Walking Down the Spreads Line

Dr. Ken Rietz

In this spreads commentary, I cover a spread strategy that is probably familiar: iron condors. I want to talk briefly about the overall construction of an iron condor and its basic properties. I will assume that you understand how to create an iron condor to suit your purposes. Rather than going over that, I want to focus on two of the more common perplexing problems: ways to defend the iron condor, and how to make it directional. Those are actually related. One more initial comment is necessary. I will be illustrating the changes that can be made to an iron condor using an equity option program set to its expiration date. This will mimic a futures contract, except the cost of carry is not included. Here is the profit graph for a typical iron condor.

The classic iron condor consists of two credit spreads. The spread with the lower strike prices is a bull put spread, with the strikes close together. The spread with the higher strikes is a bear call spread, with strikes the same width apart as the other spread. Since these are credit spreads, you collect premiums from establishing the iron condor, and the goal is to have both the component spreads expire worthless so that you keep the premiums. The classic iron condor is non-directional and consists of a central horizontal plateau, two very steep sides, and two wings. The plateau is where you want the price to stay; the component spreads expire worthless for those prices and you get the entire premium as the maximum profit. Off that plateau, things get ugly. The profit drops rapidly down the side, and once on the wings, you discover the maximum loss.

One useful property is that the maximum loss is only the loss of one of the component spreads, not the sum of both losses. The reason is that the iron condor can only lose on one side; the other side will expire worthless.

Clearly, you want to avoid dropping off the plateau, so when the price gets near an edge of the plateau, you begin to consider the choices you have. That is what is called an attack on the iron condor. There are three different common ways of defending the spread.

•  Roll away the threatened component spread. This opens up more room on the plateau, but since the price is getting close to the component spread, rolling it will be expensive. Besides, knowing how much room to add is hard to decide. The price is moving toward you and is likely to continue. It is not recommended.
• Roll the non-threatened spread toward the other spread. This will generate some income, possibly enough to allow you to afford the first choice. But you also need to realize that you are shrinking the plateau possibly a lot. It might be worth it, but probably not. This choice can dramatically reduce the profit area. This choice is not recommended, either.
• Close the trade. This is obviously a last resort, and is not guaranteed to give you a profit; depending on how close the price is to the edge, it could generate a loss. This is not recommended.

There is something in common with these choices. They are all suboptimal and often losers. There is, however, a little-known alternate choice, which gets us into non-classic iron condors.

Let’s look at the possible alterations. The first two choices change the distance between the component spreads. The classic iron condor will be set up with the current price roughly centered between the sold strikes of the component trades. This is fitting since a classic iron condor is a neutral spread. You have no idea in which direction the price will move. The classic iron condor is non-directional.

But the iron condor can actually be made directional. Here is how. If you move the bought strike of one of the component spreads, it has an unexpected effect on both wings of the iron condor. Specifically, if you move the bought side of one of the component spreads away from its sold strike, the loss of that side drops a lot (increasing the loss on that side), but the loss of the other side drops, even enough possibly to become profitable. Here is what the profit graph can look like after that move.

This becomes the preferred solution to the right-hand side of an iron condor being attacked: Roll the bought future on the left side far enough away to raise the lost right wing of the attacked component until it is profitable. (Since the iron condor is symmetric, if the left side gets attacked, then you move the bought strike on the right side further right.) Note that the cost of that roll will be a small profit, since you are selling a position and buying a further out position, and the current value of the commodity is fairly far away. You are then guaranteed a profit unless the price of the commodity travels back across the plateau and down the other side, which would be exceedingly uncommon with a well-constructed iron condor. There is an additional bonus to this method. The profit of ending on the plateau increases. You can see this by looking at the notation of Max Profit on the two graphs.

This also answers what to do if you have reason to believe that the price is more likely to move one way than the other. You can set up the iron condor to be a lower loss or even profitable if the commodity price wanders off in that direction. Of course, if you are wrong, the loss in the other direction becomes much larger, the penalty of missing the actual direction.

I will finish with a hypothetical example of fixing an iron condor on a corn futures spread. The current corn future ZCK5 (May 2025) is close to 455, so I sell a bull put spread with strikes 4.40 and 4.45, and a bear call spread with strikes at 4.70 and 4.75, (Clearly, this is not intended to be an intended iron condor, since the price will almost certainly wander off this plateau.) The profit plot then looks like this:

You will note that the maximum profit is $137.50, the sum of the prices of the two-component spreads. The maximum loss is $112.50 on either wing, and the chance of profit is estimated as 42%. Now, let’s assume the price shoots up to close to 470, and you are concerned about it moving down to the wing. Following the procedure given above, you want to move the 440 put down to, say 330. In that case, the profit graph changes to this.

All of a sudden, the region above 470 is now all profitable, with the wing now giving you a profit. The maximum loss is now $465.63 on the other wing, but the chance of getting there is very small (30% for random moves, and the market is not moving randomly). You should also note that the maximum profit (on the tableau) is now $284.38, up from the unaltered value of $137.50.

If instead, the price dropped to near 475, and you wanted to protect against the drop on that side, you could roll the 475 call option up to 490 and get this graph. There is now no loss above 475, and the maximum (plateau) profit of $293.75.