Selling Options: Strangles vs. Iron Condors

August 30, 2023 Advanced
If volatility levels out after a spike and is expected to fall, this can potentially present opportunities to use selling strategies like strangles and iron condors.

The following content is intended for option traders with substantial options knowledge. If you're not familiar with options, please review our options content for beginners available to Schwab clients.

High volatility1 can be a time of angst for traders as their screens flash with big price swings. Many trading positions may have been put in place in a low-volatility environment, so volatility spikes are often viewed through a lens of dread instead of opportunity. Potential selling strategies after periods of high volatility do sometimes exist. A couple of examples include the short strangle2 and the iron condor3. Let's look at both.

Time value and volatility

When selling naked4 or uncovered options, a drop in implied volatility5 can potentially help traders achieve the trade's maximum profit as it pushes down the value of the options. The risk of selling options is that the underlying security can make big moves in the wrong direction. For example, when a trader sells a call, the trade's risk is that the underlying stock price has no upper limit. In other words, a naked call has unlimited risk and this type of trade can only be done in a margin account.

Similarly, when a trader sells a strangle—which is the sale of both a call and a put on the same underlying security with different strike prices in the same expiration—the risk is also unlimited. One way to hedge that risk is to create an iron condor instead.

  • Short strangles: The sale of a put and a call with different strike prices and in the same expiration. Typically, both are out-of-the-money (OTM), with the call having a strike price above the underlying stock price and the put with a strike price below the underlying stock price.
  • Iron condor: A four-legged strategy that combines a short strangle with the purchase of a further OTM put and a further OTM call.

Let's put some numbers to it. The option chain below shows puts and calls for a stock that was trading around $193 at the time. In a typical short strangle, the trader would sell an OTM put, like the $190 strike for $3.65, and an OTM call, like the $195 strike for $4.05. The total premium collected, excluding transaction fees, is $7.70 or (because the multiplier for a standard options contract is 100) $770 per short strangle. Keep in mind, however, the trader has unlimited risk on the upside and large risks to the downside on this type of trade and typically a small window of profit potential.

To sell naked options, the trader must have approval and sufficient margin in the account (typically a percentage of the underlying security's value) and the amount could change if the price of the underlying makes a substantial move. Any increase in margin requirements due to an adverse move in the underlying stock is known as maintenance margin.

An option chain that includes fourteen contracts, including a 195-strike call for $4.05 per contract and a 190-strike put for $3.65 per contract.

Source: thinkorswim® platform

For illustrative purposes only.

On the other hand, if the stock stays near $193 and within the two strike prices, time decay will steadily erode the value of the options and the contracts will likely expire worthless at the expiration. Any decline in implied volatility in the options prior to expiration typically helps the short strangle as well. Keep in mind though, that short options can be assigned at any time up to expiration regardless of in-the-money (ITM) amount. If assigned, the trader would likely end up with a long or short position that they did not intend to have. If the trader ended up long the stock, it could theoretically drop to $0 value. Their max loss would be up to the full amount of the price of the stock, minus the net premium received, plus transaction fees. If the trader ended up short the stock, their loss could be theoretically unlimited as there is no limit on how high the stock might go before they bought to close out the position.

What if the stock starts moving beyond the strike prices? In that case, the short strangle can still be profitable if the stock moves beyond the higher or lower strike price before expiration. However, if the stock moves beyond one of the two breakevens at expiration, the position will likely show a loss. On the downside, the breakeven at expiration is the put's strike price minus the premium and, to the upside, it's the call strike price plus the premium. In this example, excluding transaction fees, the breakevens are $190 – $7.70 and $195 + $7.70, or $182.30 and $202.70.

Now let's consider an iron condor using the same short strangle as the "body" of the spread. Traders often refer to the body when talking about the short (middle) strikes of an iron condor and the "wings" for the two long strikes. In addition to selling the 190-strike put for $3.65 and the 190-strike call for $4.05, they buy the 185-strike put for $2.15 and the 200-strike call for $2.20. They collect $3.35 (or $3.65 + $4.05 – $2.15 – $2.20 = $3.35), or $335 for one iron condor, or half as much as the premium on the short strangle.

