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.
- 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.