Generate Income on Stable Stocks with Iron Condors

 

 

Do you want to make some money without having to invest cash upfront in stocks? Instead, you could use options on stocks that allow you to make some money, right when you enter the trade!

 

 

If you structure your options right in an “iron condor,” you could generate some income while protecting yourself against a steep decline in the stock.

 

 

There are ways to use options on stocks to bet on stocks going up or stocks going down. You can even use them with or without strategies to protect you in case the price moves away from you. However, the iron condor works best with a stock whose price you think is likely to remain pretty stable.

 

 

You’ll be able to make a profit on the original trade, which you keep in the best-case scenario. In the worst case, you’ll have a small loss. Choosing the “strike prices” (target prices) on each option that you trade determines how much you could potentially make as well as lose.

 

 

Puts and calls

 

 

 

Options on stocks, such as puts and calls, allow you to trade on a stock without purchasing it upfront. Stock options can lower your investment costs significantly!

 

 

You might already be familiar with a call. When you buy this kind of option, it allows you to “call” the stock back to you if the price rises above the target or strike price. If you believe stock’s price will rise, your call allows you to buy the stock at the lower strike price.

 

 

The premium, or cost, to buy the call depends on several factors. These include the date of expiration, and how far the price has to rise to get to the strike price. An “in the money” call means the call is worth exercising.

 

 

“Out of the money” means the stock price is not near the strike price, and the call will probably not be exercised. Owing to the economics of supply and demand, the farther out of the money the option is, the lower the premium to buy it. Out of the money options are not in demand like in the money options are.

 

 

For example, you might believe that the price of the company Hair Tie World (HTW) will increase in the next month. It’s currently trading at $45. You buy one MAR 50 call, which covers 100 shares of HTW stock. This call is “out of the money,” and costs $1.00.

 

 

If HTW goes to $60/share, you exercise your right to purchase 100 shares at $50 instead of $60. If HTW stays the same or loses value, the call expires worthless. You would be out the premium you paid ($100) to buy the call.

 

 

But what if you believe Hair Tie World is going to decrease in price? Instead of buying a call, you could buy a put that allows you to “put” back the stock. HTW is still at $45, so you buy one (out of the money) MAR 40 put for $1.00.

 

 

If HTW drops to $30, you exercise your right to sell them at $40. Your gain is $10/share or $1000, less the put cost of $100, so you would net $900.

 

 

So, you can see that if you believe a stock will rise, you can buy a call. If you think it will drop, you buy a put.

 

 

This is reversed if you sell the options instead: if you think the price will rise, sell a put; if you think it will drop, sell a call. Note that an options seller, unlike the options buyer, must honor the option if the buyer chooses to exercise.

 

 

Selling (“writing”) options instead of buying them provide an income from the premium you receive upfront from the trade. The best-case scenario for selling options is that they expire worthless, and you keep the whole premium.

 

 

For example, you think Hair Tie World is going to rise in price from its current $45. So you sell a MAR 40 put for $2.00. It goes to $50, so your put expires worthless, and you keep the $200 premium. Similarly, you can sell a call if you think the price will drop instead.

 

 

 

Put and Call Spreads

 

 

 

However, just buying and selling options as discussed above could hurt you. If the price moves against you, you could end up losing a lot of money. You can mitigate this by using a put or call spread instead, which involves buying more than one option more or less simultaneously.

 

 

A “bull” put spread, or bull put credit spread, can generate some income. It’s a bull spread because you expect the price to rise. These trades are best with stocks whose prices you believe will go up moderately.

 

 

In the bull put spread, you sell an in the money put, which provides you with a premium. You buy an out of the money put at the same time. Since its premium will be less, you end up with a net credit on the trade.

 

 

Buying the lower strike put limits the loss if the price drops sharply. Put writers can lose a lot of money if the price tanks! Therefore a put spread limits the losses you can incur.

 

 

Suppose you think Hair Tie World, still trading at $45, will go up a bit in price, and you want to profit from that. You sell a MAR 40 put for $2.00, and buy the MAR 35 put for $1.00. Your net profit is $100, and that’s the most you can make with this strategy. The maximum loss is the difference in strike prices, less the net credit. The lower strike put (MAR 35) that you buy protects you against a big drop (below $35).

 

 

Conversely, if you think HTW at $45 is likely to drop a little, you can use a “bear” call spread. The bear’s direction is down: prices are expected to decline.

 

 

Sell one in the money call to generate the income, and buy an out of the money call to protect yourself if the price rises sharply. You could sell a MAR 50 call for $2.00, and buy a MAR 55 call for $1.00, for a net (maximum) profit of $100. The long call protects you if the price rises sharply.

 

 

Notice, however, that both of these spreads are directional. In other words, you use one or the other because you think the stock price will rise or fall. You’re protected if the price moves against you, so you know you can limit your loss.

