experience in the long run. If you can avoid or properly manage the catastrophic losses, the short strangles (on the right underlying) may have a bit of an edge.

Having never tested it enough myself, I don't really have any conclusive evidence.