What is an Iron Condor?
An iron condor option is a combination of two option strategies, namely the bull put spread and the bear call spread. This strategy makes profits from a security when we think its price won’t change in the near term.
Unlike other option strategies, the iron condor credits cash in our account immediately. This cash is our profit if the underlying security doesn’t swing up or down significantly. It’s a tricky strategy and is not for novice traders. The iron condor is designed for advanced and experienced option traders.
Let’s get into the iron condor option strategy in detail and understand the advantages and risks of using this strategy in our trading.
How to construct an Iron Condor?
This strategy combines four different options contracts having the same expiration date but different strike prices. An iron condor strategy is constructed by selling an out-of-the-money call option and an out-of-the-money put, while at the same time buying a further out-of-the-money call and a further out-of-the-money put. Due to its similarity with the butterfly spread, the iron condor got its name from the profit/loss diagram that resembles a large bird with wings. The primary reason behind every trader choosing the iron condor strategy is that it typically generates a larger net credit for the same risk. However, it is important to realise that there are many slippages associated with this strategy. These slippages come from multiple purchases and sales of options. These extra charges are because iron condor has four “legs” of trade.
Why Iron Condor?
Traders who don’t expect significant moves from the underlying stock price by expiration and want to limit their risk could consider constructing an iron condor. The advantage of this strategy is that it generates a high premium while limiting potential loss. The broker also could provide an additional margin to support the position as it is limited to just one spread. This means we could get higher returns on our investments.
We cannot forget that iron condor is a limited-risk, limited-reward strategy that only benefits from sideways movements of the security while the strategy is open. Maximum profit is the credit received during the creation of the position. It is earned if the stock does not move much. Precisely, it should expire between the boundaries of the two strike prices.
A loss is incurred in iron condor when the underlying stock price did move substantially and close within the inner strikes of our option. The calculation of loss goes like, the difference between the strike prices of both strike prices multiplied by the contract size minus the premium received at the initiation.
Understanding the maximum profit and maximum loss is crucial to implementing an iron condor trade. Even though the strategy might give a small profit and potential loss may be higher than profit, but the loss is capped. What is more important here is that it is possible to increase the probability of a profitable trade. So even if some of our profit might go off our hands, it is always better to increase the likelihood of a profitable trade.
Iron Condor Example
Let’s say that on June 1, Apple Company is trading at $50. Since it is an iron condor, a trader would have to initiate a multi-leg options strategy. This can be done by buying one July 40 put, with a premium of $0.50, at the cost of $50 (100 shares multiplied by $0.50 premium) and one July 60 call with the same premium at the cost of $50. To complete the iron condor, a trader would also have to sell one July 45 put with a $1 premium and receive $100 premium (obtained by multiplying $1 with 100 shares) and one January $55 call with same $1 premium at a credit of $100. After all of the above transactions, the trader would receive a total of $100. Mathematically, $200 received sold 45 put and the 55 call minus $100 spent for purchasing 40 put and 60 call which equals $100.
The $100 received premium is the maximum profit potential for this iron condor trade. So if stock expires anywhere two sold options, i.e. the 45 put and the 55 call we will get fetch the maximum reward. This is because, at expiration, all the four options would go worthless, and the trader gets to keep the entire premium.
Break-even points: $44-$56
Maximum loss: $400 (expired at $40 or $60)
Maximum profit: $100 (expired between $45 and $55)
It is worth mentioning that even if the underlying stock price expired below $40 or above $60, the loss could not be more than $400. This is how iron condor can be taken advantage of.
Risks associated with Iron Condor
Whenever it comes to trading options with strategies, choosing the right strike price is crucial in making a profit from it. There needs to be a proper distinction between the probability of success and maximum profit potential.
- Significant loss – It is possible from iron condor that one loss could wipe out all of the previous profits. Make sure to practice it on a demo account before trying with real money.
- Limited profit – Although the strategy protects us from unlimited loss, it also limits our profits greatly. The most we get is only the premium itself received while executing orders.
The significant factor to consider before employing this strategy is volatility expectation. Only if there is a belief that a low volatility environment might persist then iron condors can be a powerful limited-risk tool. Hope you understood this options strategy. Got any questions? Ask them in the comments below. Thanks.