Reverse Iron Condor Construction
- Buy 1 OTM Put
- Sell 1 OTM Put (Lower Strike)
- Buy 1 OTM Call
- Sell 1 OTM Call (Higher Strike)
Reverse Iron Condor has a limited gain and a limited loss potential. The maximum gain It is attained when the underlying stock price drops below the strike price of the short put or rise above or equal to the higher strike price of the short call. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when initiating the trade. It will result in a loss if the price doesn't move far enough in either direction, or if it stays the same.
Compared to a straddle option strategy, RIC has limited gain potential, but it also needs the stock to move less to be profitable. It is basically a combination of bull call debit spread and bear put debit spread. You can adjust the strikes based on your expectation of the move. Constructing the trade with further OTM options will provide a better risk/reward, but lower probability of success (the stock will need to move more to produce a gain).
One of the common uses of the Reverse Iron Condor strategy is betting on a sharp move on one of the high flying stocks after earnings. It can be used on stocks like NFLX, AMZN, GOOG, TSLA, PCLN etc.
Using Reverse Iron Condor through Earnings
GOOG was scheduled to report earnings on April 21, 2016. The At-The-Money weekly straddle ($760 strike) was trading around $41, implying $41 or 5.3% move.
If you believed that GOOG is going to move, you had two options:
Option #1: buy a straddle for $41 debit
- Buy 1 760 Put
- Buy 1 760 Call
Option #2: buy RIC (Reverse Iron Condor) for 1.75 debit
- Buy 1 745 Put
- Sell 1 740 Put (Lower Strike)
- Buy 1 775 Call
- Sell 1 780 Call (Higher Strike)
Straddle would need $41 move just to break even, but would have unlimited profit potential if the stock moved big time. It also would not lose as much if the stock moved less than expected.
RIC would need only $20 move (above $780 or below $740) to make money.
The next day GOOG moved $40 and closed at $719. Since it was below the short put strike, the RIC made a nice 43% gain (2.50/1.75), while the straddle was barely breakeven.
The biggest drawdown of the RIC strategy before earnings is that if the stock doesn't move enough after earnings, IV collapse will crush the options prices. The risk of 80-100% loss is real.
Unfortunately, many options gurus present this strategy as almost risk free money, completely ignoring the risks. Here are two examples.
A Seeking Alpha contributor suggested the following play on GOOG earnings on April 12, 2012 with GOOG at $632:
- Buy twenty (20) April Week 2 $610.00 put options
- Sell twenty (20) April Week 2 $600.00 put options
- Buy twenty (20) April Week 2 $650.00 call options
- Sell twenty (20) April Week 2 $660.00 call options
Rationale behind the trade:
"Google is a notorious big-mover after reporting. I am completely confident that the trade recommendation I am writing about will work like a charm."
What is completely missing in this comment is the disclosure of the options trading risk. The next day GOOG closed at $624, and the trade has lost 100%.
As our contributor Chris (cwelsh) mentioned in the comments section:
"Earnings are wild and unpredictable. A careful analysis and you can improve your odds, but you always have to factor in position sizing and potential loss into any trade. My entire point of my posts was that I think a discussion of risks should always be included in any article that discusses huge potential gains."
I recommend reading the comments section of the article, it can tell a lot about different people's approaches to trading and risk.
The second example is from a website that is using the strategy cycle after cycle. Here is the quote:
"The Debit Iron Condor is used primarily on stocks that have a long history of big moves when announcing their quarterly earnings. We have a very good idea of how big the move will be, in one direction or the other. And the amazing thing about studying history is that history truly repeats itself, and that means a big percentage of wins. The magic works when the Debit Iron Condor is combined with big moves from stocks on earnings day."
The problem is, once again, complete lack of disclosure of the option trading risk. Even if the "history truly repeats itself" 80% of the time, in 20% of the cases when it doesn't, the strategy can lose 100%. Big percentage of wins means nothing if your losers are much higher than the winners, and you can do nothing to control the losers due to IV collapse.
One way to reduce the risk is using more distant expiration instead of the weekly options. The closer the expiration, the bigger the impact on trade. There is a trade off with respect to time, move and implied volatility drop. If the stock doesn't move, the further expiration trade will lose less because there still will be some time value left. On the other hand, if it does move, the gains will be less as well, and you will have to wait longer to realize the full potential.
Unfortunately, we tried this strategy too in 2016, and the results were pretty bad. You can read more here. We don't hold those trades through earnings anymore, but we do use the strategy before earnings and make sure to be before the earnings announcement.
The Bottom Line
If you expect a stock to move significantly but don't want to bet on direction, Reverse iron Condor is a good strategy to implement. The maximum profit and the maximum loss are both predictable, and you can adjust the strikes based on your expectation how much you the price will move.
This strategy can be successfully used for trading stocks with history of big moves. GOOG, NFLX, AMZN, TSLA, BIIB are good candidates. However, earnings are unpredictable, and you need to control the risk with proper position sizing. It is definitely possible to lose 100% with this strategy. I would define it as high probability high risk strategy.
One of the members asked me on the forum if we are going to play GOOG and AMZN with RIC. Based on earnings uncertainty and our bad experience earlier this year, I decided to skip. It was a good call. GOOG RIC would be a 100% loser, and AMZN would be a borderline as well, depending on the strikes.