 

 

But what if you don’t know (or care) which direction the price goes? What if it seems likely it will move very little? This is a market-neutral type of trade, rather than a directional one. And you can still make money (and limit losses) with a market neutral strategy.

 

 

Enter the Iron Condor

 

 

 

If you want to generate some income and limit your potential losses, combining these two spreads into an iron condor will work for you. Your maximum profit is the net credit from the trade, and maximum loss is the difference in strike price (whichever leg ends up in the money) less the net credit.

 

 

With the iron condor, the best-case scenario is that the stock price increases or decreases slightly – in other words, that the price ends up between the strike prices of the put and call you sold. In this case, all the options expire worthless, and you keep the net credit. If the price drops below the long put strike (put that you bought), or above the long call strike (call that you bought), you will experience the maximum loss.

 

 

Here, suppose that HTW isn’t likely to move much either way away from its $45 price. You combine the bull put spread and bear call spread as noted above.

 

 

  • You sell: one MAR 40 put at $2.00 and one MAR 50 call at $2.00.
    Total premium = $400

 

  • You buy: one MAR 35 put at $1.00 and one MAR 55 call at $1.00
    Total premium = $200

Your net credit is $2.00 on this trade, and your total potential premium is $200. This is the maximum profit the iron condor trade will provide.

 

 

In the best scenario, the price of Hair Tie World will be between $40 and $50, which are the options you wrote. All options will then expire worthless, and you keep your net credit of $2.00.

 

 

If, however, HTW either drops below $35 or rises above $55, you will have a loss. (The option you bought limits this loss according to its strike price.) The maximum loss is the difference in the strike prices less the net credit from the options sold upfront. If one of these legs end up in the money, you have to close out the trades. That’s why the loss is limited to the difference in strike price.

 

 

What happens if, for example, the price rises to $60? Your long call is in the money. The difference in strike price is $5, multiplied by 100 shares is $500. But you received a $2.00 net credit upfront, so your maximum loss is $300.

 

 

 

In summary

 

  • Options on a stock or index can generate income depending on the movement of the stock price.
  • Option spreads can be used to limit potential losses while still providing income.
  • The iron condor trade provides income and limits losses,   no matter how the price of the underlying stock moves.
Trading Options- 7 Things You Should Know

 

 

Options are flexible financial tools that can be used to enhance, diversify, and protect your portfolio. Options are available for equities, debt, and real estate as well as specific sectors. They are traded using stocks, indexes, and exchange-traded funds as the underlying asset.

 

In short, trading options can be endlessly complicated, but it doesn’t have to be. If you have a solid grasp of a few simple concepts, trading options can be a very smart way to help you achieve your financial goals.

 

So what do you need to know? Let’s begin with the basics:

 

 

1. What Is An Option?

 

 

Options are simply a contract between a buyer (the holder) and a seller (the writer). The buyer pays a premium, which is the price of the contract, in exchange for the right to purchase or sell an underlying asset such as a stock. The seller agrees to purchase from or deliver the underlying asset to the buyer at the agreed-upon price.  The contract specifies the price of the stock per share (the strike price), and the number of shares (usually 100) and expiration date. Buyers of a call or put have a “long position.” Sellers of a call or put have a” short position.”

 

 

Options are bought and sold on exchanges in the same fashion as any other publicly traded security. Price is based on demand in the market and is influenced by intrinsic value, time to expiration, and anticipated fluctuations in the underlying stock price (volatility). Intrinsic value is the difference between the current price of the underlying stock and the strike price.

 

Only the seller is obliged to buy or sell the stock at the strike price. The contract is “exercised” at the buyer’s discretion. A contract that gives the holder the right to purchase the stock is a “call.”

 

A call holder believes that the value of the stock will be greater than the strike price at or before the expiration date. A call writer believes that the value of the stock will be less than the strike price at or before the expiration date. A contract that gives the holder the right to sell the stock is a “put.” A put holder believes the price of the stock will be less than the strike price at or before expiration. A put writer believes the price of the stock will be greater than the strike price at or before expiration.

 

 

2. How Investors Make Or Lose Money

 

 

Let’s take a look at how option holders and writers make money using this example of a call.

 

Company: The EZ company

Option Type: Call

Expiration Date: August 5th, 2019

Strike Price: $100.00

Premium: $ 4.00

EZ Company Stock Price: $97.00

 

In this example, the holder agrees to pay the writer $ 4.00 per share for the right to buy 100 shares of EZ Company for $100.00 on or before August 5th, 2019. The stock price of EZ company is $97.00 dollars per share.

 

This option is “out of the money” because the stock price is less than the strike price. If the stock price is not above $100.00 per share on or before August 5th, 2019, the option will expire worthless. The holder will have lost $400.00, which is the premium paid to the writer. The writer made $400.00, which is the premium received from the holder.

