After Oil’s Bounce Higher Setting an Iron Condor to Capture Income
This strategy has an 88% probability of delivering a 21% profit in just six weeks.
On Monday, we took a timely dip into a bullish position in oil through a diagonal calendar spread in the SPDR Energy Select (XLE) exchange traded fund.
Shares of the Energy ETF jumped some 3% on Tuesday to $80 per share pushing the value of our spread position fully in-the-money and its value from $2.75 to $3.50 in a single day. While a quick profits of $0.75 or 25% in 24 hours is nothing to sneeze at I plan on milking this position for both more capital appreciation and income in coming weeks.
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The Wheels are Greased for More Passive Income
But the sharp snap back rally in oil itself , which has gained nearly $9 to $54 per barrel in the past two trading sessions, sets stage for establishing a much less labor intensive trade that could generate over 17% income over the course of a month. Without having to touch or adjust the position once. Or even having the price of the underlying move.
In fact the best case scenario is for oil to now settle into a range, albeit a relatively wide one, between $38 and $70 per barrel; if it can remain within that generous 56% wide price range for the six weeks you just sit back and collect the big fat premiums currently being offered in the oil related option contracts.
I’m going to use the United States Oil Fund (USO) to set up an iron condor position. This is an option strategy involves simultaneously selling both a put credit spread and call credit spread. One earns the full premium collected from both spreads if shares of the underlying expire between the two strikes sold short.
The exact position I’m going to describe in detail below has a very attractive 88% probability rate of success for returning 21% over a six week period.
Admittedly, that also means there is 12% probability of loss, but the maximum risk is limited to just a $1.65 loss per contract spread.
There are two key items that have created such an attractive set up:
- A wide range and 2) High options implied volatility.
The sharp bounce in oil creates an identifiable range for us to surround the iron condor with a wide room between the spreads.
As you can see from the chart $16 now represents a near-term definitive low. The $21-22 level is first level resistance where both congestion from December and the 50 day moving average current resides.
We want our iron condor to be both below $16 and above $22 to give I room and probability for expiring out-of-the-money and worthless.
The next key to making this an attractive trade is that the implied volatility of the USO options are at their highest level in over 6 years.
This provides nice fat premiums that will give us juicy returns for our iron condor.
Using the options that expire March 20th. Sell a $13/$15 out spread and $24/$26 call spread.
Here are the way the order looks:
-Buy to open USO March $13 put
-Sell to open USO March $15 put
-Sell to open USO March $24 call
-Buy to open USO March $26 call
For a total $0.35 (+/-.05) credit. That is a $35, give or take $5, in premium collected for the total iron condor.
If share of USO are between $15 and $24 — a $9 or 47% range– on the March 20th expiration date you collect the full $35 premium which equates to a 21% return on the maximum $165 at risk.
The 88% probability of realizing this profit rest on the likelihood that both the price of USO and the implied volatility of its options will revert to within three standard deviations of their six month mean. I like those odds.
— Steve Smith