The iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit when the underlying security is perceived to have low volatility. The iron condor strategy can also be visualized as a combination of a bull put spread and a bear call spread.
|Iron Condor Construction|
|Sell 1 OTM Put|
Buy 1 OTM Put (Lower Strike)
Sell 1 OTM Call
Buy 1 OTM Call (Higher Strike)
Using options expiring on the same expiration month, the option trader creates an iron condor by selling a lower strike out-of-the-money put, buying an even lower strike out-of-the-money put, selling a higher strike out-of-the-money call and buying another even higher strike out-of-the-money call. This results in a net credit to put on the trade.
Maximum gain for the iron condor strategy is equal to the net credit received when entering the trade. Maximum profit is attained when the underlying stock price at expiration is between the strikes of the call and put sold. At this price, all the options expire worthless.
The formula for calculating maximum profit is given below:
- Max Profit = Net Premium Received - Commissions Paid
- Max Profit Achieved When Price of Underlying is in between Strike Prices of the Short Put and the Short Call
|Iron Condor Payoff Diagram|
Maximum loss for the iron condor spread is also limited but significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.
The formula for calculating maximum loss is given below:
- Max Loss = Strike Price of Long Call - Strike Price of Short Call - Net Premium Received + Commissions Paid
- Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying <= Strike Price of Long Put
There are 2 break-even points for the iron condor position. The breakeven points can be calculated using the following formulae.
- Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
- Lower Breakeven Point = Strike Price of Short Put - Net Premium Received
Suppose XYZ stock is trading at $45 in June. An options trader executes an iron condor by buying a JUL 35 put for $50, writing a JUL 40 put for $100, writing another JUL 50 call for $100 and buying another JUL 55 call for $50. The net credit received when entering the trade is $100, which is also his maximum possible profit.
On expiration in July, XYZ stock is still trading at $45. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.
If XYZ stock is instead trading at $35 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put has an intrinsic value of $500. This option has to be bought back to exit the trade. Thus, subtracting his initial $100 credit received, the options trader suffers his maximum possible loss of $400. This maximum loss situation also occurs if the stock price had gone up to $55 instead.
To further see why $400 is the maximum possible loss, lets examine what happens when the stock price falls to $30 on expiration. At this price, both the JUL 35 put and the JUL 40 put options expire in-the-money. The long JUL 35 put has an intrinsic value of $500 while the short JUL 40 put is worth $1000. Selling the long put for $500, he still need $500 to buy back the short put. Subtracting the initial credit of $100 received, his loss is still $400.
Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the iron condor as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.
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The following strategies are similar to the iron condor in that they are also low volatility strategies that have limited profit potential and limited risk.
The Reverse Iron Condor
The converse strategy to the iron condor is the reverse or short iron condor. Short iron condors are used when one perceives the volatility of the price of the underlying stock to be high.
The iron condor spread belongs to a family of spreads called wingspreads whose members are named after a myriad of flying creatures.
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