 

If the stock price were $ 110.00 per share on or before August 5th, 2019, the option would be “in the money” because the stock price is higher than the strike price. The holder would have made $1,000 (110 – the strike price of 100 per share X 100 shares) less the premium paid to the writer of $ 400.00. The holder made $ 600.00 on a $ 400.00 investment, a 150% return. The writer could have sold the stock for $110.00 per share, but instead had to sell to the holder for $100.00 per share.

 

Our example illustrates the concept that is at the heart of the power of options, leverage. The holder risked a small amount of capital $ 400.00 to control $11,000 of EZ stock (100 shares X 110 per share) resulting in a 150% return. Let’s use a similar example to illustrate how holders and writers make money using puts:

 

Company: The EZ company

 

Option Type: Put

Expiration Date: August 5th, 2019

Strike Price: $100.00

Premium: $ 4.00

EZ Company Stock Price: $103.00

 

In this example, the holder agrees to pay the writer $ 4.00 per share for the right to sell 100 shares of EZ Company for $100.00 on or before August 5th, 2019. The stock price of EZ company is $103 dollars per share. This option is “out of the money” because the stock price is greater than the strike price. If the stock price is not below $100.00 per share on or before August 5th, 2019, the option will expire worthless.

 

The holder will have lost $400.00, which is the premium paid to the writer. The writer made $400.00, which is the premium received from the holder. If the stock price were $ 90.00 per share on or before August 5th, 2019, the option would be “in the money” because the stock price is lower than the strike price.

 

The holder would have made $1,000 (the strike price of 100 – 90 per share X 100 shares) less the premium paid to the writer of $ 400.00. The holder made $ 600.00 on a $ 400.00 investment, a 150% return. The writer could have bought the stock for $ 90.00 per share, but instead had to pay the holder $100.00 per share.

3. What Options Are Available Besides Stock?

 

 

The example above is based on an individual stock. Options are also available on indexes and ETFs (exchange-traded funds) as well as individual stocks. Options using indexes and ETFs offer exposure to the broad market, specific sectors, even market metrics such as price volatility.

 

 

Index and ETF options have several important differences.  An index is a measure of the change in price up or down of a basket of individual stocks, such as the S&P 500, or a market metric such as price volatility (VIX). After the transaction between writer and holder (settlement), only cash is exchanged.

 

 

There is no purchase or sale of the underlying security as in our example above. ETF options settle in the same fashion as individual stocks.  Index options may only be exercised on the expiration date (European style). ETF options may be exercised at any time before expiration (American Style). Options are typically available with expiration of 90 days out, but there are other options (LEAPS) that can be up two years out.

Learn more about options.

 

 

4. Trading Option Strategies

 

 

So far, we have examined option features, calls and puts, writing and holding, strike prices, expiration dates, and underlying assets. Option features may be combined into strategies designed to achieve a specific goal. There are options strategies to speculate, enhance portfolio income, protect against losses, and boost returns.

 

 

Option strategies are also used to capitalize on current market conditions. The strategies are generally categorized as bull or bear. Bull strategies anticipate that the underlying asset price will rise, bear strategies that the price will fall.  All of them have risks, ranging from loss of the premium paid, to unlimited losses.

 

Check out more on calls and puts with our free course module  Understanding Equity Options And Options Trading

5. Placing Option Orders

 

 

Options differ from other types of orders that you place In your brokerage account such as buying or selling a stock or mutual fund. An options order “opens” or “closes” a position. Opening a position initiates For example if you wanted to purchase a call (long position) the order would specify “buy to open.”

 

 

If you wanted to sell, or write a call (short position) the order specify would “sell to open.” Closing a position liquidates. If you wanted to liquidate a long position, the order would specify “sell to close,” a short position would specify “buy to close.”

 

 

6. Research Your Broker-Dealer

 

 

Options are generally purchased through brokerage accounts. A standard brokerage account does not include an options feature unless you request it. The Broker-Dealer (Charles Schwabb or Raymond James, for example) will require additional information from you about your risk tolerance, financial experience, and financial resources.

 

They may only permit certain types of options trades in your account. Broker-dealers have different levels of resources and support for options trading. Some broker-dealers are much better at it than others. It will be important for you to become familiar with your broker dealer’s option capabilities, procedures for exercise and settlement, and their commission schedules before you begin trading options.

 

 

7. Know What Your Goals Are

 

 

Your option trades should be aligned with your financial goals and risk tolerance. Trading options is different from trading other assets like stocks bonds and mutual funds. Getting good results begins with good research. Invest in learning the terminology and concepts before you trade.

 

 

Download our free course A Beginners Guide To Options Trading

 

 

Steady Dime is an expert option recommendation and education service for Options Traders. We focus on generating consistent short-term profits. Our promise to you is that each trade idea is researched thoroughly before being sent out as a recommendation.


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