An option chain that includes fourteen contracts, including a 195-strike call for $4.05 per contract, a 200-strike call for $2.20, a 190-strike put for $3.65 per contract, and a 185-strike put for $2.14.

Source: thinkorswim platform

For illustrative purposes only.

The expiration breakevens are calculated the same way as with the short strangle. On the upside, it's the short call strike plus the premium, or $195 + $3.35 = $198.35. To the downside, it's the short put strike minus the premium, or $190 – $3.35 = $186.65. Compared to the $182.30 to $202.70 range for the short strangle, the stock doesn't need to move as much for the iron condor to begin losing money. Stated differently, the short strangle has a higher probability of profit.

However, with less premium comes less risk. The iron condor can be viewed as a short call vertical spread6 and a short put vertical spread. In a short call vertical, a trader sells a short call and buys a call with a higher strike. The purchase of the higher strike call hedges the unlimited risk associated with holding a short naked call. The same is true for the short put vertical, where the trader sells a put and buys a put with a lower strike.

In the example, rather than theoretically unlimited risk like with the short strangle, the risks of the iron condor are typically limited to the difference between the two strikes minus the credit received, which is $5 - $3.35 = $1.65 or $165. Therefore, although the breakevens aren't as wide and the probability of profit is less with the iron condor compared to the short strangle, the potential risk went from unlimited to $1.65 or $165.

Understanding the difference between iron condors and short strangles

Options trading isn't for everyone. Each strategy should be considered in terms of risks and potential rewards. For example, assignment risk is another important consideration because short options can be assigned at any time up to expiration. Because of assignment risk, the short strangle should only be considered by qualified traders with very high tolerance for risk. Additionally, these qualified traders should ensure they have the time needed to keep an eye on the markets. All options trading, especially these strategies, require close monitoring.

While the greater risk and higher margin requirements of the short strangle can be seen as a disadvantage, the greater premium and higher probability of profit can also be viewed as a potential benefit if the trader is able and willing to take on the much larger risk; putting capital to work in multiple iron condors rather than one short strangle can potentially increase portfolio risk and fees because of the greater number of trades.

Unlike the iron condor, however, the short strangle is marked by unlimited risk. While a trader would only need enough margin to cover a portion of the maximum loss to enter a short strangle, a fast, unexpected move in a stock can create additional margin requirements and result in larger losses than anticipated. The iron condor, on the other hand, will typically have limited risk and lower margin requirements that are determined by the estimated risk of the trade when the position is opened.

As always, returns, risk, and transaction fees should all be weighed carefully when deciding how to employ capital toward any options strategy.

1Volatility (vol) is the amount of uncertainty or risk of changes in a security's value. This concept is based on supply and demand for options. Higher demand for options (buying calls or puts) will lead to higher vol as the premium increases. Low demand or selling of options will result in lower vol. Vol in its basic form is how much the market anticipates the price may move or fluctuate.

2Strangles are a trading position involving an equal number of puts and calls in which the puts and calls have the same expiration and underlying asset but different strike prices. When both options are owned, it's a long strangle. When both options are written, it's a short strangle.

3An iron condor is a defined-risk short spread strategy constructed of a short put vertical and a short call vertical. You assume the underlying will stay within a certain range (between the strikes of the short options). The goal: As time passes and/or volatility drops, the spreads can be bought back for less than the credit taken in or expire worthless, resulting in a profit. The risk is typically limited to the largest difference between the short and long strikes of either the calls or the puts minus the total credit received.

4Naked options is a trading position where the seller of an option contract does not own any, or enough, of the underlying security to act as protection against adverse price movements.

5Computed using an options-pricing model and expressed as a percentage, implied volatility reflects the market's perception regarding the future volatility of the underlying asset.

6A vertical spread is an options position composed of either all calls or all puts, with long options and short options at two different strikes. The options are all on the same stock and of the same expiration, with the quantity of long options and the quantity of short options netting to zero.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Supporting documentation for any claims or statistical information is available upon request.

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