Reverse Iron Condor
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The reverse (short) iron condor is a limited risk, limited profit trading strategy that is designed to earn a profit when the underlying stock price makes a sharp move in either direction.
|Reverse Iron Condor Construction|
|Buy 1 OTM Put|
Sell 1 OTM Put (Lower Strike)
Buy 1 OTM Call
Sell 1 OTM Call (Higher Strike)
To setup a reverse iron condor, the options trader buys a lower strike out-of-the-money put, sells an even lower strike out-of-the-money put, buys a higher strike out-of-the-money call and sells another even higher strike out-of-the-money call. A net debit is taken to enter this trade.
Limited Profit Potential
Maximum gain for the reverse iron condor strategy is limited but significantly higher than the maximum possible loss. It is attained when the underlying stock price drops below the strike price of the short put or rise above or equal to the higher strike price of the short call. In either situation, maximum profit is equal to the difference in strike between the calls (or puts) minus the net debit taken when initiating the trade.
The formula for calculating maximum profit is given below:
- Max Profit = Strike Price of Short Call (or Long Put) - Strike Price of Long Call (or Short Put) - Net Premium Paid - Commissions Paid
- Max Profit Achieved When Price of Underlying < Strike Price of Short Put OR Price of Underlying > Strike Price of Short Call
|Reverse Iron Condor Payoff Diagram|
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Maximum loss for the reverse iron condor strategy is also limited and is equal to the net debit taken when entering the trade. Maximum loss occurs when the underlying stock price at expiration is between the strikes of the long call and the long put. At this price, all the options expire worthless so the trader is left with nothing except a loss equal to the initial debit taken.
The formula for calculating maximum loss is given below:
- Max Loss = Net Premium Paid + Commissions Paid
- Max Loss Occurs When Price of Underlying is in between the Strike Prices of the Long Call and the Long Put
There are 2 break-even points for the reverse iron condor position. The breakeven points can be calculated using the following formulae.
- Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
- Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
Suppose XYZ stock is trading at $45 in June. An options trader executes a reverse iron condor by selling a JUL 35 put for $50, buying a JUL 40 put for $100, buying another JUL 50 call for $100 and selling another JUL 55 call for $50. A net debit of $100 is taken upon entering the trade.
Suppose if XYZ stock is still trading at $45 on options expiration in July, all 4 options expire worthless. Since the trader had taken a debit of $100 on entering the trade, he suffers a loss of $100. This is also his maximum possible loss.
If XYZ stock is instead trading at $35 on expiration date, only the long JUL 40 put option expires in the money. This JUL 40 put option is worth $500 and therefore the trader's profit is $400 after deducting the initial $100 debit. A similar situation occurs when the underlying stock trades at $55 on expiration date. In this case, only the long JUL 50 call option expires in the money and it is also worth $500.
To further see why $400 is the maximum possible profit, let's examine what happens when the stock price falls below $35 to $30 on expiration date. At this price, both the JUL 35 put and the JUL 40 put options expire in-the-money. The short JUL 35 put has an intrinsic value of $500 while the long JUL 40 put is worth $1000. Selling the long put for $1000 and buying back the short put for $500 still leaves the trader with a net $500. Subtracting the initial debit of $100 taken, his profit is still $400. A similar situation occurs when the stock trades above $55 with the call options.
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 reverse 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 reverse iron condor in that they are also high volatility strategies that have limited profit potential and limited risk.
The Long Iron Condor
The converse strategy to the reverse iron condor is the long iron condor. Long iron condor spreads are used when one perceives the volatility of the price of the underlying stock to be low.
The reverse iron condor spread belongs to a family of spreads called wingspreads whose members are named after a various flying creatures.
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