With volatility on the rise, iron condors can be a great way to take advantage of higher-than-normal option premiums.
Iron condors can produce a return on stocks that stay within a specified range over the trade period. This can be a welcome change for buy and hold investors.
When looking for a stock with both high volatility and the potential to stay in a range, I came across Caterpillar.
Caterpillar stock is showing an IV percentile of 62%. That means the current level of implied volatility is higher than 62% of all readings in the last 12 months.
On the chart, Caterpillar stock is sitting between the 50- and 200-day moving averages, with plenty of levels of resistance on the upside and support on the downside.
Setting Up The Trade
Let's look at how we might set up an iron condor on Caterpillar stock. It can be set up via a combination of a bull put spread and a bear call spread.
The idea with the trade is to profit from time decay while expecting that the stock will not move too much in either direction.
First, we take the bull put spread. Using the Oct. 18 expiry, we could sell the 300 put and buy the 290 put. That spread could be sold for around $0.90.
Then the bear call spread could be placed by selling the 380 call and buying the 390 call. This spread could be sold for around $0.50.
In total the iron condor will generate around $140 in premium.
The profit zone ranges between 298.60 and 381.60. This can calculated by taking the short strikes and adding or subtracting the premium received.
This is quite a wide range for a stock like Caterpillar.
Because both spreads are 10 points wide, the maximum risk in the trade is 10-1.40 x 100 = $860.
Therefore, if we take the premium ($140) divided by the maximum risk ($860), this iron condor trade has the potential to return 16.28%.
How Trade Could Suffer Losses
If price action stabilizes, then iron condors will work well. However, if Caterpillar stock makes a big move, the trade will suffer losses.
One way to set a stop-loss for an iron condor is based on the premium received. In this case, we received $140, so could set a stop loss at 1.5 times the premium, or around $210.
According to the IBD Stock Checkup, Caterpillar stock is ranked No. 1 in its industry group. It has a Composite Rating of 76, an EPS Rating of 88 and a Relative Strength Rating of 74.
Please remember that options are risky, and investors can lose 100% of their investment.
This article is for education purposes only and not a trade recommendation. Remember to always do your own due diligence and consult your financial advisor before making any investment decisions.
Gavin McMaster has a Masters in Applied Finance and Investment. He specializes in income trading using options, is very conservative in his style and believes patience in waiting for the best setups is the key to successful trading. Follow him on X/Twitter at @OptiontradinIQ
